Preparing for what’s next

CPAs do a masterful job of taking care of their clients’ business, but they also need to make sure they look out for their own.

Just 6% of the CPA sole practitioners responding to the 2012 AICPA Private Companies Practice Section (PCPS) Succession Survey reported having a practice-continuation agreement (PCA) in place with another practice. In the 2014 PCPS Management of an Accounting Practice (MAP) Survey, just 3% of practices with less than $200,000 in annual revenue reported having a PCA in place with another practice. Most practices in the under-$200,000 revenue range have a single owner.

Perhaps CPA practitioners avoid PCAs for the same reason that people fail to purchase life insurance or write a will. This type of planning requires confronting one’s own mortality, which makes many people, including professionals, uncomfortable.

Nonetheless, CPA leaders who are concerned about the long-term well-being of their practices, clients, and heirs can take steps toward future security by putting PCAs in place.

These agreements are contracts that provide for an individual or another CPA firm to assume a CPA practice in the event of another’s death, temporary or permanent disability, military leave of absence, or retirement. They are particularly important for sole practitioners, whose practices and clients often rely completely on the CPA’s expertise to remain successful, and for small firms. An AICPA-sponsored book by John Eads, CPA, CGMA, Practice Continuation Agreements: A Practice Survival Kit (available at aicpa.org, provides step-by-step information to help with the preparation of PCAs and is summarized in this article.

It’s important for CPAs to undertake this kind of planning, according to Eads, a director at Smith, Jackson, Boyer & Bovard PLLC, a large local CPA firm in Dallas, because an accounting practice is more than a business.

“It is a professional and personal investment in people—yourself, your family, your staff, and your clients,” Eads said.

On a couple of occasions when he has been called to help friends in need, William Potter, CPA, J.D., has seen firsthand the unfortunate results when sole practitioners don’t have a practice-continuation plan. He was asked to come to an office in crisis on a Monday morning after a CPA in his mid-40s died over a weekend without a practice-continuation plan. The office was in chaos. The employees didn’t know who was in charge, and they didn’t know what to tell clients. In that situation and another Potter encountered with a CPA who died suddenly, he was able to help arrange for succeeding firms to place bids to buy the late CPAs’ practices. But the need to make a deal quickly led to sale prices that weren’t favorable to the sellers—the heirs of the sole practitioners who were negotiating while mourning.

Note that in this article, value is not meant to be consistent with the conclusions that a CPA Accredited in Business Valuation (ABV) would reach in a formal business valuation performed for litigation or an estate. Instead, value refers to the price to be paid for the practice.

“I’m a strong believer that practices ought to meet with other firms they know and have [a PCA] in place so they don’t leave it to their family to have to negotiate,” said Potter, senior tax director at Postlethwaite & Netterville in Louisiana. “For one thing, the CPA is going to know the value of his or her business better than anybody. In those two instances, it was almost like a fire sale. We interviewed the other CPAs that were coming in to buy it, but we didn’t really know the clients. But we knew we had to act fast, or there wouldn’t be anything there.”

Nonetheless, Joel Sinkin, president of CPA succession and merger consultancy Transition Advisors LLC, said a PCA isn’t for everybody. He said it’s rare for anyone other than a sole practitioner to have a PCA, because CPAs in multiple-partner firms have colleagues who can manage the practice in the event that one partner dies or becomes disabled. Sinkin does not recommend PCAs for CPAs who are within three to five years of retirement. He said they should be creating a succession plan through a two-stage deal (see “A Two-Stage Solution to Succession Procrastination,” JofA, Oct. 2013, page 40), in which a soon-to-retire CPA continues to work at the firm during a contracted period in the first stage and then retires when a buyout is activated by an agreed-on date or triggering event.

PCAs should be reserved for death or disability scenarios for CPAs who aren’t close to retirement, Sinkin said.

“This is not a succession plan,” he said. “This is an insurance policy.”

