On January 24, Gary Adamson presented a well received and highly rated webinar on the above-titled subject. Here’s an overview of one of the webinar’s segments: How to value and purchase the interest of a retiring partner.

If you’re a partner thinking about retirement, you’re probably not going to realize the most value in an inside transaction. That said, here are the prevailing approaches to an inside sale.

It’s widely accepted that there are two components of value: Accrual basis capital and goodwill. Accrual basis capital should include 1) reserves for work-in-process (WIP), which many firms don’t use, 2) other appropriate reserves, and 3) valuation of real estate, if any, at market value.

Payout for accrual basis capital is generally made in cash or, if it’s to a partner with a large interest (e.g., 20 percent), the payment may be a short-term note with a two- to four-year payout, including interest.

Traditionally, goodwill in a CPA firm is expressed as a percentage of fees. The traditional value of 100 percent of fees doesn’t always apply in an inside buyout for a variety of reasons, including client transition (mobility), younger partner attitudes, and sweat equity.  The average value for an internal buyout, according to the Rosenberg Survey, is about 80 percent.

Here’s an example of a valuation for an inside buyout:

A firm with revenue of $6M typically might have an accrual-basis book value of $1.5M.

                        Book Value                                                               $1,500,000

                        Goodwill at 80 percent of revenue                              $4,800,000

                        Total Value                                                               $6,300,000

How is goodwill allocated among the partners? Methods include:

• Equal
• Fixed amount
• Ownership percentage
• Book of business
• Multiple of compensation

The trend is towards the last method — multiple of compensation. Over 50 percent of the firms with five or more partners in the Rosenberg Survey use that method.

In the $6M firm above, assuming the bottom line before partner compensation is $2M, goodwill is 2.4 times partner compensation. So, a retiring partner would receive book value plus 2.4 times his or her compensation. Typically, compensation for this purpose is calculated by taking the last five years compensation, eliminating the low and high years, and averaging the other three years.

How is goodwill paid out? Normally, as deferred compensation over ten years, but sometimes fewer, with no interest and no adjustment for inflation. It is ordinary income to the retired partner and an ordinary deduction to the firm. But beware of code section 409(A), which establishes strict rules on the treatment of deferred compensation.

How are partners vested? When a partner buys in, he or she is usually buying a percentage of the accrual basis value and is not buying any goodwill. Surely a partner who retires early should not get a full share of goodwill. There are two widely-used scales for determining a partner’s share of goodwill: Age of the partner and years of service. Often, there is a 15- to 20-year vesting period and a minimum age for receiving full benefits.

The webinar — which will be repeated on May 23 and August 27 — goes into much greater detail and covers many other areas. You can register for these and other webinars free under a special membership offer available until March 15. 

Upcoming Webinars

Here’s a schedule of upcoming webinars by Gary Adamson:

• Partner Compensation Methods and Trends - May 22/Sep 4
• How to Maximize Performance of Best Practices in Partner Admission, Transition, and Buyout - May 23/Aug 7
• Partner Compensation--How it Can be Linked to and Help Create a Culture of Accountability and Unity - June 19/Oct 9
• Mergers and Acquisitions--What You Need to Know - July  17/Nov 7