Add a New Owner to Your Firm

Here are sensible ideas for buying or selling ownership interest in a CPA practice.
BY STEPHEN WEINSTEIN

EXECUTIVE SUMMARY
MANY OWNERS OF CPA FIRMS KNOW their future retirement likely will be funded by enlarging the ownership pool. For young CPAs who can’t afford to purchase a partnership interest, some firms create an interim level that avoids the ownership-affordability problem by promoting an individual to “nonequity” (income) owner.

A NONEQUITY OWNER SHARES in the firm’s income but doesn’t own a share of the firm’s accrual-basis capital (ABC) and may not get full access to all its financial information, a vote on all firm issues or other entitlements. The arrangement provides both parties a period of time in which to size each other up and work out future terms.

PRESSING EQUITY-OWNER QUESTIONS include whether a new partner should buy in; how owner/partners should determine the price; whether payment goes to the firm or to “selling” owners; and what percentage of ownership to offer. Arriving at a fair deal involves factors unique to the firm.

BASED ON A FIRM’S SIZE, the amounts of money involved and the percentage owners wish to share, firms may use purchase terms similar to these: An interest in both the ABC and in the goodwill (G); an interest in the G (but no interest in the ABC that exists as of the date of admission); an interest in the G at a bargain price such as 50% of current value (it can be higher or lower) and full price for the ABC.

MOST MULTIOWNER FIRMS WILL offer a new owner a 1% to 5% stake. Smaller firms (up to three owners) might offer from 5% to 20%; a sole proprietor might offer a 50% partnership to one individual.

BEFORE A FIRM NEGOTIATES a new-owner buy-in, the owners already should have a fair buyout (retirement) formula. The two should be appropriately related.

STEPHEN WEINSTEIN, CPA, is a Branford, Connecticut, consultant who helps CPA firms and other professional companies deal with critical practice matters, including the mediation and resolution of buy-in and buyout/retirement issues. His e-mail address is swadvisor@comcast.net .

here is strength in numbers—but which numbers? Many CPA firm partners know enlarging the ownership pool likely will fund their future retirement. However, before admitting new owners, they must deal with some important financial issues, among them:

Today many young CPAs can’t afford to purchase a partnership interest, and they are unwilling to take on debt to do so.

Many owners won’t give up a percentage of ownership at below-market prices to make a deal more attractive to potential partners.

A firm’s partnership buyout formulas or amounts may not correspond to proposed new-partner buy-in amounts.

Change Is Going to Come

Only 47% of firms plan
for partner retirement.

Source: PCPS/AICPA MAP survey, 2002.

Changes in the profession during the past decade—plus some that may occur in the future—have created conditions that could undermine the potential value of an ownership interest in an accounting firm.

This article presents practical advice for dealing with those factors as well as time-tested formulas parties can use to negotiate fair terms for buying or selling ownership interest in a CPA firm. Note: For ease, firm owner is used for principal , partner or member in this article.

THE EQUITY OR NONEQUITY CONUNDRUM
An arrangement that many firms use to relieve the ownership-affordability burden is to promote an individual to “nonequity” (income) owner. This satisfies a new partner’s wish to move up by conferring a title equivalent—at least in the public eye—to the firm’s other owners’. Nonequity owner rights and privileges vary considerably, however.

Generally, a nonequity owner shares in the firm’s income, although not necessarily as part of the equity owners’ compensation system. Nonequity owners may not get full access to all of a firm’s financial information (such as how much the equity owners earn) and may not get to vote on every firm issue. Their partner benefits, retirement packages and other perks and entitlements may vary as well. An individual may remain a nonequity owner for a year or two or even permanently. With the culture of the profession in flux there is no longer a norm for admitting new owner/partners, and many firms are having to thrash it out case by case.

A beneficial feature of nonequity ownership is the arrangement provides both parties a period of time in which to size each other up in their new context and work out future terms. The firm gets an opportunity to assess the individual’s performance as a principal, and the new partner gets more time to build his or her assets and better prepare to buy in at a future date. In my work as a consultant to CPA firms over a 20-year period, I usually have recommended nonequity-partnership promotions for at least the first two years, especially at multiowner firms. I have never seen this approach cause a young practitioner to leave a firm.

