| 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. | |
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: 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. |
|
