Workshopping a Typical Deal

Veteran deal-maker, Phil Whitman, will take accounting firm leaders through the structure of a "typical" private equity deal to discuss important issues like price, rollover equity, levels of control, the "scrape" and how partner compensation is handled after a deal, and much more. The first part of the session will deal with smaller firms, and the second part with midsized and larger deals.

Transcription: 
Transcripts are generated using a combination of speech recognition software and human transcribers, and may contain errors. Please check the corresponding audio for the authoritative record. 

Phil Whitman(00:08):
Can everyone hear me? Okay? Wonderful. So Bob did a wonderful job, Bob, I mean that sincerely. I'm going to take you through a private equity transaction, but first I want to say why am I up here? Who am I? I'm Phil Whitman, the CEO of Whitman Advisory. We just went through a rebranding. Check out our new website, https://www.google.com/search?q=whitmanadvisory.com. I've been doing this for about 18 years now, and I am passionate about it. Our team focuses on M&A. We're very entrenched in this private equity arena. We've closed over 45 transactions with private equity and CPA firms. This year, we closed 24 transactions—four of them CPA firm to CPA firm. The rest of them were either private equity, family office, or wealth management firms. It's just pretty amazing. Thank you. Oh, by the way, is this the thing I use to change the slide? Okay, wonderful, thank you. So my wife told me when I get up here, don't sway and don't walk all over the place. People are going to get dizzy and nauseous. So don't mind me if I just stand here, but I may start to sway.

(01:37):
In any event, where do I point this? It's like Baskin Robbins, only it's worse. Not only who you can go with, but the different models. Are you taking a rollover equity at Topco along with everyone else or are you taking it at the local level, and what's the deal with working capital? But if you take a look at that, there's so many different flavors out there for you. I'm going to give you a little bit of an overview. For this example, we're going to say the CPA firm has revenues of $8.2 million. There's five equity partners. Current net income that's distributed is very, very profitable—46%, roughly $3.8 million. They're looking to explore private equity and other strategic investors.

(02:38):
This is what the partner group looks like. We've got a 67-year-old partner, a 57-year-old partner, a 63-year-old partner and so on, and they have very nice compensation. One of the things that you'll notice is that the two younger partners were given a token amount of equity as a retention strategy. This would be a great firm. Private equity might drool over this because they look at those two young partners and they see continuity and succession, but they make a lot of money at this firm. There's something called a "scrape." For those of you that don't know, a scrape is not like when you fall down and skin your knee; it's saying, "We're going to take what you're earning because CPA firms typically don't have EBITDA." If I'm making $1.2 million a year, that's my compensation.

(03:44):
But what these strategic investors are going to do is come in and say that to replace you—and this is a big "if" there was someone out there in the marketplace—it might cost us $350,000 or $400,000. That number is variable. But for this particular example, the private equity group is going to estimate replacement costs at $350,000 per partner. A full scrape would create a little more than $2 million in additional EBITDA. But partner number three says, "I can't live on $350,000. I need to earn $450,000." Partner number five has always felt undercompensated. We feel in order for him to stay, we're going to need to give him a token increase in compensation. In this case, we've decided to give him a $22,000 raise, and there are going to be other adjustments made to this leave-behind EBITDA.

(04:52):
Now we look at the post-scrape compensation and we see that the managing partner who was making almost $1.4 million is now at $350,000, and our highest-paid partner is at $450,000. The youngest guy who was complaining, whom we knew we needed to take care of, is at $372,000. By the way, if you have any questions, I've tried to lay this out in a simple fashion so that everyone understands. That base scrape has created a little more than $2 million of EBITDA, but remember, we need to adjust for partner number three and partner number five. Last year they did a big technology implementation that cost $185,000, and that's an expense that's not going to be recurring. So we're going to add that back. There was a non-equity partner that they had a five-year deal with. They were paying him $250,000 a year; that's also going away. There was some interest expense on a note used to acquire his practice. That's going away because this transaction is going to be done on a debt-free basis. Whatever debt is owed is going to be paid off. If there were retired equity partners they were still paying, they would pay that off as well.

