focus mergers and acquisitions of accounting firms few combinations of accounting firms are true...

It seems that every week, there is news of another mergerwithin the accounting profession. Legally speaking, however,very few combinations of accounting firms are true mergers.Most transactions are legally structured as an acquisition,wherein the acquiring firm’s owners assume ownership

of the acquired firm; however, a merger is more properlydefined as a combination of firms whereby at least some ofthe owners of both firms become owners of the combined firm.The other major deal structure is an acquisition whereby theowners of the acquired firm do not acquire an ownership inter-est in the combined firm. There are also cases where onlysome of the owners of the acquired firm become owners ofthe combined firm; these are called hybrid transactions.

The choice of which approach is best should be based onseveral factors, but one issue stands out: how long the ownersof an acquired firm plan to continue working full time. If theirtimetable is more than five years, a merger is probably the bestoption; if they are five years or less from slowing down orretiring altogether, an acquisition makes more sense. This issuealso leads to hybrid deals, as some owners in the acquiredcompany may still have long careers ahead of them, while oth-ers with a short horizon are better suited for a buyout.

MergersReasons for merging. Firms consider merging for many

reasons, but the following are the most common: Bench strength. Talent is in short supply in the accounting

profession; therefore, firms are increasingly using mergers toadd talent for growth. An additional goal is creating an internalsuccession team for the long-term security of both the successorand the acquired firm. The merger not only adds depth of staffand partners, but it can also create opportunities for growth,leading to better opportunities for internal promotion of talent.

Niche services. Successor firms are often looking to strength-en an existing niche service or create a new one. In addition,the client mix for the firm’s existing specialty services mightbe underserved; in this case, an acquired firm with the samespecialty can provide more capacity. The owners of the

30 DECEMBER 2017 / THE CPA JOURNAL

InFOCUS

Mergers and acquisitions are a typical way for accounting firmsto grow, expand into new markets, build expertise, and providefor succession. But not all mergers are true combinations ofequals, not all firms are ideal matches, and not all acquisitionsare structured the same way. The authors provide an overviewof the variations of both types of transactions, under a variety ofcircumstances, with practical advice for reaching an agreementthat will be to the benefit of both parties.

IN BRIEF

Mergers andAcquisitions of

Accounting Firms

By Joel Sinkin and Terrence Putney

When, How, and Why to Merge

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acquired firms, meanwhile, are normallylooking for the larger client base; thericher menu of consulting services alsopresents an opportunity for growth. Oftenthese firms have been referring out ser-vices as routine as auditing, let aloneniche consulting; a merger offers theopportunity to retain those services in thenewly combined firm.Geography.Many larger firms have a

geographic growth plan; for examplefirms in Manhattan may seek to expandinto Long Island, New Jersey, orWestchester. In addition, some firmsbelieve a presence in certain markets isnecessary for their brand’s prestige.Advances in technology have made iteasier for firms to operate in a multi-office environment; for example, theauthors recently helped a firm in theWashington, D.C., area merge with afirm in Florida. The successor firm inD.C. managed all of the administration;this operational synergy allowed theFlorida partners to focus on practice

development and cross selling. Anotherfirm that specialized in services for laborunions merged with smaller firms inother areas with the same niche, creatingthe opportunity for significant growthdue to their national reputation and

stronger service mix. The authors alsoadvised a New York City–based firmmerging with a firm in the Albany area;

the combined firm created a service cen-ter of sorts in Albany utilizing that mar-ket’s lower cost structure to producework product for New York City clients.Acquired firms in this situation often findthemselves in the advantageous positionof managing the combined firm’s oper-ations in their local market.

Structure of mergers. Owners ofacquired firms are primarily concernedwith the following issues:Compensation. In most mergers, the

owners of the acquired firm are not expect-ed to reduce their compensation, since it isunrealistic to suggest that they maintain thesame level of revenues, devote the sametime and effort, adapt to the successor firm’scontrol environment, and also take a cut incompensation. Thus, it is common for suc-cessor firms to offer conditional compen-sation guarantees for one to two years,typically requiring that the new owners’time commitment and client revenuesremain at historical levels. After the condi-tional guarantee expires, the new owners

DECEMBER 2017 / THE CPA JOURNAL 31

It is common for succes-sor firms to offer condi-tional compensation

guarantees for one to twoyears, typically requiringthat the new owners’ timecommitment and clientrevenues remain at historical levels.



