making partner: do the math

five times when ownership percentages shouldn’t come into play… and alternatives.

by marc rosenberg
the rosenberg practice management library

accepting a partnership invitation offers two terrific, lifetime benefits to new partners that, for most people, cannot possibly be matched in any other career pursuit.

more: there are two kinds of accounting firms | drive your profits with only four metrics | a crash course in the business of public accounting | how to get promoted to manager | how to create a path to partner | making partner: what managers need to know | the 17 rules for making partner at a cpa firm | who shouldn’t be a partner? | nine reasons people are promoted to partner | how to make partner?
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if they don’t see this and agree with it, then perhaps it would be unwise for them to accept the partnership offer.

let’s do the math.

the best investment they’ll ever make

1. the monetary benefit. this consists of the substantial return on investment (roi) of the new partner’s initial buy-in (explained in the next section) as well as the outstanding compensation that partners in cpa firms earn compared to virtually all other jobs.
2. the non-monetary benefit. this is just as important as the monetary benefit. most people will spend more of their life working at their job than doing any other activity besides sleeping. so it makes sense that their job should be as enjoyable and satisfying as possible.

the benefits of being a partner in a cpa firm include:

• • having challenging work
  • helping clients you love and who love you
  • being an entrepreneur in a small business
  • feeling the satisfaction that comes with helping young people grow
  • having staff to delegate work to, making it possible to focus on high-level priorities
  • being your own boss, for the most part; partners have a high degree of control over what they do, how they do it and when they do it
  • working in an organization that has a diverse array of talent to draw upon, making teamwork a rewarding and enviable feature

new partners make two major investments. the first is the initial buy-in at the outset of becoming a partner. the second is made over many years, sharing in the payment of buyouts of partners who retire or otherwise leave the firm. the burden of the latter is greatly lessened because it is shared with other partners in the firm.

the return on investment for new partner obligations is a whopping 23 percent. here are the assumptions behind this calculation:

1. a manager is made partner at age 35.
2. the initial buy-in is $150,000, paid all at once.
3. the new partner joins five existing partners.
4. all partners, including the new one, retire at 65.
5. the new partner’s share of buying out the five older partners, over the next 30 years, is $1 million.
6. the firm’s annual growth rate over the next 30 years is 3 percent.
7. compensation of the new partner starts at $175,000.
8. this compensation increases, on average, 7 percent per year.
9. if the new partner decides to quit and work in another job, their compensation would increase 2 percent a year. so, the assumption is that a partner in a growing, profitable cpa firm will out-earn all other jobs by 5 percent per year.

in addition, there’s the appreciation of the initial capital investment and its return to partners upon their retirement. a $150,000 buy-in will appreciate to $364,000 in 30 years, assuming an annual increase of 3 percent.

all in all, the financial benefits of being a partner in a cpa firm are quite substantial. the money a new partner invests will probably be the best investment that person ever makes.

create written criteria for making partner

before shooting from the hip and elevating managers to partner because you somehow feel they are “ready” or have “earned it,” think this through. firms should first decide what experience, skills and achievements they want from a prospective partner before making the partnership offer. firms should be consistent in applying this process. then the firm should evaluate partner candidates against these criteria.

here’s another important reason to create written partner admission criteria: it’s a critical part of the mentoring process. when partners talk to staff about their future with the firm and what it means to be a partner, it makes sense to share with them these written criteria.

consider the non-equity partner role first

for many years, local cpa firms have commonly promoted managers directly to equity partner for one or both of these reasons: (1) they intuitively felt that the manager earned the promotion or deserved it because of his or her excellent technical performance, loyalty as staff and years of service (time in grade) and (2) they made the promotion as a staff retention tactic, fearing that if they didn’t, the employee would leave the firm, and that would give the partners heartburn.

as stated earlier, there is a trend well under way among cpa firms to raise the bar for becoming an equity partner. one reason for this is the increased use of the non-equity partner position.

two common ways the non-equity partner position is used are:

1. as an equity-partner-in-training program. it gives the partner candidate one to three years to demonstrate that he or she is capable of functioning like an equity partner. the main skills to be demonstrated are managing client relationships, bringing in business and displaying leadership skills.
2. as a permanent position in the firm. this could be the case if the first type of non-equity partner is unable to acquire the necessary skills to advance to equity partner. or it could be a manager who is unlikely to develop all the equity partner skills but deserves to be called a “partner” and is capable of performing many partner duties. the title is often advantageous for both employee retention and client-service marketing. clients always want to know “who’s the partner?” on their account, and this person can fill that role and save an equity partner from having to keep the client.