(05:55):
Now we're going to take a look at that total transaction value. When I first saw a transaction I was involved with three years ago, my jaw dropped. I was working with a $6.3 million firm in New York City. That firm had a 67-year-old managing partner and a 63-year-old second partner, with no future partners in the ranks—just a great staff of about 18 folks who were loyal and came to work every day. They had a trophy client that generated anywhere from $750,000 to a million dollars a year of that $6.3 million. Long story short, they ended up with $7 million at closing, a $5 million seller note (that's $12 million), and a $3 million earnout (up to $15 million). Then, to be nice guys, this private equity group said, "Instead of paying the two of you $1.1 million a year—which dropped about 50% to the bottom line—we're only going to pay you $600,000 a year." Why? Because they said, "We're going to take $500,000 for the next five years ($2.5 million) and add it to total enterprise value so that you get capital gains treatment." Imagine that: $17.5 million total enterprise value for a $6.3 million firm. This managing partner two years earlier was hopeful he would get a multiple of one. In this particular example, we've got debt-free entity value of almost $21 million, and this private equity group is going to acquire 60% of the firm, or $12.3 million.

(08:48):
If you think about this, an $8.2 million firm is not worth $8.2 million. It's worth $20-plus million, which is a pretty amazing payout structure. Regarding cash at closing: I've seen transactions where some firms start at 25%, some at 40%, and we've had some that paid 60% at closing after negotiation. But on average it's 50%. That's what we're going to use. In this particular case, there's no earnout. They're going to receive a seller's note for five years: $6.2 million at closing and $6.2 million paid out over five years. In some cases, they will receive a nominal interest rate on that deferred portion. In many transactions, that deferred portion may be subject to attaining certain goals, but as Bob said, those goals are typically low bars. In three years of doing this, I have never had a transaction where a seller did not meet the hurdle of getting the additional payment.

(10:15):
This is the "money slide." This is what everyone gets at closing. If you look at the two younger partners, you might say, "Wow, they're getting $50,000; that's enough to get them to stay," and $50,000 deferred because they own less than 1% of the firm. In some cases, managing partners say, "I'm going to take a little bit of mine and spread it around to make them happier." One of the things we frequently get asked is: how is this good for my younger partners? I was earning $1.3 million. That person making $300,000 might be thinking, "I want to remain independent. I want to be the one earning $1.3 or $2 million one day."

(11:31):
How is this good for them? Here is the rollover equity allocation. If taken at face value, that rollover equity—the 40% they still have retained—is $8.2 million. This is pre-adjustment, as if we just spread it around in the ratios of partner equity. But that's not going to happen because private equity is not going to allow it. They want to get more equity into the hands of the younger folks, probably about 40% of the 40%. What I have here shows the older partner group, who have significantly more equity, being diluted in relation to their percentages. What you have here is an adjusted rollover equity of $1.65 million. If you are a young person in your 30s or early 40s and someone says you are sitting there with this rollover equity at today's value, let's see what happens with certain assumptions.

(13:05):
But before we do, here is why you adjust rollover equity: You want those people to stay. You want that future leadership. It aligns incentives for partners who have the longest runway remaining, and it protects the private equity investors. If all the senior partners kept all that rollover equity, the young partners would certainly be a flight risk. It truly creates significant retention. We're going to take a look now at the transaction waterfall. We had a total enterprise value of almost $21 million. Private equity acquired 60%; they got $6.2 million cash at closing, $6.2 million deferred over five years, and rollover equity value of $8.2 million. On the day of transaction closing, the total consideration given to this $8.2 million firm is $21 million, which is a little more than a 2.3 or 2.4 multiple.

(14:30):
Let's look at the exit multiple. Let's assume EBITDA doubles. How is it going to double? It's going to double if your firm does all the things Bob shared to create additional value. We go into so many firms that are not offshoring, don't have wealth management, and sometimes have zero advisory service offerings. There are so many things that could be added, and with a capital stack behind your firm, these private equity groups know how to grow businesses. I'm using a multiple of 14 as an exit. Why? Because I know there are groups out there that have taken investments. We haven't seen any liquidity events other than Citrin Cooperman doing their transaction with Blackstone, and those partners did really well. We're going to see other firms in the same situation. Imagine doubling EBITDA and a 14 multiple: this $8.2 million firm could see total proceeds of $64 million.

(16:07):
Let's take a look at that. Partner number one, the managing partner, got $3.8 million at close, another $3.8 million deferred, and look at that "second bite." That 40% ends up being $17 million. I frequently tell people that second bite can be significantly more value than the first bite. In this case, they got a total of $12 million in the first bite, and in the second bite, $18 million. But look at partner number four and partner number five. Typically, private equity groups will tell younger partners they can only sell 20% or 25% of their equity when we have these additional bites at the apple. That's because they want to retain them. If they get all this money and decide to retire at 45, the private equity group hasn't achieved what they're looking for. But look at this: they've taken $1.4 million each in total between the cash at close, deferred payments, and the second bite. They've taken $1.4 million off the table, and now the value of their rollover equity resets, but they're sitting on $3.9 million. There are people in this room right now in that situation who are ultimately going to see a monetization of their firm like we've never seen before.