SOMETHING FOR SOMETHING
Equity-owner issues can be frustrating for owners (whose sweat equity is worth only what the market will give them) and potential partners (who crave value for their cash). Among the many questions that need to be resolved the most pressing are

Will a new partner really gain anything by buying in?
How do owners determine a price?
Should payment go to the firm or to “selling” owners?
How and on what schedule should the new partner make payments?
What percentage of ownership should the firm offer?
Will the new partner ever be allowed to become an equal owner/partner?

Buy-in terms are extremely important to all parties, and arriving at a fair deal involves factors unique to a given firm. For example, if existing owners are aware a prospective partner has brought in many new clients over a period of years, they may offer a better price and a larger ownership percentage than they otherwise would. Some even may be willing to give an ownership interest (usually a small one) at no cost based on what the firm member has contributed to the organization. One reason some owners are comfortable doing this is that they don’t attribute value to ownership unless it is tied directly to annual compensation. (For example, if a firm’s partner-compensation system includes a tier of money split according to ownership interest, a 10% stake entitling a partner to $20,000 of a $200,000 compensation tier clearly has value.)

Other owners may strongly believe that future partners should pay full value for ownership (in effect, partially buying out the ownership percentage of majority partners, especially for those who soon will retire). In such cases existing owners may seek full payment of the purchase price, which includes both the accrual-basis capital (ABC)—that is, the equity of the partnership interest—as well as 100% of the “goodwill” value (G), defined as 100% of gross professional fees. (Such a valuation would be similar to an owner’s selling his or her interest to an acquiring firm in an acquisition-type merger.)

BUY-IN FORMULAS
The following are some formulas for structuring an entering owner’s purchase terms:

The existing owner gives the new person some part of the firm’s assets, both tangible (ABC) and intangible (G). In this situation the entering owner pays nothing.

The owners give an interest in the G (but no interest in the ABC that exists as of the date of admission). The owners retain 100% of the tangible assets but give the entering owner a share of the intangible asset. The new owner will share in the future growth of the tangible assets, however. For example, assume an individual gets a 5% interest in the company at a time when the existing ABC is $1 million; if a year later the ABC is $1.2 million, the new owner now has a 5% stake in the increase, which would equal $10,000 (that is, 5% of $1,200,000 – $1,000,000 = $200,000 X .05 = $10,000).

Note: In the examples above, credit for the G may have been based on revenue contributed from clients the new owner originated. For instance, if a firm’s gross revenue is $2 million (and that amount is considered the G value), and the new owner is recognized as having brought in $100,000 of the client base, then existing owners might give the new owner a 5% interest in the G ($100,000 of $2,000,000 = 5%).

Resources
e-MAP: Management of an Accounting Practice Handbook

E-MAP has practice management guidance and tools covering a wide spectrum of topics, including succession planning and partnership issues.

AICPA Business Succession Planning
Conference
December 8–9, 2003
Orlando, Florida

This conference will present case studies, general sessions and workshops on up-to-date succession information applicable to firms as well as clients.

For more information, see www.aicpa.org or www.cpa2biz.com .

Existing owners may require a new principal to purchase

An interest in the G at a bargain price such as 50% of current value (it can be higher or lower). As an example, we will assume that a particular firm grosses $2 million (G value) and has $500,000 in ABC. The owners decide to let the new person buy a 5% interest at full price for the ABC and only 50% of the value for the G portion, possibly because he or she brought in some clients. Accordingly, the new owner pays a total of $75,000. This is the full price for the ABC (5% of $500,000 = $25,000) plus the 50% price for the G (5% of $2,000,000 X .50 = $50,000).

An interest in the G at full price (that is, 100% of current value) and either a 100% interest in the ABC at full price or possibly no interest in the ABC as of the date of admission. Using the preceding example, owners who require the new owner to pay full price for the 5% interest in both the ABC and G, would obtain $125,000.

Based on their evaluation of the amount of money involved, the firm’s size and the ownership percentage owners wish to share, owners often offer deals similar to the above alternatives. Most multipartner firms will offer a new owner a small percentage, typically 1% to 5%. Smaller firms (up to three partners) might offer 5% to 20%; a sole proprietor might offer a 50% partnership to one individual.

For multiowner firms, it’s often prudent to offer a new partner only a small percentage (up to 5%), unless one or more principals plan to use the buy-in as the start of their buyout. The incoming owner usually should pay for both the ABC and the G, because paying for both avoids a potential area of dispute down the road. It gets all parties on the same page regarding future decisions that might affect firm capital, such as bringing in another owner a few years later.

