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Positioning your accounting firm for M&A success

In the world of accounting firm M&A, the numerous issues that could prove challenging and even put deals at risk can at times seem overwhelming.

From evaluating characteristics that are valued in a target firm, to avoiding missteps, let’s take a closer look at what is happening in the marketplace, the primary considerations for firms considering mergers and, where appropriate, discuss best practices.

How Accounting Firm Mergers Work

Most M&A transactions are priced from 80 to 100 percent of annual revenue. However, certain factors will affect that pricing, including profitability, in-place succession and expertise. Most transactions are simply asset transactions in which partners of the smaller firm become partners of the larger firm and the larger firm absorbs the obligations to retired partners. The merging-in partners will have retirement benefits from the larger firm based on the new firm’s retirement formula. Sometimes there is a grandfathering under the old firm’s formula, or credit is given for the time spent at the old firm, especially for the older partners. The merging-in partners will make a capital contribution to the new firm. Occasionally, for tax reasons, you might see a stock deal or a merger; however, more often than not, the larger firm wants to avoid any liability for the prior firm’s obligations, so stock deals are less common.

In seeking a target firm for acquisition, most buyers look for a firm with stable partners and strong profitability. Often, larger firms are looking to increase their geographic footprint in specific markets and will limit their targets to that area. In other instances, they wish to acquire a firm with a niche practice that they currently lack. It can be far easier to acquire a firm where that niche capability already exists than to try to build the same practice organically. And in still other instances, headcount or critical mass is the impetus for growth, the other two factors notwithstanding.

As for firms seeking to be acquired, in my experience, most firms look to merge up because they do not see the next generation of partners as being able to sustain the firm. This impacts their retirement benefits, lateral recruiting and the legacy of the firm. In one instance, a younger partner said he could not do it alone given the dearth of people like him at the firm. Sometimes the firm has clients who require the services of a larger firm or the partners feel that too much work is being referred out or left on the table. More and more firms are identifying technological requirements as being a factor, along with difficulty in recruiting at smaller firms.

Unfortunately, deals can fall apart for myriad reasons. The devil is certainly in the details. I have seen too many deals fall apart before closing because there was never really a deal at the term sheet stage. Things were glossed over that should have been addressed. Other problems arise when a firm agrees to allow retiring partners to dictate what the firm can do after they retire. Sometimes retired partners are given these rights because they insist on assurance that their retirement benefits will be paid; however, these post-retirement rights can hamstring the ability of the firm to do a deal altogether.

Mergers of Equals

Mergers of equals or near equals (let’s say the smaller is 50 percent of the larger) are the most difficult, time consuming and expensive to get done. If done correctly, they can also be among the most successful. Essentially, you are creating a third firm. There is much discussion around governance, as there will be power sharing at every level (from departments to the Executive Committee), and there may be compensation protections. However, there will also be burn-off periods for both the power sharing and compensation protections. No money changes hands. If the firms have different capital and retirement systems, these must be reconciled. Furthermore, there is frequently a grandfathering of certain payment rights for partners who are nearing retirement. Of course, all these changes necessitate a new partnership agreement.

I always recommend that a detailed outline be developed over several meetings. This is in addition to the customary transaction considerations and due diligence on both sides, including what software to use, harmonization of manager/staff compensation, and benefits and billing rates. Partner dynamics can become challenging when partners try to maintain their positions. And sometimes the stickiest issue, believe it or not, is what to name the new firm, with both firms attempting to hold on to their identities.

Assessing Liabilities

We recently had a transaction fall apart after a lawsuit was brought against the target. The buyer was concerned there was potential successor liability and it did not want to assume the risk of being brought in as a deep pocket defendant. A lot goes into a successor liability analysis, though it is often difficult to assess risk or even the merits of a lawsuit. On the other hand, we had a similar matter where the buyer was more aggressive and was willing to try to find a way to get additional coverage against the suit. Typically, the acquirer’s insurance will not protect it against successor liability, but will defend you.