(18:22):
Why does this work for the firm? It works because of the liquidity event. I ran firms for a total of 18 years, and when a partner would retire, we'd have a celebration and they would receive the average of three of the last five years times a multiple, paid out over 10 years—maybe $200,000 to $400,000 a year for a managing partner. But the money firms are seeing today makes these private equity groups look like the "white knight" coming in to save the day. If you look at every survey, whether it's the PCPS section or the AICPA, one of the top things is always talent and succession. Who is taking over for us? I go to a conference now and the average age is coming down significantly. No disrespect—I'm a senior citizen. I get a 50% discount on New Jersey Transit now! It's great.

(20:09):
They are going to bring the average age of the people in the room down. We are a baby boomer-dominated profession. I've never sat around the table with such smart people who have done this in other industries. They've told me they love this industry more than any other—more than veterinarians, MSP roll-ups, medical practices, or HVAC companies. Look at the clients you serve. Look at the opportunity. I know this is true because New Mountain invested in Citrin, then Grant Thornton, then did a minority interest in Wipfli. That tells me when they sell Grant, they're coming for someone else. Blackstone coming in is certainly validation that private equity is here to stay. There was a doctor who wrote an article bashing private equity in accounting, saying it would do the same thing it did in the medical arena. Everyone has a sad story with private equity. What I tell you is: know who your partner is going to be if you decide not to remain independent.

(22:00):
I'm not preaching that this is something you should run out and do right now. But private equity is here to stay. You heard Bob Lewis say how many of the top 30 firms have already done a transaction, whether it's an ESOP, an RIA, a family office, or a venture fund. Private equity says the top 100 have been "picked through." Those that remain independent will sit on the sidelines and we'll see what happens. But what does that do for the value of your firm that doesn't appear on the Top 500 list? A $21 million firm, a $50 million firm—the firms nobody knows about. There's tremendous value that can be created.

(23:16):
How do partners of an $8.2 million firm end up with $30 million? You have the cash at close, the deferred payments, and the rollover equity which appreciates at exit. The rollover converts into a second liquidity event or a "third bite at the apple." Those combined proceeds frequently exceed two to four times the initial payout. Generational wealth is being created in our profession. I feel blessed to have selected this industry. As a CPA, I always wanted to help people. My dad, who was a partner at Pricewaterhouse, used to come home with dinner table stories about the different businesses he worked with. We have an amazing profession. It disheartens me when people say they would never tell their kids to go into this profession. I'm the son of a CPA and I'm proud of it. This is a great profession. Even before private equity, how many "millionaires next door" did it create? We are helpers. You're doing an amazing thing for your clients if you're doing more than just reporting history. There's an opportunity before us today, whether or not you decide taking an investment is right for your firm.

(24:37):
While I'm up here speaking about private equity, two weeks ago I was in Miami with BDO talking to firms about remaining independent. The one thing I try hard to do—and some of you will laugh because you know I can really talk—is listen. I am not going to go over my time today. I may give you the gift of some additional networking time. I listen to all of you. You've created something wonderful. I'm not going to be the guy who tells you to go this way or that way. You can remain independent, or you can monetize your lifetime of work. I'm proud to be here co-chairing this conference and I'd like to thank Dan Hood, Danielle Lee, Heather, and everyone at Accounting Today. I'm looking forward to sharing more later, but if there are any questions, I'm happy to answer.

(27:15): Audience Member:
One question—why would a senior majority partner give up rollover equity to junior partners for free? You mentioned in some cases the PE group would require it. Are there other reasons?

(27:37):Phil Whitman:
When you look at the sheer volume—I call it the wheelbarrow full of cash—I hear managing partners say, "This isn't about me. It's about my clients and my team." If the managing partner is truly a fiduciary and a steward of the firm, he's going to look at the $10, $15, or $20 million he's going to get and say, "These are the folks that got me to where I am today, and I'm happy to share that rolled equity with them." We have managing partners tell me it's not about the money until we start negotiating, and then it becomes about the money. But for the most part, we are staring at potential multiples we've never seen before. Why look a gift horse in the mouth? I hope that answered that question. I want to take a quick survey: would all of you tell my wife I didn't sway and I didn't make you dizzy? Thank you.