Eads has a different view. He said that once sole practitioners enter into PCAs, they tend to allow those agreements to be their succession plan for retirement purposes as well. Eads said that a PCA can serve as a vehicle for a two-stage deal if it is written to allow for a period of transition with the successor and eventual retirement. But Eads said that for practitioners without a succession plan, only a PCA can guarantee clients uninterrupted service and provide employees the likelihood of continued employment while preserving the practice’s value.

PART OF A CPA’S FINANCIAL PLAN

A PCA is no less important than a will in a sole practitioner’s personal financial plan. For small partnerships that choose to use one, it can provide protection in case of a disaster affecting one or more partners. The ideal time to draw up this agreement is when a practice is established, but many CPAs don’t think of death or disability or the end of their career at that point. The agreement provides for:

• An orderly transfer of clients without any break in professional services.
• Financial support for spouses, families, and heirs, who also are relieved of the burden of figuring out what to do with the practice in case of death or disability.
• Potential employment security for the practice’s staff.

Time is of the essence, Eads suggested, because selling the practice within 30 days of death is critical to obtaining any significant benefit, and the value of a practice can diminish quickly in the case of permanent disability. Eads has experience with cases in which a substantial number of clients have left a practice within a few days of reading the CPA’s obituary when a PCA was not in place.

There are two basic types of agreements:

• One-on-one agreements are buy/sell agreements with other sole practitioners, partnerships, or professional corporations, usually written to cover death or disability.
• Group agreements identify several CPAs to act as successors, with payment terms agreed on in advance, whereby clients can select a new CPA from surviving members of the group upon a member’s death or disability.

Certain state CPA societies have plans (also called emergency-assistance plans) to assist spouses and heirs in disposing of a practice and transferring clients in the event a member CPA did not make prior arrangements. But relying on an emergency plan leaves CPAs, their heirs, and their clients at risk of a rocky transition with less-than-optimal financial results.

The two primary steps for CPAs to take as they develop a PCA are assessing the value of their practice and identifying a successor.

Before these issues can be tackled, however, CPAs need to analyze their practice to prepare themselves to negotiate with prospective successors. CPAs need to understand their own practice and can request information about the successor’s firm to find the right match. CPAs’ evaluation of their practice would include an assessment of the practice’s reputation, specialties, location, staff, rates, efficiency, and profitability. Statistics should be prepared in advance of any discussions to assess the practice’s financial health. These metrics—examples include gross fees per partner and staff, average chargeable hours, average billing rates, expenses per chargeable hour, receivables, and work in process—can then be shared during negotiations. Eads suggested reviewing the practice’s accrual- and cash-basis financial statements for the most recent year and past five years to document trends and demonstrate the practice’s success, before negotiating with others.

Client information is critical to assess value prior to negotiations. Eads suggested getting practice files in order and updated. He recommended preparing a spreadsheet that includes key statistics by client, such as how the client was obtained, who the principals are, years as a client, type of business, fees by type of service (audit, tax, and advisory), collections, seasonality, and service problems. Time and billing software programs are available to help summarize this information.

WHAT IS THE PRACTICE WORTH?

To conduct meaningful negotiations about a PCA, an understanding of the practice’s value and individual clients is needed. This is not the same as valuing the practice at the time it is sold or transferred. The agreement will include the method of determining value that both parties agree on. Eads suggested a minimum value based on the previous 12 months’ cash collections on each client. The total of the assigned cash values to each client would be the total potential payment due from the successor if all clients stay during the PCA period. This is the cash flow the successor will be using to make installment payments as cash is received over the period of the PCA on a per client basis. The successor may be able to increase the cash flow by offering services that have not been previously offered and not have to pay the former CPA. This adds value for the successor.

Cash flow, client retention, the personal and professional goodwill established in the practice, and profitability all affect the price to be paid. Balance sheet data of interest to a purchaser include client receivables, work in process, and property and equipment. Income statement data and historical and projected cash flows are the most important factors in determining value. Clients are the intangible asset that represents the most critical element in the valuation of a practice.

