Untying the Knot: Planning for a De-Merger

EXECUTIVE SUMMARY

A merger process should include planning for a de-merger and establishing a sound agreement if a de-merger subsequently becomes necessary. De-merger agreements define how to treat specific issues if a de-merger has to take place. Items to consider addressing in a de-merger agreement include: Protecting the original client relationships of each firm Treatment of new clients acquired during and after a merger Staff Office facilities and infrastructure Partial de-mergers in the event that one or more partners wish to leave a combined firm under a predetermined set of conditions Merger costs Most mergers include issuing the equity of one firm or a newly formed firm to the partners of one or both of the merging firms. Affiliations involving the “purchase” of one firm by the other might involve acquiring the value of one firm for consideration other than the issuance of equity. Joel Sinkin and Terrence Putney, CPA, are the senior partners of Accounting Transition Advisors LLC, which consults nationally exclusively on the merger and acquisition of accounting practices. Their e-mail addresses are jsinkin@transitionadvisors.com and tputney@transitionadvisors.com, respectively.

C elebrity divorce is often the cause of rampant public speculation, especially if a prenuptial agreement is not in effect. While a prenup agreement is an obvious necessity to some, planning for divorce is rarely at the top of anyone’s list when entering into marriage. Similarly, when two accounting firms agree to merge, they focus on the deal’s positive aspects and invest significant time in due diligence to ensure the merger will be successful. But having a sound de-merger agreement in place may also be a prudent part of the merger planning process.

WHY MERGE?
In 2001, a $1 million firm and an $8 million firm decided to merge. The merger presented exciting opportunities for growth and cross-selling, overall operational effectiveness, and a better synergy of talent. Each firm gave up its current office space and relocated to a larger space that accommodated both firms.

Six months into the merger, things were not going well. Unforeseen cultural and personality differences were contributing to a crisis, and the firms decided to de-merge and return to their former arrangements. Because they did not have a de-merger agreement in place, they were forced to “undo” the plans that had been created through the merger. At first, the de-merging of the firms went pretty well. They quickly resolved that each firm would take back its original clients (of course, they had to break the news to their clients that they were switching them again to the “old” firm). However, both firms had clients they wanted to trade to better serve their needs. Things became complicated when the larger firm wanted the smaller firm to pay for new clients the smaller firm had developed after the merger had started. Due to its reputation, the larger firm felt the smaller firm would not have been in a position to generate new clients had it not been for the merger and the backup support provided by the larger firm.

Other issues compounded an already contentious situation. The larger firm was now on the lease for the new office space but couldn’t afford to pay the overhead. The smaller firm had given up a lot of its hard assets to make the move and now had nowhere to go. Further complicating matters, a few staff members wanted to switch firms; the potential existed for some clients to do so also.

When our firm was called in to help, it was obvious that a de-merger clause would have saved a lot of headaches.

We have consulted on more than 850 transactions over the past 16 years. Of those, approximately 150 were pure mergers (not for the purpose of succession) and 75% of those mergers had a de-merger clause in their agreement. The suggestions in this article are based on those experiences.

TERMS TO ADDRESS IN A DE-MERGER AGREEMENT
De-merger agreements define how to treat very specific issues if a de-merger has to take place. Each merger is unique and requires special considerations. The time during which a de-merger can be exercised under the terms of the agreement should range from as short as possible (for example, the next tax season) to two years. The longer a de-merger option is available, the harder it is to merge the firms into a cohesive team. While a de-merger clause is still effective, partners and associates of both firms are likely to protect their turf to maintain their viability if something should go wrong.

PROTECT CLIENT RELATIONSHIPS
A primary objective of a de-merger plan should be to protect the original client relationships of each firm where possible. Identify each firm’s clients and create restrictions that prohibit competition for those clients for an agreed-upon time, up to several years. Most client relationships are easy to assign to each party. This is normally handled by attaching lists of existing clients to the merger agreement on the date of the merger.

Sometimes, clients are shifted to partners or staff of the other firm. This may be due to special expertise, pending partner retirement, or capacity or location considerations. Even when it’s not intended, a client may prefer to remain with the new firm instead of staying with its original firm (after a de-merger has taken place). Rather than attempting to force the client to accept a solution that is not in its best interest, it is better for all parties if the firm losing the client “sells” the client to the firm retaining the relationship.

Example. Firm A, with a $2 million practice, merged with Firm B that has a $1 million practice. A de-merger is triggered and after sifting out all the clients that shifted allegiance, Firm A retained $1.8 million in clients and Firm B retained $1.2 million. Firm B is required to “buy” the $200,000 in clients it acquired based on an agreed-upon valuation formula. In this case, Firm B would typically agree to pay a premium, between 1.25X and 2X, with little to no retention considerations for taking more than it brought into the merger to ensure the firms have no incentive to steal each other’s clients.

NEW CLIENTS
The treatment of new clients developed after a merger is trickier. If a de-merger is put into effect, it is best to allow clients that are developed and served by a partner of one firm to remain with that firm if they choose. Two basic approaches are used to assign value and determine compensation for new clients:

1. Assume the firm that retains the relationship has earned the value and, therefore, no compensation is required.
   
2. Assume new clients are shared pro rata and account for any disproportionate allocation (based on relative equity of the two firms) with an agreed-upon valuation formula.

Sometimes a partner or associate in one firm develops a client relationship, but the client is assigned to someone from the other firm who retains the relationship after the de-merger. Or a client may elect to stay with the “other” firm due to size, location or other considerations.

