Succession, Partner Buyout, and Valuation: 12 Best Practices
Succession planning has been and continues to be a significant issue for CPA firms, particularly as baby boomers retire at an accelerating rate. Yet recent surveys show that more than half of multi-owner firms lack a written succession plan. Here are 12 best practices that can help smooth the transition down the road:
1. Run your firm as if you’re planning to merge. This includes charging clients fair fees (often that means raising them), investing in training and technology, regularly spending time with your top clients, ridding yourself of marginal clients (“D” clients), leveraging partners’ time, and not building your organization around people you know need to go. This article focuses on internal succession, but doing these things will increase the firm’s value and ease the succession process, whether it’s internal or external.
Most important, you need to “build your bench” by investing in people, creating career paths, hiring more than you need, and accepting (even promoting) turnover. Failure to invest sufficiently in people is often the biggest obstacle to an effective succession plan.
2. Develop an effective plan. A good succession plan rewards partners for building and transferring value — that is, doing what’s best for the firm. It removes any mystery about when partners will retire and motivates retiring partners to transfer their clients and stay connected with the firm after they retire. The plan should outline how the firm will preserve or replace the value provided by a retiring partner, including:
- Technical knowledge or expertise
- The block of hours (getting the work done)
- Voids left in firm leadership
- Client relationships
3. Focus on client relationships. Most succession plans are unfunded. That means the “currency” used to pay out a retiring partner will be the continuing income stream from those client relationships. To protect that income stream, it’s important to create expectations regarding mandatory retirement and transition; help partners learn to “let go” (often, the risks associated with client transition are lower than retiring partners think); be prepared to move the biggest, most significant clients to the right partner; and treat transitioned clients as “new” clients.
4. Don’t put on your business valuator “hat.” Resist the temptation to value your firm the same way you would conduct a business valuation of a client. The approach to valuing your firm is different than the one you would use for the vast majority of your clients. CPA firms are different because of:
- Personal relationships and transition issues,
- Relatively low buy-ins coupled with the concept of vesting
- Longer term payouts
It’s critical to understand the tensions among the older partners, the younger partners, and the firm, to determine what’s fair, and to assess the risks associated with values that are too high or too low.
The two components of value are:
- Accrual basis capital
- Goodwill
Accrual basis capital is “normalized” accrual book value, determined the same way as you would for a client. The payout of capital is either in cash or a short-term interest-bearing note (typically no more than two or three years), depending on the partner’s percentage interest in the firm.
Goodwill in internal succession represents the value of the firm to your partners, typically expressed as a percentage of revenue. On average, CPA firms value their goodwill, for internal succession purposes, in the neighborhood of 80 percent of revenue, although the figure varies by firm size and other factors. For example, smaller firms tend to value their goodwill somewhat higher than larger firms.
5. Use the “multiple of compensation” approach to allocate goodwill. Capital is generally allocated among partners according to ownership percentage. But what about goodwill? There are a variety of methods of allocating goodwill, including:
- Equal
- Fixed amount
- Ownership percentage
- Book of business
- Average annual volume
- Relative compensation — that is, a multiple of compensation
The last approach, relative compensation, has emerged as a best practice and is the most widely accepted approach today. To determine compensation, most firms use an average — for example, the average of the highest three of the last five years, or the highest five of the last seven years. According to recent surveys, a majority of firms use a multiple of 2.5 or 3 times compensation.
6. Goodwill payout: Use deferred compensation structure. Some firms continue to treat goodwill transactions with retiring partners as capital gain transactions, but the vast majority of firms are moving toward a deferred compensation structure. In structuring the transaction, it’s important to ensure that its terms don’t violate Internal Revenue Code Sec. 409A. Most firms use a 10-year payout (some firms use payout periods as short as seven years). Typically, firms do not pay interest or make cost-of-living adjustments.
7. Establish a vesting schedule. Regardless of the methods used to value and allocate goodwill, new partners should earn their share of goodwill over time. Usually this is based on both years of service as a partner and age. Best practices generally call for minimum years of partner service of 15 to 20 and a minimum age in the early to mid 60s. Recent surveys show, however, that firms are using minimum years of service ranging from five or less to 20-plus and minimum ages ranging from 55 to 65. Most firms use the same payout terms for death or disability as they do for normal retirement.
8. Noncompetition: Payments for clients taken. True noncompete provisions are rare today. Payments for clients taken is the new norm. The most common payment is 100 percent of fees, but many firms are now using 125% and some are going as high as 150 to 200 percent. Most firms don’t require payments for staff taken, but they should.
9. Place a cap on payouts. To protect the firm in the event several partners retire around the same time, firms should place a cap on payouts (a majority of firms don’t). Typically, these range from five percent to eight percent of fees, although sometimes they’re based on profits. Retiring partners don’t lose anything, but if the firm hits the cap it pushes the payouts further into the future.
10. Have a mandatory retirement age. To avoid surprises, firms should establish a mandatory retirement/buyout age that the firm controls (a majority of firms don’t). The firm can always make exceptions in individual cases. The age may or may not be the same as the vesting age. The most common mandatory retirement age is 65, but many firms use ages ranging from 66 to 70.
11. Don’t retire partners in name only. Partners who continue to work past “retirement” should be paid for specific duties and tasks, at the firm’s discretion. Don’t allow them to continue doing what they have always done and receive retirement benefits. Once partners reach retirement age they should have transitioned their client relationships and, in theory, should have nothing to do unless the firm creates new duties for them.
12. Include notice and transition provisions. Your plan should require one to two years’ notice for early retirement and require retiring partners to complete a transition process. Firms should penalize partners who fail to comply with notice and transition requirements (although most firms don’t).
Blog Prepared by: Gary Adamson, CPA.
For more information about internal and external succession planning in CPA firms, you can reach Gary Adamson at 765-488-0691 or [email protected].