Once the practice’s value is agreed on, it must be allocated to each client on the client list. The client list, assigned values, and negotiated allocation method become part of the PCA and can be used to establish payment ceilings—the maximum amount the successor will pay—for each client upon sale.

Eads said it’s important to note that the payments are isolated to the assigned value of a specific client. Any payments received go to that specific client until all payments under the PCA are made on that client. Therefore, if a successor is able to collect more than the value placed on that client for additional work the successor completed, the payment to the seller could be up to 100% of the value assigned based on the PCA terms in a short period. It is important to note that this amount would be applied only to the specific client and no other client balance. Each client value stands on its own.

CHOOSING A SUCCESSOR

Choosing a successor is the first priority of a PCA. Eads advised that it is critical for CPAs to find a successor they trust, with a reputation as a competent and ethical CPA. The successor’s operating philosophy and management style should be compatible with that of the original CPA, and the successor’s personality and experience must be considered. An ideal successor is a CPA or firm the original CPA has known for a number of years and has discussed practice issues with. Candidate sources include friends and acquaintances, practitioners met at seminars and professional meetings, and referrals from sources such as bankers, attorneys, state societies, or other CPAs. Because knowledge of the successor is an important factor in the decision, it is critical that the search for the successor take place while the CPA who is preparing the PCA is alive and well.

The successor’s experience, resources, and ability to retain and continue to serve clients should be considered. Once the most likely prospects have been identified, they can be approached for preliminary discussions.

One common mistake to avoid, Sinkin said, is choosing a practice-continuation partner who is not able to handle the work. Sometimes a pair of sole practitioners who already have a full-time client load agree to a reciprocal relationship as practice-continuation partners for each other. That situation can be unworkable because it can leave a successor with an unmanageable double full-time workload. Sinkin said it’s better for a sole practitioner to have a multiple-partner firm—or a CPA who has lots of excess capacity—as a practice-continuation partner. In the case that a CPA with excess capacity is chosen, the agreement should be reevaluated periodically to make sure that his or her ability to take on extra work has not changed, Sinkin said.

“When you’re choosing a PCA partner, they not only have to have the financial wherewithal and understand the systems and the nature of the work and have a culture that’s going to keep the customer happy and a fee structure that makes sense,” he said, “they also have to have the capacity to replace you. So it’s very rare that you’re going to have a reciprocal PCA.”

CONSTRUCTING THE AGREEMENT

Once a value has been placed on the practice and a successor has been identified, negotiations can begin and an agreement can be drafted. It is advisable to consult a lawyer to draft the agreement and review all related documents. In addition to basic legal requirements, such as definitions of terms, and noncompete and termination provisions, some of the most significant provisions to include are how clients, assets, files, and workpapers will be transferred; how liabilities and insurance will be transferred; who is responsible for tax issues; and how payment will be made. The PCA should be incorporated into the CPA’s will. Because circumstances change over time, Eads suggested meeting at least annually to consider any changes that could affect the agreement or value of the practice, including updating the client list and revising the agreement as needed.

PAYMENT METHODS

The agreement should specify the method and timing of all payments and any penalties for failure to pay. Different methods of payment exist, with one common method being to spread payments over a period of five to seven years with a down payment of zero to 10%, according to Eads. Sinkin said he usually sees no down payment, with occasional down payments of 10%; Eads said down payments of 10% are possible where balance sheet assets are passed on to the successor. Eads said payments would continue to be made until they reach 100% of the value assigned to that client under the PCA, but only if the client stays with the successor for the full term of the agreement’s payment schedule. If the client terminates early, no more payments are due on that client.

He suggested making it as easy and as financially undemanding as possible for the successor to pay for the practice. Payment amounts can be based on gross fees received for a period, values assigned to the clients on the client list, or some other negotiated method.