InFOCUS

are usually expected to adapt to the succes-sor firm’s compensation plan, which doesnot necessarily mean a drop in compensa-tion, but rather a different method of deter-mining it. Equity. Equity does not mean the same

thing in every owner agreement. In someagreements, it governs almost everything,including compensation, governance, cap-ital contribution requirements and thevalue of retirement buyouts; in others, itmeans virtually nothing. A first step forfirms considering an upstream merger isgaining an understanding of what equitymeans in the owner agreement of thepotential successor firm. The authors havefound that, generally speaking, the largerthe firm, the less important equity is.

Many mergers use a basic fractional for-mula for determining equity for each owner;the numerator is the gross revenues of eachfirm, and the denominator is the combinedfirm’s revenues. If one firm has $5 millionin revenue and the other has $10 million,1/3 of the equity is allocated to the firstfirm’s owners and 2/3 to the second. Theallocation to individual partners is often leftto each firm to decide, as long as the resultis reasonable. In the case of two West Coastfirms the authors worked with, however,the larger firm felt that only 80% of thesmaller firm’s revenue should be countedfor this purpose due to the disparity of met-rics such as realized billing rates, infrastruc-ture, and technology.

In reviewing the larger firm’s owneragreement, which was slated to be the com-bined firm’s agreement, the authors discov-ered that the only thing equity affected wasvoting for “major decisions,” which includ-ed merging with another firm and admittingand terminating partners. As it turned out,the variance in equity amongst the partnerswas spread fairly equally, and the partieswere convinced that any concerns otherthan relative revenues were not relevant.

Retirement buyout valuations.The trendfor internal retirement buyouts is a decreasein valuations, and this seems to be contin-uing. This is heavily influenced by firms

finding a way to balance the amount ofbaby boomer owners seeking a successionsolution, the competition for talent, the dif-ficulty of attracting partner-level talent, andthe desire to avoid strapping the next gen-eration with an unaffordable buyout. Forlarger firms, the approach to valuation willlikely be based on a multiple of compen-sation; the current average, according toexperience and surveys, is between two andthree times compensation, distributed over10 years and treated as retirement payments.Smaller firms are more likely to use an

approach based on a multiple of revenuestime either equity owned or book of busi-ness managed. The current average isbetween 75% and 100% of revenues paidout over five to 10 years, most often treatedas retirement payments.

What makes a firm attractive toanother firm seeking a merger? Theauthors have found that firms looking togrow through a merger look favorablyon the following characteristics:n Up-to-date technologyn Strong operating metrics, such asbilling rates, productivity, realization, andprofit marginsn Clients that pay and provide informa-tion on timen Strong staff, and especially staff withlong-term partner potentialn Good time records, even for owners

n A service model wherein owners are notthe only ones who deal with clientsn A commitment to delivering qualityservice and compliance with professionalethics.

Regarding profit margins, there can betoo much of a good thing. A very high prof-it margin (net income before any ownercompensation, perquisites, and benefits), inexcess of 50% for example, can create sev-eral issues. The compensation level relativeto an owner’s managed book of businessmay be very different from that of the suc-cessor firm, which can be a problem withcultural fit. That level of profitability alsoimplies a low-cost structure, which meansit will be harder to find cost synergies. Ifsuch a merger goes through, the acquiredfirm’s owners might not see a pro rataincrease in compensation compared to thegrowth in revenues they help create.

Owners of successor firms should keepin mind that their firm’s owner agreementwill determine the value of the acquiredfirm’s owners’ interests. If the agreementsets a low value for an owner’s interest, ascompared to the market, the firm might notbe an attractive merger opportunity. Ownersneed to be able to demonstrate how merg-ing with their firm will create an upsideopportunity, such as the capacity to supportmerger candidates, a strong IT environment,a compensation system that will reward theexpected growth, and new services to offerthe acquired firm’s clients. Another keyattribute is flexibility towards the mergerand respect for what the other firm bringsto the table.

