The art of the deal: An M&A transaction
While merger mania between CPA firms has been occurring for the last several years, for every transaction that is consummated, personal experience tells us there are at least two that die at the altar. Further, there is at least one in 10 chances (if not slightly more) that every consummated transaction winds up in a divorce within a short period of time.
An M&A transaction is not for every CPA firm and is an acquired taste. It truly is an art to negotiate a deal to the mutual satisfaction of both firms. It takes time to master the juggling and negotiating skills, patience and leadership necessary to successfully navigate through the obstacles (sand traps and pitfalls). While there many obstacles to navigate, culture and valuation are the two that most often thwart potential transactions. This is why culture compatibility and a good understanding of valuation expectations are so important. Without them, deals fall short of expectations or never see the light of day.
A firm’s culture is the accumulation of shared values, beliefs and behaviors that determine how partners and staff carry out day-to-day tasks such as managing and governing the practice, serving clients, and attracting and retaining talent. It has three key prongs:
• The behaviors of the CEO, senior management and staff;
• The capabilities and decisions about where and how to compete; and
• A firm’s operating and governance models that are core to how it functions on a day-to-day basis.
Valuation is often referred to as the practice payment. It is what the larger firm believes the merged-in firm is worth in the market place. It also has three prongs: price, payout terms and financing.
The art of negotiating between the two firms’ cultures lies in understanding where the clashes or differences exist. Clashes usually take considerable time before they bubble up to the top of the “we have an issue” heap. When it comes to determining culture compatibilities, many firms talk about a few cultural similarities as proof of compatibility, but cheap culture talk often fails to help firms navigate through the difficult task of dealing with potential culture clashes.
To successfully deal with culture, an assessment of culture compatibilities should be an area of concentration (not a gloss over or an afterthought). This assessment is usually addressed in the due diligence process. My advice is to give mutual culture due diligence the same type of timely priority as financial, operational and legal due diligence. Have the CEO and other senior management (at both firms) drive culture due diligence and subsequent integration. It’s that important! Don’t delegate this important task to the human resources department or, worse yet, have it outsourced to an outside consulting firm.
Use some simple tools to diagnose the potential problems. Observe different ways of working, particularly when it comes to quality control. Hold key interviews and small group dinners to determine how the other firm interacts among themselves and if you would be proud to hold out the other partners at the other firm as your very own. This is commonly referred to as the “beer” or “cigar” test.
Determine the culture you want to see. The larger firm usually has two choices here. It can assimilate the merged-in firm into its culture or it can create a blend of the cultures at the two firms. Depending on the facts and circumstances, either approach is viable.
Develop a culture change plan, and sustain and measure its progress. Be astute in developing transaction communications relating to cultural matters. Both the substance and timing of messages are very important. Senior management at both firms need to be tuned into managing expectations and anxieties while shaping workforce behavior in the desired cultural direction.
Many CPA firm partners believe deals fall apart because of economics, but while economics are clearly important, this conclusion is a myth as financial considerations are usually flushed out quickly. If there isn’t a meeting of the minds, deal discussions shut down. Little ventured, little gained.
Valuation can be successfully negotiated if two firms believe that 1+1=3 and that they can have greater success in the marketplace if they are together rather than apart. “Expectation gaps” in valuation, on the other hand, are oftentimes why deals never get traction. This is why it’s so important to understand, as you go into a negotiation, what the marketplace says a firm is worth. If you are misinformed about valuation, you may be passing on an opportunity that you should not be passing on.
Today, while some say it’s a seller’s market because so many of the larger firms are hungry for growth that isn’t coming organically, that’s not necessarily the case. Many CPA firms are looking to sell, either because of an aging partner group or a lack of confidence in the next generation. As a result, it’s a buyer’s market. Obviously, when you have a buyer’s market, valuations usually soften.
Expect your firm to be valued somewhere between 80 to 100 percent of net revenues, unless you are a fixer-upper (in which case you probably will be offered less), or if you are an extremely profitable firm (in which case you probably will be offered more). Some of the larger firms won’t pay more than what they provide for fully vested equity partners, which is usually two to three times average compensation over the three highest years. For example, if the larger firm’s retirement plan calls for three times compensation and the merged-in firm is doing $10 million in net revenues and $3 million net earnings to equity partners, the larger firm will not offer more than there $9 million in valuation (three times $3 million).
Whatever the valuation, most larger firms will want to make the practice payment over 10 years and use the merged-in firm’s net current assets as the financing vehicle for the transaction. This is what the merged-in firm should expect as they enter into a negotiation. If that’s acceptable, the other potential challenges can be dealt with successfully.
There are many other reasons transactions don’t get consummated or break-up shortly after consummation. These include:
• Egos of senior partners;
• Different views on governance, autonomy and accountability;
• Concern that it “may not work” so why take a risk;
• The larger firm decides the pain to integrate is greater than the gain to be realized, and isn’t willing to invest the time and effort to see if 1+1=3;
• Lack of effective leadership in taking partners through the decision tree from initial transaction identification to transaction consummation;
• Too many partners who are willing to torpedo the transaction;
• Disagreement among the merged-in partners on how to cut up the practice payment;
• Amount of retirement obligations at both the larger firm and the merged-in firm or at either firm;
• Dissimilar retirement and compensation plans.
These issues can be successfully dealt with if you take into account the culture and know what to expect as to valuation. If you can’t artfully address the two “biggies,” it’s better to call off the marriage than go through a divorce, or worse yet, live together in disillusionment and frustration.