the managing partner’s role in mergers

17 key factors and 18 common turnoffs. bonus: an 8-point history of cpa firm mergers.

by marc rosenberg
the role of the managing partner

we have discussed how the managing partner impacts organic growth activities. but a major growth strategy was not addressed: mergers and acquisitions, or more precisely, how managing partners impact m&a at their firms.

more: 10 ways to hold partners accountable | five ways to evaluate partners | manage partners with goal setting | overarching authority that managing partners must have
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when managing partners are asked what their revenue growth is, they invariably respond something like this: “we grew 12 percent last year, 8 percent organically and 4 percent through mergers.” it’s almost like the 4 percent from mergers didn’t count. but this is changing.

in the third decade of this century, mergers are representing a substantial 25-35 percent of cpa firms’ growth. if you look at public comments by large corporations, they rarely break out their growth between organic and merger. that’s because they view mergers as a perfectly normal and expected method of growth. they count as much as internal growth. cpa firms need to adopt the same mentality.

why firms merge

cpa firms merge in smaller firms for these reasons:

• to make more money
• to acquire talent
• to access new markets, specialties and services
• to increase the new firm’s critical mass, making the firm more attractive to larger clients and staff
• to acquire the “bigger things” that bigger firms can afford, like a coo and technology
• to provide more and greater growth opportunities for staff

another reason for mergers is that it’s getting harder and harder to attract new clients. many firms find it less costly and time-consuming to buy clients and talent rather than try to develop them internally.

a very short history of cpa firm mergers

1. the most famous mergers took place between 1989 and 1998 when three pairs of big 8 firms merged into what are now deloitte, ernst & young and pricewaterhousecoopers. with the tragic 2002 demise of arthur andersen, we now have the big 4.
2. although the big 8’s shrinkage to the big 4 got all the headlines, cpa industry insiders are familiar with hundreds of other mergers. if we look at the top 100 firms in the early 1990s, half of those firms merged with each other.
3. cpa firm mergers or acquisitions of hundreds and hundreds of firms below the top 100 have taken place throughout the history of the cpa industry. smaller firms constantly struggle with succession planning. in fact, 70-80 percent of first-generation firms never make it to the second. this is unlikely to change.
4. a major explosion in the number of small and medium-size cpa firm mergers began in roughly 2005 as the largest generation of all time, the baby boomers (born between 1944 and 1964), approached traditional retirement age.
5. just after the dawn of the 21^st century, large regional firms began expanding outside their traditional geographic markets. some of these regional powerhouses have transformed into national behemoths. examples: cla, marcum, baker tilly and wipfli.
6. over the years of this merger frenzy, which continues to this day, buyers have gotten smarter as their experience has grown. they are now pickier and more strategic in selecting merger partners. but the volume of new sellers continues to be quite substantial as more and more boomers approach retirement age.
7. prior to 2015 or so, the cpa firm merger market was a seller’s market. i would define “seller’s market” as the situation in which virtually any cpa firm with reasonably attractive clients and staff and respectable profitability could find one or more very interested buyers with little difficulty. but around 2015, the market shifted to a buyer’s market because buyers:

• • became more proficient in negotiating
  • became pickier in their selection process
  • cherry-picked the best firms in their markets; buyers are now limiting their discussions to the most attractive sellers

highly successful sellers, especially those in the largest american cities, continue to be hotly sought after.

8. a merger trend that began in roughly 2016 is for cpa firms to merge in consulting firms. in 2019, 20-25 percent of mergers at top 100 firms involved non-cpa firms and this is forecasted to rise. says joel sinkin of transition advisors:

“firms expect artificial intelligence, blockchain and data analytics to substantially reduce the demand for traditional accounting services. as a result, demand for niche mergers in areas such as cybersecurity, hr, it, wealth management and litigation support, to name a few, is skyrocketing.”

mergers vs. acquisitions

let’s clarify two terms often used synonymously:

• a merger is the union of two practices, usually of unequal size, to form a new firm. cash is rarely exchanged. although it’s almost always clear in a merger who the surviving firm is, there are instances in which the “other” firm may play a role in the organization of the new firm. a very small percentage of firm combinations are true mergers.
• an acquisition occurs when one firm purchases another firm for cash paid over a number of years. in many acquisitions, the seller’s owners phase into retirement a few years after the deal closes. in most cases, not only is the buyer the surviving firm, but the seller rarely has any input into its management. the vast majority of deals that may be called mergers are, in substance, acquisitions.

throughout this post and related ones, we use the term “mergers” to describe both mergers and acquisitions.

the state of the cpa firm merger market

as time marches on, there will undoubtedly be some changes, but most of this summary will likely apply for several years to come.

1. the merger market is frenetic, fueled by both baby boomer retirements and buyers’ voracious appetite for growth. buyers are flooded with opportunities, with no letup in sight. most active buyers are evaluating multiple deals at any given time.
2. buyers are more selective and strategic than ever before. more and more, buyers are looking for sellers that will be a good strategic fit: great staff with partner potentials (i.e., talent). specialties. new location. synergies. buyers have raised the bar for who they will look at.
3. some sellers are lucky to get a deal at all. sellers who are willing to take a lower sales price to get the deal done are increasingly finding that many buyers simply aren’t interested at any price.
   
4. staff are critically important to buyers. many buyers feel staff are just as important as the clients acquired. many buyers reject sellers whose staff are mediocre or whose clients have an unhealthy overreliance on the partners. the younger the staff, the better.
   
5. sales multiples are coming down. many buyers are reluctant to go above 1x fees. great, small sellers used to consistently sell above 1x; now they have to settle. even firms that are nothing special could always get at least 1x, but now they are looking at less, some quite a bit less.
6. buyers prefer a business client base to a 1040/write-up practice. a heavy concentration of low-value, high-volume, standalone 1040s is a big turnoff to many buyers.
7. wealth management is increasingly important to buyers in selecting sellers.
8. buyers want sellers that will grow with them. there must be opportunities to grow by cross-selling buyers’ services. less interesting are sellers with little growth potential.
9. buyers want consulting services. more and more buyers, especially the top 100 firms, are acquiring consulting firms instead of or in addition to cpa firms.
10. deals are taking longer to negotiate because of sellers struggling with pulling the merger trigger, buyers having so many sellers to choose from, buyers doing more due diligence and other delays.
11. down payments are not something that buyers want to do, so they are getting less and less common.
12. deals are still done on collections, not billings.
13. buyers don’t like partners who want to work past age 65-67. the longer the seller wants to work past normal retirement age, the more of a turnoff it is. buyers have been burned in the past by aging partners with declining skills who never want to retire.
14. two-stage deals are popular with those sellers who want to keep working for a few years while having their buyout in place.
15. buyers are reluctant to bring in sellers as equity partners. buyers want to (a) maintain a certain revenue-per-partner ratio, (b) keep the bar high on who makes partner and (c) avoid making “older people” partners. many partners at seller’s firms would never qualify as equity partners at larger firms, regardless of age.
16. beware the uber-profitable solo. these practitioners earn high incomes partly because of their small firm structure, which includes very little if any investment in the firm. solos’ profit model doesn’t fit with multipartner buyers. the buyers can’t possibly make the same profit on the seller’s firm as the seller did alone. these sellers must be willing to accept a substantial pay cut.
17. big regionals are more likely to offer lower revenue multiples. generally, large regional buyers offer standard deal terms, and there is little opportunity for sellers to negotiate. these terms often feature a sales multiple well under 1x.

common turnoffs to buyers

this is a list of things that are likely to turn off buyers in today’s buyers’ market. i’ve personally experienced each of them multiple times in recent years.

