2021 Trends in the Marketplace for CPA Firm Mergers and Acquisitions
(This article includes updates of what we have seen in the marketplace since this webinar was originally presented.)
CPA firms considering a merger or acquisition this year should look at emerging trends in 2021. The coronavirus has affected every aspect of our world, including M&A. With that in mind, new patterns—both positive and negative—are arising in mergers and acquisitions.
The recommendations and predictions in this article are drawn from conversations with and insights from firms buying or selling, as well as from the experience of the economic downturns in 2001 and 2008 and discussions with dozens of managing partners of all types and sizes of firms.
For example, the two charts below show GDP and unemployment comparisons pre- and post-9/11, as well as those before and after the 2008 financial crisis. The third chart includes projections for the post-COVID economy.
When the coronavirus began impacting the US economy, most projections were dire. That said, it appears that most accounting firms did not see much if any decline in fees. In fact, many firms grew, due to assisting clients with pandemic-related services (such as PPP loans). With this in mind, let’s look at some of the M&A trends and the impact of COVID-19 on business dealings and bring you up to date.
The Zoom Effect
The move to virtual meetings has had a varied impact on accounting firms. Based on general observation of M&A activity since March 2020, it seems that when two parties had the chance to meet in person prior to the pandemic, both parties were also willing to finish the deal virtually. However, the longer business was conducted under COVID-19 restrictions, it became apparent that parties have some difficulty meeting online and closing the deal online as well. This was a major roadblock for mergers in which the firms are creating a relationship that will last for years. The parties often prefer to meet in person, see each other’s offices, and meet the critical players. The pandemic made conducting these meetings difficult. In many cases, it became impossible to finalize the deal until face-to-face meetings could occur. Two firms can share metrics, but nothing can replace in-person meetings. Thus, M&A activity was way down as compared to prior years until after the 2021 tax season when things started to pick up again in a major way.
Recently, because firms were able to meet face-to-face, we have seen strong activity in the marketplace being pushed by pent-up demand for mergers to address growth and succession.
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Buyer’s or Seller’s Market?
Prior to the pandemic, it was a seller’s marketplace for small firms in densely populated areas of the US, lesser so in sparsely populated areas. For mid-size and larger firms seeking an upstream merger, the trend was leaning more toward a buyer’s marketplace. Buyers were more selective and required tighter terms for their deals. The pandemic economy has exacerbated this trend. The supply of sellers has increased, and it has become even more of a buyer’s marketplace for all sizes of traditional tax and accounting firms that are primarily focused on compliance-based services. Buyers are not looking just for revenues; they also seek talent. Consequently, deals where all or most of the owners are seeking near-term retirement are not as popular as in the past. Buyers do not want to replace that level of talent immediately.
In contrast, niche firms are in high demand and often are commanding a premium price as a result. Examples of popular niche services are client accounting services (CAS), cybersecurity, data analytics, HR consulting, and other similar advisory services. Larger firms are especially interested in de-emphasizing the compliance work they traditionally provided as technology takes over those functions.
Valuing a Firm
When it comes to valuations in this new era, it is important to remember the five main variables that have traditionally determined the value of any acquisition in “normal” times:
- cash up front
- retention clauses
- profitability
- length of payout period
- the multiple of revenues
Now, let’s look at these variables through the lens of a 2021 COVID-19-recovery economy.
- Cash up front
Buyers were already reluctant to invest much cash up front before the pandemic, and the weaker marketplace for sellers is making this trend even more pronounced. Consequently, buyers are less inclined to make down payments, and many request the use of the seller’s working capital, with payback over one to five years. Buyers may also want terms that will stretch out the payments. It has become rare for buyers to make any down payment in acquisitions of traditional accounting firms.
- Retention clauses
In the COVID-19 era, some buyers perceive it will be more difficult to retain a seller’s clients. In some segments of the economy, clients may still be at a higher risk of business closures, illness, or other uncertainties, and future revenues may be less predictable. As a result, many buyers will require longer retention periods and collections-oriented deals. In some cases, the terms may require that the entire payout be based on client retention. When buyers do not ask for a collections-based deal, they may want a limited retention period, traditionally not less than two years.
As a compromise, we have seen the use of an economy clause, in which buyers are given some protection from client loss due to economic downturn after the limited retention period ends. For example, if the retention period in the terms was two years but in year three a client dies, relocates, sells, goes out of business, or loses the need for a local accountant, the price of the acquisition is still subject to adjustment.