Nevertheless, I often recommend owners consider reducing the purchase price for the G piece to an individual who has been a part of the firm for several years and has contributed to revenue growth. For example, let’s assume that a firm has four owners (V, W, X and Y), each of whom owns a 25% share. The gross volume for the past year was $3 million (which is considered a fair estimate of the G value), and the ABC as of the date of admission is valued (based on fair allowances for accounts receivable and work in process) at $1 million.

The owners decide to offer Z, the person being admitted to the firm, a 4% interest. They ask him to pay $40,000 for his share of the ABC (4% of $1,000,000) and $60,000 for his share of the G (4% of $3,000,000 X .50). His 50% discount for G is based on his prior contribution to the firm’s growth and is intended to make his purchase price more affordable. Each owner would receive a total of $25,000 for his or her 1% stake transferred to Z (each would own 24% after the transaction). Z would be asked to pay $30,000 at the date of admission ( Note: If necessary, Z might borrow those funds, and the firm might act as guarantor.) Z would pay the remaining $70,000 over the next five years from his earnings as an owner. Alternatively, the owners might decide to structure the transaction differently, such as having Z make payments to the firm as an investment in it, rather than to the four owners. Tax and other considerations often influence owners’ decisions about whether new partner payments should go to the firm or to individuals.

If the purchase price still is too great for a new owner, a firm might not require him or her to acquire an interest in the ABC that exists as of the date of admission. Instead, the new owner would share only in the increased amount of the ABC, if any, that develops subsequent to the date of his or her admission.

CASE STUDY
Good Things Do Happen to Good People
In January 1988 Michele A. Spence, CPA, graduated from Southern Connecticut State University with a BS in business administration and immediately went to work at a local CPA firm. She worked diligently as a junior accountant during her first two years, expanding her knowledge while servicing closely held business clients.

Then the firm split in two. Spence recognized a growth opportunity and went with the new firm that included many of her small business clients. She quickly rose to senior accountant and then to the accounting and audit manager. Spence took on her responsibilities with earnest enthusiasm and successfully led her firm through its first peer review.

The two partners in her firm, Marenna, Pia & Associates LLC, in Wallingford, Connecticut, were so impressed by the strong client relationships she had fostered, and by her enthusiasm for her career, that they soon began to discuss partnership with her. She became an “income (nonequity) partner” at the end of 1994, with an agreement to become an equal “equity partner” after a five-year period.

Her buy-in. Because of her outstanding performance, the original partners offered Spence very favorable terms. She paid the firm an appropriate initial lump sum to acquire her one-third interest in the accrual-basis capital (ABC). Then, to acquire her one-third interest in the client base or goodwill (G), Spence in effect financed the rest of her buy-in by taking a reduced profits-based annual salary for five years. It started out substantially lower than the other partners’ and over the five-year buy-in period increased until it was equal with theirs in the sixth year. This is how it worked:

First-year compensation, 16% of firm profits.
Second-year compensation, 19.4% of firm profits.
Third-year compensation, 22.8% of firm profits.
Fourth-year compensation, 26.2% of firm profits.
Fifth-year compensation, 29.6% of firm profits.
Thereafter, her compensation was 33.3% of firm profits.

Even though her ownership would not vest until the end of the five-year period, Spence was given an equal vote on all important firm matters during that time. At the end of the fifth year, the partners granted her a full one-third equity ownership without any additional payment.

It’s all good. Spence continues to flourish in her career while raising two children, with the help and support of her husband, Bill. Her partners continue to be impressed with her ability to maintain her client following while handling many of the firm’s administrative responsibilities.

OTHER IMPORTANT CONSIDERATIONS
Before a firm negotiates a new-owner buy-in, the owners already should have developed a fair buyout (retirement) formula. The two should be appropriately related. The buyout formula for sample firm VWXYZ might include payments (over a period of years) to exiting owners for the ABC and G (valued as of the date of their retirement). The ABC would be paid at 100% and the G might be paid at 80% of the current year’s gross fees. At firm VWXYZ, the fact that Z had obtained his G at a greater discount doesn’t violate this plan, because his partnership interest is very small and his additional discount was based on prior contributions to the firm.

If V, W, X and Y offer Z a future opportunity to obtain additional ownership interest (let’s say 6% more for a total of 10%), the original owners likely will require him to conform to the retirement buyout formula (100% of ABC and 80% of G). Nevertheless, other factors could influence future terms, such as if Z’s promotional efforts over the years add a significant number of new clients.

