Key considerations and potential pitfalls in accounting firm M&A transactions
As counsel to the accounting profession in mergers and acquisitions, I am frequently called upon to ensure proper diligence, anticipate and avoid roadblocks, and help my clients smoothly and successfully complete significant transactions. While every M&A deal is different, below are some key considerations for accounting firms contemplating a merger.
Partner Dynamics in Merging Up a Firm
The wrong partner dynamics can torpedo (or at least slow down) a transaction. I would say this is the number one issue. It is important to communicate with your partners and work with the acquiring firm to get the partners comfortable. I can remember one transaction where a partner (perhaps because he figured out he was going to lose clout relative to his partners) decided he didn’t like the proposed deal anymore and tried to undercut the transaction by talking it down to other partners. Some partners fear loss of autonomy and new accountability, but that is not the reason they will give for their concerns with the proposed merger.
In another recent transaction, an important partner decided to retire rather than be a partner in a new firm. In yet another recent transaction, the buyer decided it did not want one of the partners because they determined that his work was sloppy. This caused a restructuring of the deal, delay and hard feelings.
Two transactions were stopped in their tracks because the buyers were concerned with a lawsuit against the target firm. They were concerned with the potential for successor liability. While we as counsel to the selling firm did not feel this was a material risk, the buyer did not want to take the chance of being dragged into a lawsuit and the selling firm partners did not want to give an unlimited indemnity to the buying firm against potential costs relating to the lawsuit.
Seller Due Diligence
I often get asked what due diligence the selling firm should conduct with respect to the larger buying firm. Typically, I recommend that the selling firm’s due diligence consist of three things: (a) review of financial statements, (b) review of future retirement commitments to current partners which are not typically reflected on the balance sheet, and (c) review of outstanding litigation.
The litigation is difficult to review because it is very hard to assess the merits of the cases. In addition to the customary indemnification, sometimes we negotiate compensation protection for the incoming partners’ compensation in the event that a lawsuit against the buyer is adversely determined. Due diligence by the buying firm is generally quite extensive and indemnification is fulsome.
Client List Sharing
A question we often get is, “When should the client list be shared?” This issue is more acute when the merging firms are in the same city. Depending on the level of sensitivity, I will recommend sharing, without names, up until a certain point in the transaction.
I may also recommend that there be an agreement that only people in the head office, as opposed to people in the local office, are permitted to review the information.
Retired Partner Issue
From time to time, retired partners may have significant rights. This is especially the case for retired partners who were founding partners. In one case, the retired partners had the right to say no to a sale transaction unless their retirement benefits were paid in full at the time of the transaction. This ended the proposed deal.
In other instances, the retired partners’ notes are required to be paid on a sale, but in most of those cases, the retired partners will agree to the buyer assuming the notes because usually the buyer is a better credit risk. When drafting your partnership agreement, you need to understand the rights that you are granting to retired partners.
Merger of Equals
Mergers of equals often involve additional and more difficult issues. By equal, I mean two firms where the smaller is half or more of the size of the larger. In these cases, the negotiations are often protracted because in essence a new, third firm is being created. There is a lot of discussion around governance as there will be power sharing at every level. There may be compensation protections. There will be burn-off periods for the power sharing and compensation protections.
If the firms have different capital and retirement systems, they will have to be reconciled and there is often grandfathering of certain payment rights for partners who are close to retirement. All these changes result in a new partnership agreement.
Firms, when embarking on the process, often hope to use one or the other firm’s partnership agreement, but I have never seen it work out that way — a new agreement is always required for the reasons mentioned. This is all in addition to the regular transaction considerations and due diligence on both sides, including what software to use, harmonization of manager/staff compensation and billing rates. Furthermore, the partner dynamics become even more acute as partners try to maintain their positions. And sometimes, the most thorny issue, believe it or not, is what will be the new name.
From to time to time I am asked about including a de-merger clause. This would be a provision in a merger agreement that allows one or both parties to “reverse” the transaction for some period of time if it is not working out. Regardless of which side I am on, I recommend against such a provision. My view is that you are getting married and if you decide you want a divorce, you can negotiate that at that time. I don’t think you should go into a relationship assuming it will not work out. Furthermore, a de-merger clause is very difficult to negotiate and creates a lot of negative energy.
Accounting firm M&A transactions are a balancing act — from managing personalities to disclosing client lists to addressing complicated governance issues, merging firms must be focused, diligent and flexible. Hopefully some of the examples and lessons noted above will help you approach a significant sale or acquisition with open eyes.