Both the acquired firm and the successorfirm should consider “the four Cs” whenevaluating merger candidates: n Chemistry: Most people spend morewaking hours with their coworkers thantheir spouse, so having good chemistry iscritical. This is a key factor in choosingclients and staff, so it should be the samewith choosing partners; after all, the rela-tionship between the combined partnershipwill inevitably trickle down to the clientsand staff. The authors’ rule of thumb is not

A first step for firms con-

sidering an upstream

merger is gaining an

understanding of what

equity means in the

owner agreement of the

potential successor firm.

02-12-0107 Infocus_Sinkin.qxp_Layout 1 12/1/17 1:48 PM 2


to merge with anyone who is not a goodcandidate for sharing regular lunches with.n Capacity: This is even more importantfor sellers who must be replaced shortlyafter the merger. Most mergers include agoal that the combined successor firm willcreate capacity and room for growththrough cross-selling and new client devel-opment. Capacity is not just about officefacilities; it is more about the organization’sability to grow as necessary and to put peo-ple in place at the needed levels to managegrowth, especially as others slow down.n Continuity: Clients and staff like the waythe firm’s ship is sailing. If a merger wouldrequire wholesale changes that might causethose clients and staff to leave, it is unlikelythe merger will be successful. Some changeis necessary, and in some cases it may besubstantial; the key is to manage the paceof change so the combined firm remainssensitive to clients and staff. n Culture: This concept can be definedmany ways, but the authors suggest com-paring what it is like to be an owner in eachfirm, what it is like to be a staff member,and what it is like to be a client. Some cul-tures are hard to combine; for example, afirm that pays its owners on an “eat-what-you-kill” basis usually has a very differentculture than a firm that embraces the “one-firm” philosophy. The cultural differencesare likely to affect not just compensation,but every aspect of how the firm is managedand operates. A firm that has embraced cur-rent technology will be much different froma firm with older technology.

Acquisitions When seeking to sell or buy a firm, many

of the same considerations for mergersapply, but there are also stark differences.The following considerations are usually ofprimary concern for both parties.

Value of the acquired firm. The termsof a transaction are as important as the price.The seller needs to be paid fairly for itsyears of sweat equity, and the buyer needsto make a profit on the deal. The price isbest thought of in terms of the multiple; a

1x multiple of a firm with a value of$1,000,000 means the selling price is$1,000,000. The terms of how that amountwill be paid, however, make a huge differ-ence. Ideally, the multiple should be theresult of the structure of the rest of the terms.The less money paid to the seller up front,the more client retention adjusts the pay-ments and the longer the payout period lasts.The more profitable the acquisition for thesuccessor firm is, the higher the multiple islikely to be. (Note that the payout periodreferred to is for the amount of the deal thatis seller financed. To the extent a transaction

is financed by the buyer obtaining third-party financing, the amount of that financingis effectively a down payment.)

Anything is possible with regard to theterms of a merger—but there will need tobe an offsetting adjustment for the deal tomake sense to the other party. In a recentdeal the authors were involved with in theSoutheast, a small firm was offered threedifferent deals from the same buyer. Dealnumber one had a 1.25× multiple based on12.5% of collections from the seller’s orig-inal clients for 10 years with no cash down.Deal number 2 was a 1× multiple paid outover five years based on 20% of collectionsfrom the seller’s original clients with nocash down. Deal number 3 was a .76× mul-tiple based on 19% of collections from theseller’s original clients for four years, witha 20% down payment and the price locked

in after two years. None of the three offershad any allocation for goodwill. The buyeroffered three options because he knew cer-tain terms would be more important thanothers to the seller. If obtaining the highestmultiple was the most important issue forthe seller, she could choose the first offer.If limiting the period during which clientretention could affect the price or receivinga down payment was the most importantissue, she could choose the third offer. Allthe offers were satisfactory to the buyerbecause all appropriately offset certain termswith an adjustment to the multiple.

