The art of the deal
The last several years have seen a “merger frenzy,” with small and midsize CPA firms (with annual revenues between $10 million and $24 million) getting acquired by larger CPA firms that have a strong brand and a track record of average to above average equity partner profitability. Meanwhile, there has been considerable “consolidation” among firms with annual revenues between $25 million and $100+ million.
The “merger frenzy” and “consolidation” will continue (at least in the near future) because of a combination of the following challenges:
- Since the 2008 financial crisis, there has been a decline in equity partner profitability because of slow organic growth;
- The inability to find experienced, professional talent;
- An aging baby boomer population, with senior partners (significant generators of new business) retiring at a significant pace;
- The concern about significant technology and HR investments and their drain on profitability;
- The transformation (occurring as firms pursue higher-margin lines of business) from the traditional CPA firm model to a professional services firm model that requires significant investment for talent and acquisitions;
- The need to shore up partner talent, credentials and the ability to compete for larger clients; and
- Leadership succession issues.
As a result, there is a good chance your CPA firm, either as an acquirer or acquiree, will entertain a strategic transaction or deal in the near future.
The practice payment (i.e., the price paid) for CPA firms with annual revenues between $10 million and $100+ million is based on a multiple of annual revenues (usually ranging between 75 to 100 percent, although there are exceptions both below and above this range). The multiple varies and depends on the bottom-line profitability percentage distributed to the equity partners.
For smaller firms, with annual revenues below $25 million, experience has demonstrated that many of these firms face serious succession issues and usually require some upgrade in partner talent, audit or tax quality, size and profitability of clients, IT systems, marketing, etc. The expectation is that a firm’s bottom-line profitability percentage (distributed to the equity partners) usually ranges between 37 to 50+ percent (although there are exceptions both below and above this range) as the partners, on average, have between 1,500 and 1,800 annual billable hours.
Typically, if a $20 million firm with 40 percent equity partner profitability is acquired, the practice payment would be about $20 million. If a $20 million firm with 60 percent equity partner profitability is acquired, the practice payment would be about $24 million.
For firms with annual revenues up to $100 million, experience has demonstrated that many of these firms want to be associated with a larger brand to shore up their partner talent and client credentials and to enhance their ability to compete for larger clients. Succession issues are also a concern, but usually to a lesser extent than at firms with annual revenues below $25 million. The expectation is that a firm’s bottom line profitability percentage (distributed to the equity partners) usually ranges between 32 to 37 percent (although there are exceptions both below and above this range) as the partners, on average, have between 1,200 and 1,500 annual billable hours.
Typically, if an $80 million firm with 37 percent equity partner profitability is acquired, the practice payment would be about $80 million. If an $80 million firm with 60 percent equity partner profitability is acquired, the practice payment would be about $96 million.
CPA firm merger frenzy and consolidation are also likely to continue because acquirers need talent and critical mass to fund their investments and compete in the marketplace. The transactions are usually structured as asset purchases. Generally, acquired firm partners will join the acquiring firm as either equity or non-equity partners with the rights and obligations set forth in the acquiring firm’s partnership agreement, except as expressly amended in their respective agreements in supplement. The partnership agreement contains customary restrictive covenants as to clients and employees after a partner leaves the firm.
Individuals admitted as equity partners will make varying amounts of capital contributions (risk capital) per the terms of the acquiring firm’s partnership agreement (usually about $100,000 upon admission and up to $350,000 over time, with annual contributions after the initial $100,000 at 6 to 10 percent of compensation, along with the right to prepay up to $350,000 at any time). The proceeds from the purchase of the acquired firm’s fixed assets can be credited toward capital contributions. Interest is paid on capital contributions at about 10 percent per annum.
Aggregate compensation to acquired firm partners during the two years after closing (the “guarantee years”) will be guaranteed at not less than their aggregate compensation for the year prior to closing, provided the overall acquired firm revenues and profit are maintained at the same level as for the year prior to closing. Compensation would be reduced pro rata in the event of a decrease in revenues and/or profitability. Acquired firm partners will be considered for discretionary bonuses should revenues and/or profitability increase. Compensation would be allocated among the acquired firm partners in such manner as the acquired firm representatives determine, subject to the acquiring firm’s right of reasonable review.
Compensation would be paid according to the terms of the acquiring firm’s partnership agreement and the compensation plan, with the anticipation, however, that during the guarantee years, no newly admitted partner would receive after-tax cash flow at any point during the year (assuming target revenues and profitability are met) less than after-tax cash flow received during the year prior to closing
Acquired firm partners will receive a practice payment that would be allocated among the acquired firm partners prior to closing in such a manner as the acquired firm representatives determine, subject to an acquiring firm’s right of reasonable review. Each acquired firm partner would be entitled to receive their benefit upon withdrawal from the acquiring firm (provided the partner has remained with the firm a minimum of four years), paid over 10 years from the date of withdrawal. The acquired firm partners would be eligible for consideration for vesting into the acquiring firm retirement plan (in lieu of the practice payment provided for above) based upon future performance.
The “art of the deal” is a sensitive negotiation between buyers and sellers. The best deals are cut when there is both an educated consumer as a buyer and an educated consumer as the seller, and there is an understanding that there has to be reasonable give and take. A deep understanding of the prices paid and the important terms and deal points will create efficiencies in the transaction process, which usually is filled with starts and stops and can take months before closure is attained.