1. stickiness of the seller’s clients. clients are overly attached to one of seller’s partners and may be difficult to transition.
2. the seller has too many standalone 1040s and write-up work and not enough business clients.
3. small sellers with income in the stratosphere overvalue their firm’s worth and are unwilling to take a pay cut.
4. seller’s staff are weak: low billable hours, low competence, too old, no upward potential.
5. seller is not a good strategic fit. buyers want sellers with the potential and desire to cross-sell their ancillary services. buyers are most interested in sellers with specific areas of expertise they don’t have. they are least interested in sellers with the same generalist practice they already have.
6. seller wants to work way past retirement age. i’ve been told by several buyers that they “don’t like old guys hanging around.”
7. work quality gap between seller and buyer is too wide. seller’s client work won’t be profitable once it conforms to the buyer’s work standards.
8. seller wants ridiculous terms re: sales multiple, high down payment, etc. too many “must haves.”
9. seller has too many partners. buyers are reluctant to make all sellers’ partners equity partners.
10. buyers are much more interested in sellers who have wealth management practices.
    
11. seller is retirement-minded and wants out too quickly to transition clients properly. staff is too weak to take over.
12. seller is slow in responding to buyer’s efforts to move the merger along.
13. seller’s office lease has too many years left on it.
14. seller has key people who won’t stay or has problem partners who seller wants the buyer to “fix.”
15. seller is woefully behind on technology. the learning curve is too steep.
16. low billing rates. low realization.
17. seller has lots of bank debt, almost always because of partners overpaying themselves in recent years. seller wants help from the buyer paying off this debt.
18. seller has one or more branch offices that are not successful that mainly got established to accommodate a partner’s desire to work close to home.

do mergers work?

yes … if you do them right. what do i mean by that?

1. do proper due diligence. albert einstein famously said, “once i know the proper question, i could solve the problem in five minutes.” buyers should follow a thorough process for checking out the seller.
2. manage implementation of the merger effectively. if a buyer acquires a firm that has a great client base, good staff and respectable profitability, and the terms of the transaction are reasonable and competitive, they should expect a successful merger, right? success should be automatic if proper due diligence was done, right? wrong on both counts. the actual process of merging the two firms together after the closing is far from automatic and needs to be proactively managed. the managing partner must lead the charge. here’s an example of what appeared to be a great merger that went bad.

a firm asked me to facilitate a merger of equal-size firms. both were located in a major city. the firms were both successful, had attractive client bases and were profitable. there were tremendous synergies to be had: the strengths of one firm were weaknesses of the other, and vice versa.

the firms decided to handle the merger negotiations themselves rather than hire me to help. a year later, they invited me to facilitate the first partner retreat of the newly combined firm. to my horror, i found that literally nothing had been done in a year to combine the two firms and exploit the synergies. the reason was a weak managing partner of the overall firm. it will come as no surprise to you that the firms demerged a few years later.

3. measure the success of the merger properly. a longtime client of mine was a second-generation firm with revenue of $8 million. all seven partners were in their mid- to upper 50s and wanted to work until their mid-60s. the partners loved each other and worked well as a team. they had a great work environment. but they had no succession plan, and that triggered their search for an upward merger. i found them a great buyer from which they got great terms.
   

a year later, i asked some of the partners if they were happy with the merger. one said, “we’re not jumping for joy.” i asked him to explain. he said, “when we were on our own, we may not have had the greatest firm, but we were happy. we were entrepreneurial. we were our own bosses. we were independent. we had all been there a long time and were comfortable with the way things worked. but now things are different. we’ve lost control of our firm and we feel like we’ve failed by merging out of existence, unable to preserve the firm’s legacy.”

this is the wrong way to measure the success of a merger! how the partners emotionally feel about it shouldn’t be the main issue. this is the main way to measure whether the merger worked:

• • did you get an exit strategy and firm up your buyout payments?
  • did your clients and staff react well and were they retained?
  • do you like the buyer’s people? are you treated nicely?
  • have you taken advantage of the buyer’s services?
  • have you retained or increased your income?

these should be the measures of merger success, not the fact that you lost that lovin’ feeling (props to the righteous brothers) and pine for the good old days that were doomed to end.

posted on april 1, 2021