Multiples for the acquisition of largerfirms tend to be lower and payout periodstend to be longer than with smaller firms;however, there are also shorter retentionperiods for acquisitions of larger firms,because many buyers believe a larger firm’sclient base is more brand loyal than partnerloyal. Another consideration is that largerfirms tend to have multiple owners; if allof the selling owners are not leaving at once,the owners staying behind can play animportant role in retaining the clients pre-viously managed by the departing owners.Therefore, buyers tend to be less concernedabout client retention following the closing.That said, there are still some deals withlarger firms that include a retention periodequal to the payout period.

Structure of the deal. The way a sale oracquisition is structured needs to fit the sit-uation, especially true for the seller. Forexample, if a seller is ready to immediatelyslow down or retire, the structure of thatdeal should be different than if the sellerwants to continue working full time for sev-eral years. Some situations call for a “cullout sale,” which involves selling only partof the practice. The following are examplesof common approaches the authors haveseen used.

One firm in the Mid-Atlantic regionwanted to retain its wealth managementpractice but sell its traditional accountingand tax work to a firm who would not com-pete in wealth management. A firm wasfound that was looking for an affiliation

The less money paid to

the seller up front, the

more client retention

adjusts the payments and

the longer the payout

period lasts.



with a firm that provided wealth manage-ment but was not interested in doing thatwork themselves. The two firms moved intogether, and clients were told the reasonfor the “merger” (although the underlyingtransaction was a sale of the accountingpractice) was to allow the seller to focus hisattention on the wealth management part ofthe practice. This is an example of a cullout sale. Another frequent structure is called a

two-stage deal (TSD). This structure isdesigned for practitioners who are one tofive years from slowing down but recognizethat the transition of their practice, and there-fore the eventual value, will be optimizedif they begin acclimating their clients to thesuccessor firm now. Although they recog-nize the need for a succession plan, theyare also reluctant to give up control of theirday-to-day professional life and their currentlevel of income. The first stage involves theseller moving into the successor firm’s prac-tice, either physically or operating as a satel-lite office, and operating the practice as ifthe firms have merged. The seller continuesto make the same money during this stage,providing time commitment and revenuesremain steady, while gradually gettingclients comfortable with the successor firm.The buyer is not asked to maintain the sell-er’s level of income while simultaneouslypaying for the practice value, which mostbuyers would not be willing to do. The sec-ond stage is the actual buyout.For example, a New York CPA who

was generating about $800,000 in revenuewith a 35% profit margin wanted to workfull time for three more years. The deal wasstructured so that the buyer assumed theentire overhead necessary to operate the sell-er’s practice, the selling practitioner operatedas a contract partner in the buyer’s practice,and the buyer paid the seller 35% of thecollections from the seller’s clients as com-pensation (provided the seller devoted thesame time to the practice as in the past),and the seller agreed to retire from workingfull time and stay on in a part-time coun-seling role with the successor firm after the

third year, at which time the seller’s buyoutpayments would commence. If the sellerhad tried to be paid for the value of his firmwhile still working in the practice full time,the buyer would likely either offer below-market value for the firm or require the sell-er to accept a significant reduction incompensation in order to avoid negativecash flow. Neither of those outcomes is nec-essary with a TSD.The authors routinely run into situations

with larger firms that have partners withdifferent career plans, which are ideal forhybrid transactions. For example, one firm

in New York City had four partners; onewas seeking to slow down quickly, onewanted to work four more years then slowdown, and the other two had long-termcareer aspirations but lacked the capacity totake over for the two senior partners. Thedeal structure was effectively four separatedeals; the first partner sold his interest inthe firm (which was determined based onhis equity) to the buyer and started his buy-out immediately, the second entered intowhat was effectively a TSD, and the othertwo were admitted as equity partners in thesuccessor firm.

