We have a quantifiable problem. It is creating a problem for some, opportunity for others, and confusion for those remaining. There is a massive value gap with an internal succession versus an external transaction, and the gap is uncomfortably alarming to many firms. Firms who, when they understand their market value, are torn about what to do.
The dilemma for many is emotional. In five short years, the accounting profession has gone from sleepy and stable to dynamic and revolutionary. The Visionary Group has been conducting accounting firm mergers and acquisitions for decades, giving us a front row seat to watch this unfold and be front and center in the acceleration of firm value with the deals we are involved in. Six years ago, transactions were simple. They were a merger with little to no money changing hands or a sale with some cash involved, and firm values ranged from 80% to 120% of revenue collected, paid over five years. That was over 90% of all deals.
Today, the gloves are off. In general, transactions are from 1.5x to 3x revenue with 50-70% cash up front and rolled equity. The traditional unfunded, deferred compensation programs are becoming outdated. The issue is not just the unfunded liability of the deferred compensation buyout, but also compounded the value gap, timing of the cash, and the potential upside of the rolled equity.
A basic example will illustrate the situation. Let us use a $10 million firm with five equal equity partners and a 30% profit margin before any equity partner compensation. Not every firm follows the same process, but this example is common. The partner exit buyout is the average of the partner's compensation for the last five years, the highest and the lowest amount. For example, Partner A makes $400,000, $700,000, $500,000, $600,000 and $800,000 for the last five years. We remove the $400,000 and $800,000 and add the $700,000, $500,000 and $600,000, then divide by three for an average of $600,000.
Take the $600,000 times a multiple of three — it could be 2.5x or 3.5x — for a total of $1,800,000 paid over 10 years. Partner A gets $180,000 a year and their capital account back as well, but they also get their capital account back in an external transaction, so that is a wash. The net-present value of $1,800,000 is about $1,400,000. In addition, it often makes no difference how much Partner A owns. We have seen several programs where the $180,000 in this example is capped at a lower value, resulting in even less for the partner.
To make this simple, we are cutting through the detailed process of how you value a firm in this market, but externally that firm would transact around $15 million to $20 million. Could it be lower or higher? Yes, there are many pieces to calculate a firm's value, but this is just a simple example. Using the lower estimate of $15 million and a typical transaction value of 70% cash and 30% rolled equity, the firm would get $10.5 million in cash and $4.5 million in equity. Assuming all splits were equal, which most are not, Partner A would get 20% of the cash, $2.1 million at closing, and another $900,000 in rolled equity.
The cash at closing alone would be worth more than Partner A would get over 10 years and more than the net-present value of their deferred comp payments. When you add in the equity and factor in the net present value of the cash, Partner A is looking at a buyout worth about 2.2 times of what they would get with an external transaction versus an internal transaction. This ignores all growth of the cash being reinvested and adds zero growth to the equity. Both would just make the gap wider.
That was the conservative estimate of $10 million going for $15 million. If closer to $20 million in purchase price value, Partner A would get $2.8 million in cash at closing and $1.2 million in rolled equity. Partner A's new buyout value would be 2.8 times the internal buyout and again assumes no growth on the cash to reinvest or the equity growth. Every firm may have a different buyout program, but the numbers are compelling. We gave you a middle-of-the-road set of examples.
This is where the problem, opportunity and confusion come back into play. For those wanting to remain independent, are they willing to take less for their firm? Can they restructure their buyout to have the internal team match the external transaction values? The answer to this is no, because it would financially cripple the succession team. Also, do they have the capital, or can they create the internal capital to build the infrastructure needed?
A major swing factor is, will there be profit creation from the automation coming via artificial intelligence? Will that create enough internal capital to close the value gap? The answer is 100% yes. It is just a matter of time, skill sets to pull this off internally, and how much internal capital can be created. Firms need to realistically assess if they have the internal discipline, alignment and accountability to compete for talent, build infrastructure, and transact internally at a lower value.
Money is an obvious factor in favor of being acquired, but money is not the only consideration in a decision. Outside of the financial consideration, most independence decisions center on two key considerations. First is the infrastructure: Does the firm have the succession team, financial capability and leadership to implement the changes needed with artificial intelligence and advisory services? Second, are there better opportunities for employees if they are part of a bigger firm versus staying independent?
This is a process each firm's leaders need to wrap their heads around. For some, it is a clear decision. They do not have the succession team and/or the depth to fund or lead the changes that are coming. Age is a creeping factor in part of that decision. Others may have the pieces and can or have pulled them together. The financial gap may not bother them.
There are "hard ifs." If the succession team is not deep enough, that is a "hard if." You need to consider your alternatives. "If" you feel uncertain about any aspect of your ability to remain independent, you should go through an independence planning process. It will add clarity to your decisions.