avoid overemphasizing ownership percentage

the term “ownership percentage” has wrought havoc in cpa firm ownership structures for decades. throughout my 20 years of cpa firm consulting, i have frequently asked partners to explain how their present ownership percentage was arrived at. invariably, i’m greeted by blank stares. they don’t have a clue.

most cpa firms seem to feel it is intuitive to use ownership percentage to decide important financial and governance issues. why is this? firms reason: “if our clients do it, why shouldn’t we?” here are some reasons why they shouldn’t.

many companies derive a major portion of their growth, profitability, overall success and value from branded products, plant, equipment, proprietary processes, patented technology and the goodwill/market recognition that comes from these assets. it’s understandable that an executive’s ownership percentage in these businesses should impact financial and governance issues.

but cpa firms are different. their primary asset is the partners’ ability to bring in and retain annuity clients, every day in every year, to perform a highly technical service from scratch, every day in every year and thereby earn clients’ trust and respect, every day in every year. the growth, profits and success of a cpa firm occur because of the quality of the owners’ work effort and skills to create these benefits every day in every year. cpa firms need to reinvent themselves every day in every year to remain successful.

relying too heavily on ownership percentage and not performance is a power grab and/or an opportunity to avoid accountability. it’s so much easier to take 30 percent of the firm’s profits because one is a 30 percent owner instead of earning it. it’s so much easier to commit transgressions of firm policies (take excessive time off, be delinquent in billing and collections, give oneself a waiver on business or staff development) safe in the knowledge that one can never be held accountable for those shortcomings because of the protection of a lofty ownership percentage.

one of the strongest arguments to minimize the importance of ownership percentage in cpa firms is simple: fairness. it’s simply not fair to rely on the use of ownership percentage to decide critical financial and governance matters. heavy emphasis on ownership percentage is guaranteed to cause tremendous acrimony among current and future partners. firms get twisted up in the illogic and unfairness of using ownership percentage and find themselves trying to solve problems that are unsolvable with old-school methods. they need to employ outside-the-box thinking.

here is a simple illustration. contrast the performance of the following two partners:

	partner a	partner b
owner percentage	30%	20%
business originated	$200,000	$500,000
business managed	$800,000	$1m
intangible performance	average	great

 

can there be any possible justification for partner a’s compensation and buyout being 50 percent higher than partner b’s, simply because partner a’s ownership percentage is 50 percent more than partner b’s?

there are five major partner issues for which firms should resist determining their outcomes on ownership percentage. here are recommended alternative treatments:

1. allocation of partner income. it should be based primarily on each partner’s performance, not their ownership percentages.
2. calculation of partner buyout. it should be based primarily on what partners have contributed to the firm’s profitability and success, usually measured by relative partner income, not ownership percentage.
3. it should be one person, one vote for the vast majority of issues (though most firms tell us they rarely take formal votes). if voting is based on ownership percentage, new and younger partners feel disenfranchised because older partners control the votes.
4. new partner buy-in. it should be determined as a fixed amount, independent of ownership percentage. use of ownership percentage to determine new partner buy-in usually results in an enormous buy-in cost that new partners are unwilling or unable to pay.
5. allocation of proceeds of a firm sale. it should use the same method as partner buyout. why use ownership percentage for firm sales when you use performance-based measures to decide buyout? this makes no sense. they really are the exact same transaction.

new partner buy-in: key concepts

the value of a cpa firm. there are two components: capital and goodwill, the latter of which is often stated as a percentage of the firm’s annual revenue. capital is on the balance sheet; goodwill is not.

here’s a crash course in cpa firm business valuations. assume a firm with annual revenue of $10 million. most firms have accrual basis capital of roughly 20 percent of their revenues, consisting mostly of wip and a/r. if we value the goodwill at 100 percent of revenue (this used to be so common it was automatic; today it is still common but much less so), the total value of the firm is $12 million: $2 million of capital and $10 million of goodwill.

why is this important? because when new partners buy into the firm, they are purchasing a part of the total value of the firm, which is quite substantial.

the decline of large buy-ins. in the old days, a manager would be summoned to the managing partner’s office and informed that he (and it was almost always a he) was being promoted to partner. while the manager was still wafting in the euphoria of finding out that he’d just been awarded the equivalent of a professor’s tenure, the managing partner stated that the buy-in would be $600,000, preferably in $10s and 20s. being of a generation raised to, when ordered to jump, dutifully respond, “how high?” he went home and figured out how to come up with the money.

how did the $600,000 get computed? the firm would first decide what ownership percentage to award the new partner. let’s assume that is 5 percent. this would be multiplied by the value of the firm, $12 million, to arrive at $600,000.