Conversely, if the acquiring firm is involved in a lawsuit, there are steps it can take to make its target more comfortable with the situation. The buyer can discuss the case and share an analysis of the risk exposure. Diligence on their insurance coverage can be conducted. Finally, in addition to being indemnified against the claim, we have negotiated a provision saying that if the firm had to come out of pocket to fund a settlement or a judgment, the merging-in partners’ compensation would not be impacted.

De-merger Clauses

I am sometimes asked about including a de-merger clause in a transaction. This is an agreement provision that allows one or both parties to “reverse” the transaction for some period of time if it is proving problematic. Regardless of which side of the transaction I am on, I counsel against such a provision. The analogy I usually give is that if you are getting married and you decide you want a divorce, you can negotiate at that time. You should not enter into a relationship assuming it will not work out. Additionally, a de-merger clause is very difficult to negotiate and creates a lot of negative energy. Once you start to discuss the elements of a break-up, all sorts of issues come into play: who controls client relationships, does staff stay with one firm or another, and what about new hires, new equipment and jointly developed clients? I had one significant transaction fall apart due, in part, to the inclusion of a de-merger clause. It was not the stated reason, but there was so much lost confidence and trust in the transaction that the relationships between the managing partners deteriorated and then a small thing did it in. As with every general rule, there are always exceptions — a de-merger clause, limited in time, might make sense when a smaller firm is bringing in a sole practitioner, for example.

AT-112017-Merger Plans

Partnership Agreement Issues

Buy-in: Most firms will require a set payment for a new partner who has risen through the ranks. It is typically $50,000 or $100,000, payable over time. Some firms will require a buy-in based on the value of the firm or link it to compensation. In merger situations, the capital needs of the merged-in business will need to be met. This is typically done by requiring capital similar to what the old business needed or what the larger firm requires.

Retirement issues: Most firms have mandatory retirement at or around the age of 65, though larger firms may have younger ages. Merged-in partners will generally be given more flexibly, especially if their firm had an older age. Firms must, however, be very careful about applying mandatory retirement to income partners, who are typically viewed under employment laws as employees and not owners, subject to age discrimination laws. The laws on age discrimination provide an exception for owners. While there used to be a trend against post-retirement adjustments for loss of business, lately we have seen more firms wanting the right to give a retired partner a haircut if a significant amount of their business is lost soon after retirement. This is not the majority view. In merger deals, you will often see this haircut as it applies to retirement benefits.

We usually see at least a one-year notice requirement for early retirement. If insufficient notice is given, or the partner fails to follow a transition plan, the executive committee typically has the authority to reduce the payout by up to 25 percent. This is generally in lieu of a provision that reduces benefits if business is lost.

Guaranteeing compensation: In my view the standard for acquiring firms is to guarantee compensation for one to two years. Usually, there is a minimum amount of business that must be maintained in order for this to be effective, generally around 95 percent of prior year revenue.

Violations of restrictive covenants: Most firms have a liquidated damages provision, meaning there is no need to prove the amount of damages, and a firm will have something to work off of when negotiating a deal. If a client doesn’t want to stay with the firm, then they should be able to be purchased. Maintaining a realistic view is essential. I have seen firms use 200 percent, but this is hard to enforce and could invalidate an entire clause. We try to stay in the 125 percent range, which is more likely to be enforceable. We also prefer arbitration as a means of keeping these things out of court. In a slightly different vein, when accounting firms acquire other types of businesses, like software or cloud based platforms, we may actually ask for non-compete agreements.

Russell Shapiro is a partner at Levenfeld Pearlstein LLC in Chicago. He has practiced for 25 years as a corporate and M&A attorney. Prior to that, he took and passed the CPA exam (but did not practice). Based on his work in accounting firm M&A and accounting firm partnership agreements, he was named to the Top 100 Most Influential People by Accounting Today in 2017.

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