Example. Firm C and Firm D merge. Firm C was assigned 60% of the equity at the merger. During the time the firms remained merged, $500,000 of new business was generated. After the de-merger, Firm D retains $300,000 of the new business. An allocation based on relative equity would require Firm D to compensate Firm C for $100,000 of excess new business it retained. This payment is typically structured based on retention and collection of this new client going forward at a reasonable multiple, for example, 1X their equity share.

STAFF
In today’s marketplace, the value of staff is at an all-time premium. Staff members should return to their original firms in the event of a de-merger. However, their wishes should be considered. If one firm retains a disproportionate amount of staff following a de-merger, compensation similar to the fee paid a recruitment firm may be appropriate. The normal range of compensation should be 10% to 30% of annual salary and should be agreed to as part of the de-merger agreement. Compensation creates capital for the affected firm to replace lost staff and is also a disincentive to “recruit” staff to switch firms.

OFFICE FACILITIES AND INFRASTRUCTURE
When the two firms have not moved in together, this issue is rarely difficult to address in a de-merger clause. Each firm remains in its space and goes on as before. If the firms moved in together, the separation has to address infrastructure. This part of the agreement has two objectives:

n Allow both firms to continue to operate after the de-merger with as little disruption as possible.

n Protect both firms from the commitment for long-term investments in infrastructure.

If the space that will be left unoccupied in the event of a de-merger is not material to one firm, a three-month transition period to find and equip new space for the smaller firm is normally adequate. If a material amount of space will be left unoccupied, the agreement should allow for the space to be subdivided, and each firm then assumes its share of the cost going forward until other arrangements can be made.

Similar issues must be addressed for computer networks, telecommunication systems and other shared infrastructure. Agreements often allow for a transition period where the systems continue to be shared and, in some cases, sharing the cost of a new system for one of the firms may be built into the agreement as well.

PARTIAL DE-MERGERS
De-merger clauses sometimes allow a partner to leave the combined firm during an agreed-upon window even if the rest of the partners will remain. In such cases, discontented partners are often allowed to leave with clients whose volume is equal to the partner’s equity interest in the firm. If the volume of clients the partner leaves with is less than his or her pro rata share, compensation may be provided for the shortfall. If the volume exceeds the pro rata share, compensation should be paid, often at a premium, to what is considered market value. This discourages aggressive recruiting of clients by the partner who is leaving.

Another popular approach is to prohibit partners that leave from taking any clients. In these cases, a buyout of their equity is probably appropriate. The downside risk of this solution might be significant enough to some partners to preclude a merger from being consummated in the first place.

MERGER COSTS
In almost every merger one or both firms incur closing costs. These costs include but are not limited to legal fees, moving expenses, technology investment, consulting/brokerage fees, leasehold improvements, and furniture and equipment. Often, one firm (usually the larger if substantially different in size) bears most or all of these costs. However, a de-merger clause may require a retroactive allocation of the costs to both firms. This creates fairness and can be a disincentive for one firm to trigger a de-merger without good cause.

COMBINATION AFFILIATIONS
Normally, in a merger, equity in one of the firms or in a newly formed firm is issued to the partners of one or both of the firms.

Affiliations involving the “purchase” of one firm by the other might acquire the value of one firm for consideration other than issuing equity. An example of this would be where Firm A merges with Firm B. Firm B has four partners. Part of the merger had Firm A buying out two partners of Firm B and the remaining partners merging into Firm A. In cases involving a combination of some equity and some purchase, a de-merger clause is normally appropriate when the equity being acquired through purchase is not substantial. If the purpose of the merger includes succession within approximately five years or less from the onset of the merger, a de-merger clause would not be appropriate.

In a combination affiliation where some equity is acquired for cash or deferred compensation in the transaction, the equity may need to be acquired from the party that paid for it if a de-merger option is triggered.

Example. Firm A merges into Firm B. Four of the partners of Firm A, who own 80% of the equity in Firm A, received equity in Firm B as a part of the merger. One Firm A partner was bought out in the transaction and received deferred compensation from Firm B to be paid over five years. After two years, the de-merger clause is triggered and Firm A de-merges. The partners of Firm A should be required by the de-merger clause to reimburse Firm B for the payments made through the date of the de-merger and to assume the liability to the Firm A partner who was bought out.

DISADVANTAGES OF DE-MERGER CLAUSES
Normally, mergers create synergy through cross-selling services, opening new markets, creating stronger brand identity, absorbing excess capacity and eliminating redundant costs. All of these require change and commitment. Discussing the potential for that commitment and investment to end in a de-merger is not conducive to an effective team-building environment. The easier it is to unwind the merger, the less likely the parties will be to work out their differences and keep the firms together.

Firms surviving a de-merger are likely to be, at least for some time, weaker than they were before the merger. In extreme cases, viability of one or both firms may be at stake.

DOCUMENTATION
A de-merger agreement must be included in the merger agreement and be as specific as possible. It is not advisable to negotiate this after the fact. Leave as little as possible to decide later. In addition to the major issues addressed above, the method of handling accounts receivable, work in process, and professional and other liability incurred while merged should be considered. (See section B of the sample de-merger agreement for an example of how to address accounts receivable and work in process.)

AICPA RESOURCES JofA article “ Two-Stage Deals,” March 06, page 43. Publication Mergers and Acquisitions of CPA Firms: A Guide to Practical Valuation (#090441). For more information or to place an order go to www.cpa2biz.com, or call the Institute at 888–777–7077.