Bigger = better? You bet it is
This perspective has been written for CEOs at CPA firms doing $50 million to $100 million in annual revenue with quality profits per partner who want to make their firms bigger, better, stronger and more profitable.
While conventional wisdom tells us that better is better, that’s plain and simple nonsense when it comes to midsized CPA firms and a convenient excuse for less than stellar growth by a firm’s partner group. Look at “better” through the lens of the marketplace for both existing and prospective clients and talent.
To the marketplace there is no doubt that bigger is better, and that means size sells and matters. Make no mistake about it. Your existing and prospective clients and people respect big, and more importantly, they buy big, known brands. The supposition is that if you are big, you must be good. If you are big, you must have client and people credentials that are impressive, and those credentials attract better-quality prospects and people. With better clients and talent and a brand that is known for certain niches, your firm has pricing power when it comes to fees. That translates into better profits per partner. At the end of the day, our scorecard is profits per partner.
So, while you might not like to hear it, to the marketplace, if your firm is big, it’s an easier buy for them than if your firm is better. Even though your firm might be better, if the marketplace doesn’t recognize your brand, there’s always going to be buyer skepticism. And you don’t need buyer skepticism in making the sales pitch. Ever hear of the old saying, “Nobody ever got fired for buying IBM”? Sure you have. We all have heard it many times over the years. Same is true with accounting, tax and advisory services.
Now that is not to suggest your firm doesn’t need to deliver on the sales pitch with quality services. Of course you do. It makes absolutely no sense to bring clients in through the front door and have them leave you through the back door.
If you’re not growing into a bigger, better, stronger and more profitable firm at an acceptable rate (say 8 percent per annum, which is very difficult to do organically in this economy), there’s no better time than today to jump all over the many merger opportunities bubbling out there as founding partners (baby boomers turning 65 every eight seconds since 2011) pursue exit strategies.
More than one out of every two midsized CPA firms is either discussing a merger combination or is planning to do so soon. In many cases, this is occurring because CEOs are not confident in the leadership talents and financial wherewithal of younger partners. In many other cases, it’s occurring because these firms are unable to attract and retain talent. And in still other cases, these firms are finding they’re not able to hold onto their growing clients as they seek capital. In 2016 alone, over 200 firms merged up. At this pace, a very large percentage of the approximately 14,000 multi-partner CPA firms (about 90 percent of which are under $10 million in revenue) will be looking at an upward merger in the next few years.
Let’s take a deep dive into what you need to know about merger combinations, which are as much about the addition of talent as they are about the addition of clients.
CPA Firm Valuations
The two typical valuation components in most merger combinations are capital and goodwill.
• Capital is straightforward. It is a firm’s accrual-based capital adjusted for the fair market value of fixed assets, work in process and receivable reserves. It is paid as cash or a note (in some cases the note bears interest), over a relatively short term.
• Goodwill is always expressed as a multiple of revenue; the generally accepted value of goodwill in the old days (circa 2001 to 2007) used to be one times revenue, but today, as profits have declined, CPA firm valuations average about 80 percent of revenue. Partners of the merged-in firm allocate firm valuation by using a “multiple of compensation” model based on relative partner compensation over a period of three to five years. Average compensation is then multiplied by a factor to arrive at a partner’s share of goodwill that is paid out upon retirement over five to 10 years. Some firms also provide an option to younger partners (i.e., offering the retirement benefit or deferred compensation plan offered to existing partners).
Approaching the Market
When approaching the market, most CPA firms retain a professional consultant who has significant credentials with M&A and strategy. Fees generally are structured as follows:
• An upfront retainer, plus monthly progress bills and reimbursement for out-of-pocket costs.
• A significant contingent fee paid upon closing for identifying potential candidates and for assistance in closing the transaction. It mirrors the “Lehman formula” summarized below:
|Cumulative Fee ||Purchase Price |
|5% of || |
The first $1,000,000 of firm revenue, plus
|4% of || |
The second $1,000,000 of firm revenue, plus
|3% of || |
The third $1,000,000 of firm revenue, plus
|2% of || |
The fourth $1,000,000 of firm revenue, plus
|1% of ||Any amount in excess of $4,000,000 of firm revenue |
Identifying Viable Candidates and Working the Circuit
Identifying candidates can be an exhausting process for the CEO so it’s important to define what should and should not be looked at. Some potential targets, local “tuck-ins,” will be obvious because of local geography. Other potential targets are more strategic and require that the “circuit” be worked. Once you have determined the desired geographic markets and strategic add-ons, you have to make contact, develop a relationship with the targets, and narrow the candidates down to one or two firms.
Making Sure It Feels Right
Before you decide whether to proceed to due diligence or not, you need to make sure the targets feel right by chatting with the senior partners about respective histories, cultures, “sacred cows” or deal-breakers in a possible transaction and the potential upside and synergies that might be derived. This is the magic sauce that will make a potential merger combination very exciting. Once the senior partners get comfortable with each other, the next step is to create broader buy-in through a meet-and-greet with all the partners from both firms and establish several committees that focus on integration of the different areas in the practice:
• Human resources and continuing education
• Information technology
• Marketing and sales
• Finance and accounting
• Partner matters
Due Diligence, Closing the Transaction, Integration
Due diligence consists of three components:
• Culture fit (very important)
• Commitment to technical excellence and quality client service
• Kicking the financial and operational tires
When it comes to kicking the tires, most firms use a CPA firm combination program that drills down into the operational aspects of the target. Once potential deal-breakers have been successfully dealt with, attorneys draft a letter of intent, followed by a detailed combination agreement. The easier part of a merger combination is getting the contract signed; the harder part is the integration of the two practices, which typically takes about two years.
From an acquirer’s perspective, there are wonderful opportunities to grow firms through merger combinations. As long as the marketplace buys bigger is better, there is no better time than now to capitalize on the opportunities. A word of caution, however: No matter how tempting it may be, don’t do a merger combination if 1 + 1 doesn’t at least = 3.