- Profitability of acquired practice
To protect a buyer’s profitability, some mergers might need to include a sliding scale to account for dropping revenues. For example, including a “lookback period” in the deal would account for revenues dropping by five to 10 percent or more within a certain period, and result in changes in compensation, equity, and any other relevant factors identified.
- Length of payout period
Buyers were already requesting longer payout periods prior to COVID-19, and that trend continues. Though there will be some exceptions, larger deals—$5 million or greater—will often have a ten-year payout period. Smaller deals in the $1–$2 million range will likely have a five- to eight-year payout.
- The multiple
Generally, the multiple is the result of the other four variables: cash up front, retention clause, profitability of acquired practice, and length of payout period. A lower down payment, longer retention period, profitably structured deal, and longer guarantees will likely lead to a higher multiple. Think of these four variables as the cause and the multiple as the effect.
Regarding the impact of the COVID-19 economy, buyers may intuitively expect multiples to come down, but from 2008 to 2010, multiples stayed strong because of the demand. When organic growth slows, M&A tends to increase as an alternative means to growth. That said, in recent months we have seen a general reduction of accounting firms’ valuations for those who do not offer advisory services or have many partners seeking near-term succession, while niche firms have grown in value.
Staffing and Office Space
In the past, staff shortages have often kept firms from pursuing acquisitions. Buyer firms have been too short-staffed to execute a successful acquisition. Initially, due to the expected economic downturn, we thought staff shortages would become less of an issue due to pandemic-related layoffs, making more staff available. As it turns out, the talent wars have intensified, and the talent shortage still exists. Firms seeking a sale or upstream merger in which the successor firm will need to replace a lot of professional personnel are finding fewer interested firms.
With workplace flexibility on the rise, long-term leases have become a less desirable aspect of M&A deals. Because firms now function more remotely, long-term office space commitments are less necessary, and can be considered a financial burden to a potential buyer. Leases can be an albatross to getting a deal done.
Partner Retirement Obligations
The economic impact at the beginning of the COVID-19 pandemic made it difficult for some firms to maintain their obligations to retired or retiring partners. Consequently, some of those firms looked to sell or merge up to be released from those burdensome obligations.
This situation highlights the need to build caps into ownership agreements so that a predetermined percentage of revenue is designated to pay retiring partners. For example, an agreement might limit payments to all retired partners in a firm to 10 percent of the firm’s overall revenues. From an M&A perspective, no buyer wants a firm that will create negative cash flow due to partner retirement obligations assumed from the seller.
Continued Trends from Pre-COVID-19 Economy
Following are some trends in CPA firms that were happening prior to the pandemic and are continuing in 2021.
- Firms are moving their focus away from compliance activities, which may be at risk due to ever-increasing technology capabilities. Instead, firms are turning to value-added client services and advisory offerings.
- Firms are acquiring niches. These deals require a different structure in that the firm may need the purchased company to continue to operate so that the accounting firm can offer the acquired company’s services to its clients. It’s worth noting that niche firms tend to sell for higher values than traditional accounting firms. Additionally, CPA-based buyer firms are competing for these acquisitions with non-accounting firms and private equity firms, which are willing to offer more lucrative terms than a traditional CPA firm buyer.
- The demand for and importance of equity was already decreasing prior to the pandemic and that continues. For smaller firms, equity is more likely a factor, but for larger firms, partner voting, compensation, and buyout increasingly rely on factors other than equity.
Simultaneously, firms are moving toward a one-firm client culture, as they de-emphasize the connection between book of business and compensation and encourage team members to serve clients to the best of the firm’s ability, rather than individual partners gaining clients and clinging to them. In this way, firms are working to avoid creating silos, which allows accountants to put their clients’ needs first.
- Firms are expanding their offerings by adding advisory services. CPAs can expect this type of expansion to continue for the foreseeable future, even as some firms recognize that the predictable income from compliance services may help them through a period of economic decline.
- Upstream mergers for the purpose of gaining talent, IT, advisory services, and niches— such as CAS and cloud consulting — will continue to increase in frequency.
- Most mid-size to larger firms will not be as interested in acquiring traditional accounting firm clients as they used to be, because the emphasis right now is adding talent and niches.
Remember the 4 C’s
- Chemistry – If you don’t want to eat lunch with someone, don’t merge with them.
- Continuity – If the client experience will change significantly in a negative way, don’t do the deal.
- Capacity – The successor firm must have the capacity (and skill set) to replace the people retiring.
- Culture – To assess a firm’s culture, ask yourself:
- What’s it like to be a partner in that firm?
- What’s it like to be a staff person in that firm?
- What’s the client experience in that firm?
- How do these answers for the target firm compare to these experiences in our firm?