Should you fund your firm through partner capital or bank debt?
Small and midsized CPA firms often ask about best practices when it comes to funding their operations. Should they fund operations through partner capital, bank debt or a combination of both?
By way of background, I believe a firm should maintain its books and records on both an accrual basis (which is meaningful when matching gross production to costs of delivery) and on a cash basis (as the methodology for distributing partner compensation). It should also compensate all partners and file firm tax returns on a cash basis. Firms should provide all equity partners, upon retirement, a deferred compensation/retirement benefit plan and the return of their cash capital contributions. You’ll note that I did not mention that upon retirement, firms should provide each equity partner their share of the firm’s accrual capital. When added to the deferred compensation/retirement benefit plan, an additional distribution for a share of the firm’s accrual capital often cripples a firm.
Some firms provide partners both their share of the firm’s accrual capital and a deferred compensation benefit upon retirement, but that amount of payout is generous and beyond that offered at many of the best firms in the U.S. Accordingly, I maintain it’s not either necessary or in the long-term best interests of the firm to provide each equity partner their share of the firm’s accrual capital upon retirement on top of a deferred compensation/retirement benefit plan.
Firms should also require that every equity partner make an initial investment in the firm (after all, they are partners and owners) and contribute cash capital or “risk capital” upon admission into the partnership. The amount can vary depending on the firm’s size, complexity and operational needs. At smaller firms, initial cash capital for newly admitted partners usually hovers at about $25,000, while at larger firms it can be around $100,000. If the initial cash capital is a substantial amount, the firm usually provides new partners access to a banking relationship that will lend the partner money at the prevailing prime rate. In these cases, the firm usually acts as the bank guarantor of the individual partner loan.
Some firms only require an initial contribution of capital, while others require there be an annual holdback of cash compensation (usually 5 to 10 percent annually until a maximum amount is reached). It’s not unusual to find senior partners at some midsized CPA firms with cash capital in excess of $300,000. As “risk capital,” interest on cash capital is usually paid annually to each partner at an attractive, predetermined rate that is favorable when compared to conservative investment returns (such as U.S. Treasury Bonds) that might otherwise be available.
With that background out of the way, here’s my perspective on the important topic of funding operations. In my opinion, small and midsized CPA firms should fund operations through a combination of
- Partner paid-in capital;
- Seasonal lines of credit to get them through operations during the busy or tax season as work-in-process and accounts receivable build-up (the line is usually cleaned up annually); and
- Long term borrowings for the purchase of fixed assets and leasehold improvements.
Regarding partner compensation, many small and midsized CPA firms use a three-pronged approach of annual interest, monthly draws and discretionary profit allocations:
- The annual interest on a partner’s total paid-in cash capital is usually paid within 90 days following year-end.
- For junior partners, monthly draws approximate 65 percent of a partner’s “targeted” compensation. (While not guaranteed, the target compensation for all partners usually approximates 75 to 80 percent of a firm’s budgeted profit or aggregate, anticipated compensation for all partners.) For a senior partner, monthly draws approximate below 65 percent of a partner’s targeted compensation. For a junior partner, monthly draws approximate above 65 percent of a partner’s targeted compensation. By the way, one of the traps that some small and midsized CPA firms fall into is paying monthly partner draws from a line of credit as opposed to earnings. Many firms lose some of their highest-performing partners and get financially crippled when they play this “game” of paying monthly draws out of a bank line of credit (as opposed to earnings), and therefore I strongly advise against it. If a firm can’t pay monthly draws out of earnings, the partners are either drawing at an unsustainable level, or they aren’t billing and collecting on high-margin work on a timely basis, or perhaps both. Whatever the case, paying monthly draws from a bank line is usually a prescription for a disaster.
- Discretionary profit allocations are generally used to reward exceptional partner performance for high-performing partners and to reward one-time achievements. Stand-out performances are special by their very nature. The firm distributes discretionary profit allocations, minus monthly draws and any capital contribution holdback. As cash flow allows, a large percentage of discretionary profit allocations is distributed shortly before April 15; the remaining percentage is distributed ratably on June 15, Sept. 15 and the following Jan. 15.
When it comes to deferred compensation and retirement benefit plans, most small and midsized CPA firms have arrangements that reflect the following thinking:
- Plans are not funded by current operations. Instead they are funded by future operations. This can be a dicey proposition for individual partners if a firm is not financially sound and properly governed.
- As a general guide, CPA firms are valued at one times annual revenues or three times total aggregate compensation paid to active partners. Equity partners are entitled to a return on their investment in the firm beyond the annual interest on their paid-in capital.
- An equity partner’s deferred compensation or retirement benefit is usually two to three times their annual compensation (computed using the average of the three best years out of the last five years as an active partner).
- Deferred compensation/retirement benefit plan payouts to all retired partners are usually capped at a percentage of total earnings paid to all current partners as it is important for firms not to get too top heavy and burden future partners with an unfunded retirement obligation that can be crippling. This percentage generally ranges from 8 to 12 percent of total earnings paid to all current partners.
Successful small and midsized CPA firms are usually well run from a cash flow perspective if the factors above are adhered to. In today’s environment, firms can potentially run into financial difficulties when they aren’t growing at a 6 to 8 percent annual rate to cover the ever increasing costs of delivery, not the least of which is the bottomless pit referred to as information technology. Don’t fall victim to the “shoemaker’s shoes” syndrome. Let’s practice what we preach to our clients. Keep your eyes on the financial prize and fund your business with prudence.