Owner Agreements: Barrier or Pathway to Succession and Transition?

Is your CPA firm’s ownership agreement well-suited to partner succession and the admission of new partners? A bad owner agreement can be an obstacle to healthy internal succession. It pays to know your ownership agreement options and carefully choose the best one for your firm. According to the 2021 Rosenberg Survey, the firms that offer retirement buyouts utilized the following breakdown of ownership agreements:

• Multiple of compensation – 51 percent
  • To determine the multiple of compensation equation, firms commonly use the highest three of the last five years of compensation. That average number is multiplied by two or three and paid out over 10 years. For example, if the average is $300,000, that multiplies to $900,000, and the payout is $90,000 per year for 10 years. Normally, the partner’s share of capital is added as well.
• Book of business – 7 percent
  • Firms using this agreement recognize that the book of business is unique to the individual partner and has its own value. Firms pay the retiring partner for transitioning his or her book of business to the firm.
• Equity ownership – 15 percent
  • This approach establishes equity ownership in the firm. The partner owns a percentage of the firm and the value for the overall firm is often determined using a multiple of revenues. A hypothetical scenario could be that the firm uses 1x revenues, the partner owns 25 percent of the firm, the firm is worth $4 million, and the intangible portion is worth $1 million. Add to that amount the appropriate capital to be paid.
• Average annual value (AAV) – 15 percent
  • Firms using the AAV system create a pool of units directly tied to the firm’s volume. For example, a $5 million dollar firm could have 5 million units which is used to allocate intangible value. Although each unit is determined based on $1 of volume, the price paid a retiring partner for each unit can be other than $1. As the firm’s volume changes, the units also change, and that change is allocated to the current partners. As retired partners are paid off, the units acquired by those partners are allocated to the current partners.
• Other – 12 percent

The Fairness Factor

When considering an owner agreement, both sides have an interest in receiving a fair deal. Senior partners don’t want to give away their hard-earned assets. Often, the firm is the most valuable investment a senior partner owns. At the same time, new partners want a significant return for their investment and to know they can afford to pay off the senior partners. An incoming partner will not want or expect to make less money or even the same money after buying into the firm and paying for senior partner retirements. Fair consideration must be given to both parties when creating the ownership agreement.

Principles of Value

As your firm decides how to value its assets for purposes of allocating value to the partners, it’s important to consider there are two distinct pools of assets.

• Intangible assets: Often consisting of “goodwill,” the intangibles are likely to be tied to the revenue of the firm, taking into consideration the firm’s volume, book of business or client base, workforce, and brand. Intangible value is often offset by the unpaid liability to retired partners for their portion of intangible value. That would not necessarily be the case if the intangible value is based on a multiple of compensation and partner compensation is net of the cost of partner retirement payments.
• Tangible assets: Tangibles are based on the accrual-basis balance sheet, which includes accounts receivable, work in process, and equipment and furniture. These assets are offset by liabilities such as borrowing for equipment or from a line of credit.

And Don’t Forget Sweat Equity

Sweat equity is the time and effort invested by a partner after his or her initial financial investment, which results in increased firm value. Sweat equity is earned by helping the firm grow or by being part of a team that successfully executes the firm’s partner succession plan. A key to motivating new partners long term is to recognize their contribution to building the firm’s value through their sweat equity.

Intangible Valuations

There is a perception in the field that firms are being valued in internal agreements at 1x, but internal succession has been significantly below 1x for a while. Many firms have recognized pricing the retirement value too high makes it cost prohibitive and puts too much pressure on the plan. Following are examples of average intangible valuations from the 2021 Rosenberg Survey.

• < $2 million in fees: 90.5 percent
• $2 million to $5 million: 81.7 percent
• $5 million to $10 million: 75.2 percent
• $10 million to $20 million: 74.5 percent
• >$20 million: 69.2 percent

A realistic and fair valuation based on intangible and tangible assets, sweat equity, and the going valuation metrics can be critical to the success of an owner agreement.

Equity-Based System Can Transition to AAV

As an additional note on this subject, if your firm is currently using an equity-based system and it is no longer the right fit, transitioning to an AAV system could be an option. Let’s compare a scenario using the equity system and the AAV system.

Example Firm

• Firm volume $4 million + $1 million capital = $5 million value
• 1x valuation

Equity System

• Two senior partners – 50 percent each; $600,000 each in compensation
• Two junior partners admitted at $150,000 each in compensation

At admission

• 3% each equity for $150,000 (3 percent of $5 million)
• Paid over five years
• $50,000 each increase in base compensation

AAV System (using the same firm volume)

At admission

• 15 percent each equity for $150,000 (15 percent of $1 million)
• Paid over five years
• No AAV units allocated
• Each receive $50,000 increase in base compensation

Compare these two firms 10 years later:

Example Firm

• Volume is now $7 million.

Equity System

• Senior partners at 47 percent now have $3.29 million
• Junior partners at 3 percent now have $210,000

AAV System

• Senior partners now have $2.75 million
• Junior partners now $750,000

With the AAV system, the senior partners still benefit significantly, but the junior partners acquire much more value, which creates a much fairer outcome. The AAV system is an example of how to recognize the sweat equity new partners contribute to the firm versus the equity system, which tends to ignore that contribution.

Terry Putney, CPA, is a partner at Whitman Transition Advisors. Terry is a frequent speaker and author to the accounting profession. He has been providing consulting to CPA firms since 2004.

More from Terry Putney: How to Admit New Partners

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