at least 15 years ago, it became apparent to most firms that these enormous buy-ins were untenable. new partners were neither willing nor able to pay these buy-ins.

this old-school tactic was replaced by the following:

• the firm decides on a discretionary, fixed buy-in, enough for the new partner to have skin in the game, with a substantial amount of money at risk. the buy-in as of 2020 for most firms, large and small, is in the $100,000 to $175,000 range. very small firms may have a buy in considerably less than $100,000.
• there is a disconnect between the buy-in and ownership percentage.
• the buy-in is usually paid to the firm by money withheld from the new partner’s compensation over a period of years. most firms try to make sure the net cash new partners take home is higher than their manager take-home pay.

as is the case with all major life changes, there are still some holdout firms that continue to require large buy-ins. but 95 percent of all firms have opted to make their new partner buy-ins affordable.

performance-based compensation. the vast majority of all multipartner cpa firms allocate income using a system that is performance-based. a performance-based system is simply one in which partners’ pay is in direct proportion to their performance compared to the other partners. the better one performs, the higher the pay. and vice versa. systems that are not performance-based are primarily based on ownership percentage or pay-equal. in these systems, a partner’s income is unaffected by performance.

why is this important? new partners should understand that beginning on their first day as a partner, they will be paid based on how well they perform and how the firm performs. they aren’t suddenly entitled to share in a huge profit pool without first earning it. besides, if a new partner’s income went way up, the way the math works, all the other partners’ income would have to go down. but that doesn’t sound very fair, does it?

no windfalls. similar to performance-based compensation, the process of being promoted from manager to partner should not result in any windfall financial gains to the new partner. most firms will give the new partner a nice promotion raise of perhaps 10-15 percent. that’s it. no windfall.

another windfall that new partners do not get. new partners don’t receive ownership in the firm unless they pay for it. let’s go back to the example of the $10 million firm. buy-in practices have changed to requiring a relatively nominal buy-in, say, $150,000. but with this buy-in, new partners are not buying any of the value of the firm. if the firm was worth $12 million before the new partner was admitted, the value of the firm after it receives the new partner’s buy-in is now $12,150,000 (assuming the buy-in is paid immediately, all at once, as capital). that’s it. if the new partner wants to pay, say, $600,000 to acquire part of the $12 million value, the partners would probably be more than happy to accept the money.

the $12 million value is relatively liquid. it has a reliably established value on the street. no one in their right mind would give it away for free or for a bargain price. new partners need to understand this.

sweat equity. as you read the last paragraph, some of you may be wondering about sweat equity. this colloquial term means a new partner is gifted a percentage of the firm in recognition of years of devoted, excellent service to the firm, service that enabled the partners to service their clients and reap the financial benefits that come with this. sweat equity is very rarely granted, but as with so many things, it’s up to the partners of the firm what they want to do.

voting. it’s natural for partner candidates to look forward to having a vote once they become partner. it feels like an inalienable right that any owner in an enterprise should be entitled to.

make no mistake about it: new equity partners do get a vote. but the significance of getting a vote is often much ado about nothing. most firms take few, if any formal votes. instead, they discuss and brainstorm issues at hand, reach a consensus and make decisions.

the real significance of a vote is to have a seat at the table or, as sung in the great musical hamilton, “to be in the room where it happens.” each partner has the opportunity to influence other partners to agree with their own position. more often than not, as a practical matter, that is what constitutes a vote.

assets of the firm. clients and staff are assets of the firm, not of any individual partner or staff person. i once was engaged by a three-partner firm to help them devise a methodology for bringing in a new partner, something they hadn’t done for quite some time. as part of this project, they asked me to explain to the partner candidate what it means to be a partner and the provisions of the firm’s partner agreement. when we got to the non-solicitation agreement, the manager shrieked with horror. unbelievably, he said: “i’m not signing that agreement. in five years or so, i want to start my own firm and take some of the firm’s clients i’ve worked on for years to get started.” needless to say, when the partners heard this, they terminated the manager.

it’s important for new partners to understand that clients and staff are assets of the firm. therefore, no firm members, including partners, are allowed to take these assets with them if they leave the firm. well-managed firms require staff to sign non-solicitation agreements and incorporate a non-solicitation covenant in their partner agreement.

the enforceability of this provision in partner agreements is, for the most part, legally indisputable. the enforceability of non-solicitation agreements for staff, on the other hand, is subject to state laws, which vary widely. most non-solicitation agreements provide for liquidated damages if they are violated.

posted on july 13, 2021