Choosing the right firm. Sellers shouldfocus on the 4 Cs discussed above whenevaluating buyer candidates. In almostevery case, the value and success of thesale of the practice will be affected by

the clients retained after the sale, and acritical driver of that success is findingthe right buyer firm. Location can be an important factor

because it implies continuity; however, stay-ing in the exact same location is typicallynot as critical as one might believe. Partnersshould first ask themselves how manyclients actually come to the office and wherethey come from. Insisting on a successorretaining a specific location dramaticallylimits the number of buyers that will beinterested and might lead to a lower valu-ation from firms that already have an officein the same area, while enabling the suc-cessor firm to absorb the practice into itscurrent location creates synergies. The moremoney the buyer makes, the more the buyeris motivated to pay the seller and still realizea profit.In the areas of continuity and capacity,

consider any specialties or licenses the suc-cessor will need to take over the client base.For example, in New Jersey a CPA mustalso be an RMA to audit municipalities andcounties; a firm with that kind of client baseobviously must find a successor with thatadditional certification. Other examples arethe successor firm’s reputation in the com-munity, results of prior mergers or acqui-sitions, and the successor firm’s own trackrecord of retaining clients and staff.In interviews with potential successor

firms, ask about the firm’s interest in theclient base. Look for hints that they mightonly want some of the existing client base.This is usually a matter of scale and a will-ingness on the part of the successor firm tomaximize the value of the practice by retain-ing as much business as possible while stillassimilating the practice into its culture.The same four Cs require buyers’ atten-

tion as well. Successor firms should makesure that they have the capacity to take onthe work, that they can promote strong con-tinuity to clients, that the cultures of the twofirms align, and that the chemistry betweenthe parties is solid. Then, when discussingthe acquisition with the seller firm’s owners,promote how these will be addressed. Stress

InFOCUS

A two-stage deal structureis designed for practition-ers who are one to fiveyears from slowing downbut recognize that the

transition of their practicewill be optimized if theybegin acclimating theirclients to the successor

firm now.



what joining the acquiring firm will providefor the clients and staff of the seller firm,rather than what they will lose in leavingthe seller firm.

Comparison of operating metricsbetween the parties is also important forboth buyer and seller. For instance, if thelevel of fees the seller has been chargingclients is substantially below what the buyercharges, that is probably unsustainableunless the work can be given to lower-levelstaff, where the fees make more sense. Totalexpected work hours for staff is anotherexample of a metric that can indicate a cul-ture issue.

Many successor firms do not considerhow emotional the decision to sell their firmcan be for the seller. For buyers, the trans-action is a business decision and the finan-cial results are most important; they tend tomake decisions rationally. Sellers gothrough the same rational evaluations, butare also making a decision about the end

of a 40-to-50-year professional career. It isimportant for both sides to recognize theemotions involved in order to be the mosteffective in the negotiations.

When to start the process. Potential sellerfirms should start as soon as possible. Inalmost every situation, the value of the prac-tice is going to be affected by how wellclients are retained after the sale. For smallerfirms, clients tend to be very partner loyalrather than as opposed to brand loyal.Adding to the challenge, many practitionersrarely see their clients face to face; betweenthe cloud, phone, and e-mail, statistics claimthat as much as 87% of clients are only inthe same room physically with the ownerwho manages their account once a year.Clients cannot be effectively transitionedremotely, so taking advantage of thesemeetings is a key to a successful transition.Therefore, the more time allowed for thetransition and the more active the sellingpartners are in it, the better it will go. This

is why a TSD, as described above, is sucha powerful tool for succession.

Achieving the Desired ResultsThe life cycle of any sufficiently large or

long-lasting accounting firm will inevitablyinvolve a merger, an acquisition, or somecombination of both. When the time comes,it is important to find the right firm to sellor buy, taking into account chemistry, capac-ity, continuity, and culture. Preconceivednotions of equity or valuation should bereconsidered, and firms should be open tomore flexible deal structures that suit thespecific circumstances. Firm partners needto be aware of all of the intricacies and pos-sible permutations of a transaction in orderto achieve a beneficial result for themselves,their clients, their staff, and the other party.q

Joel Sinkin is the president, andTerrence Putney, CPA, is the CEO, ofTransition Advisors LLC, Commack, N.Y.


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