IS THAT ALL THERE IS?
New owners often ask how or when they can obtain additional ownership. Original owners don’t necessarily contemplate that new owners will become equal owners, but every partnership must answer this on the basis of what’s best for the firm. Many circumstances will change over the lifetime of a firm, so it’s sensible that existing owners base decisions about diluting their control of the business on current market conditions rather than on a rigid formula. Unfair as it may be to the vast majority of CPAs, headlined accounting lapses, Sarbanes-Oxley restrictions and public mistrust are factors that in some cases may dampen new-owner enthusiasm.

Citing a staffing shortage of several years’ duration and other factors, many local and regional firm owners say not enough people are moving through the ranks who possess the attributes new owners must have. Four of the most important qualities are

Leadership ability.
Entrepreneurial spirit.
Rainmaking skill.
The desire/drive/ambition to become an owner.

PRACTICAL TIPS TO REMEMBER

Owners considering adding another owner to their firm should keep the following in mind:

Firms can promote an individual to “nonequity” (income) owner to make partnership more affordable. This satisfies a new partner’s wish to move up and confers a title equivalent to the firm’s equity owners’ without conferring identical rights.

A multiowner firm should offer only a small percentage (up to 5%) to the new partner, unless one or more owners plan to use the buy-in as the start of their buyout.

In some cases owners can structure the transaction so the new partner makes payments to the company as an investment in the firm, rather than to the original owners.

Tell prospective candidates what achievements will make them eligible for equity and/or nonequity ownership. Career counseling for individuals who are on the “owner track” is a worthwhile investment.

Base decisions about ownership on current business factors rather than on a predetermined formula.

Firm owners must find practical ways to attract or develop these scarce and very valuable people. Creating a nonequity (income) owner position—with the visible perks, benefits and public status of partnership—is a proven strategy for interesting them. Clients and contacts who learn about the promotion don’t know there is a difference in the underlying level of ownership, and the new partner fulfills a need that in some cases is as much psychological as professional.

Next, the firm should establish clear written guidelines for partner buy-in terms, and these formulas need to be fair. Owners must recognize that a new equity partner’s buy-in has to give him or her something concrete such as a greater say in determining compensation.

Communication is vital to the success of a new-owner-admission program. Original owners need to make partnership criteria absolutely clear and to be aware of and supportive of each person’s career goals. They should tell prospective candidates what achievements will establish eligibility for equity and/or nonequity ownership, set yearly development goals and discuss potential owners’ progress toward them at regular intervals. Partners who work closely with candidates and track their accomplishments help motivate them to achieve success—which rewards the firm with growth and longevity. The financial formula for the buy-in is only one part of the ownership/firm-continuity equation.

CASE STUDY
Be Fair and Flexible
James F. Kask, CPA, says Haggett, Longobardi & Co., LLC, in Glastonbury Connecticut, found the formula for a successful partnership—partners who are fair and flexible. “I became increasingly aware of this as I worked my way up from a senior role to partnership in 1997, when I was 31,” he says.

The firm’s program at the time provided him with an “income-only” partnership. Under this arrangement he says he joined his partners in becoming “self-employed.”

“After counseling clients for years about schedule K-1 filings, the need for quarterly estimated income tax payments and self-employment tax, I finally began to understand the difference between being an employee and a partner,” Kask says. “It became clear to me how important it is to have partners who are supportive about compensation and responsibility.”

After he had been an income partner for a few years, the firm offered Kask the opportunity to purchase an equity position in the firm. “I had sticker shock at first,” he says. “The dollar amount of the equity partnership at first seemed unmanageable because it was more than the cost of the home I lived in.” He was confident about its worth, however. “I never lost sight of what I was ‘buying into.’ It had far greater value.” The original partners offered a “fair and flexible economic model that included a discounted valuation for the goodwill piece, a percentage of accrual-basis net book value and the ability to pay over a number of years with future earnings.”

The firm went from four to five equity partners. “I’m now entering my fourth year as an equity partner and my 14th year with the firm,” Kask says. “We’ve gone from an approximately 25-person firm performing basic accounting and compliance services to one of the largest regional firms in our state. We have about 75 people and niches in many areas, including manufacturing, the medical profession, technology, forensic accounting, human resources and not-for-profit organizations.” He’s pleased at how well his partners have allowed for growth opportunities.

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