Sinkin said it’s important to make sure the PCA would prove worthwhile to the successor. A temporarily disabled CPA risks losing the majority of his or her business while disabled if the practice-continuation partner isn’t incentivized and motivated by the fee structure. Eads suggested that the successor fee in a temporary disability be at the successor’s standard rate for anyone who works on a client during the disability. This provides an incentive to the successor to help out during the disability period.

In case of death, the agreement should bring the successor firm work it can perform successfully and profitably. One of the first steps toward this is making sure account information and personal identification number (PIN) codes are shared properly in the agreement. In an increasingly digital environment, it’s unlikely that all the information the successor needs can be found in paper records in a file cabinet. PIN codes and account information must be able to be transferred quickly because clients may leave the practice after just a short time when they learn their CPA has died or is disabled, particularly during busy season.

“Things need to be handled in a very expedient way,” Sinkin said. “And if I don’t have all your PIN codes and access to all your information, I’m in big trouble. And the more we get involved in technology, the more this becomes an issue.”

SPREADING THE WORD

When the agreement is completed and signed, notification of the relevant details should be made to the CPA’s lawyer, staff, spouse, heirs, and clients so that all know what to expect and what their roles are in ensuring a smooth transfer of the practice. Surviving spouses need to be educated beforehand about how the practice operates, including where documents and funds are, and how the PCA will operate. Copies of the agreement and all related documents should be filed in a secure place.

When an event occurs that triggers the PCA, the practitioner’s lawyer should be contacted first, the surviving spouse or family member should instruct the successor to put the agreement into effect, and the lawyer should notify the practice’s clients of the transfer within 24 hours.

For CPAs who fit the profile, a PCA is a critical element in the protection of assets, and acts as insurance for a family’s financial future. PCAs also can provide some level of security for staff at the CPA’s practice. Although the successor is not obligated to do so, there can be value in transferring the staff, at least at inception, because of their familiarity with the clients. This can help create a seamless transition.

And, of course, PCAs provide important insurance for CPAs’ clients.

“It’s the right thing to do for our clients,” Sinkin said. “It’s not just the right thing to do for yourself. Your clients have put you in position to pay your mortgage, and you should want to protect them as much as you want to protect yourself.”

About the authors

Maria L. Murphy (emailmariamurphy@gmail.com) is a freelance writer in Wilmington, N.C. Ken Tysiac is a JofA editorial director. To comment on this article or to suggest an idea for another article, contact him at ktysiac@aicpa.org or 919-402-2112.

AICPA RESOURCES

JofA articles

• “Succession Challenges for U.S. CPA Firms to Tackle,” Nov. 2014, page 54
• “Seven Steps to Closing a Succession Sale,” Dec. 2013, page 48
• “A Two-Stage Solution to Succession Procrastination,” Oct. 2013, page 40
• “How to Select a Successor,” Sept. 2013, page 40

Publications

• CPA Firm Mergers & Acquisitions: How to Buy a Firm, How to Sell a Firm, and How to Make the Best Deal (#PPM1304P, paperback; #PPM1304E, ebook)
• Navigating Mergers & Acquisitions: Guidance for Small and Mid-Sized Organizations (#PGN1302P, paperback; #PGN1302E, ebook)
• Practice Continuation Agreements: A Practice Survival Kit, www.aicpa.org
• Securing the Future (#PPM1307HI, vol. 1 & 2 set, paperback; #PPM1305P, vol. 1, paperback; #PPM1305E, vol. 1, ebook; #PPM1306P, vol. 2, paperback; #PPM1306D, vol. 2, PDF, online access)

CPE self-study

• Succession Planning: Developing Tomorrow’s Leaders Today (#BLI165040, one-year online access)
• Understanding Business Valuation (#732886001, text)

For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.

Online resources

• Private Companies Practice Section (PCPS) Firm Practice Management Center, aicpa.org/PCPS
• PCPS Succession Planning Resource Center, aicpa.org