why merging in smaller firms is fabulous

eleven reasons to do it.

by marc rosenberg
cpa firm mergers: your complete guide

if an opportunity to merge in an attractive smaller firm was presented to you, would you be interested in pursuing it?

my guess is that at least 90 percent of all cpa firms would answer this question with a resounding yes! (and a healthy percentage of the remaining 10 percent perform at such high levels that they cannot conceive of merging in a smaller firm whose performance falls well below their own high standards.)

more: selling your firm? what to expect | thirteen ways to woo potential firm buyers | 13 reasons to merge up | merger? the 100 data points you need first | one times fees isn’t the only way | thinking merger? first ask why. | why do you want to merge? be honest. | four reasons to fear a merger
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why is this? the short answer is that it’s a great deal, both financially and operationally. it’s an almost can’t-lose proposition, as long as you do it right.

eleven reasons to merge in smaller firms

1. it’s a great growth strategy. for many firms, it’s easier to buy clients than to generate them internally. most cpas admit that they don’t like business development and aren’t good at it. so any strategy that lets them skip business development is a strategy to love. indeed, i have worked with many firms over the years whose primary growth strategy is to merge in one small firm after another. and they are perfectly content with this.
2. it’s a great investment. if you calculate the return on investment (roi) of acquiring a cpa firm, the yield is an astonishing 30 percent to 70 percent, depending on the facts. the main reason for this high roi is that the cpa industry has saddled itself with a notion that paying one times fees for a cpa firm, or even a small premium on one times fees, is reasonable. the fact is firms should be selling at 1.5 to 2 times fees because they are worth it. but 90 percent of firms are sold for 80 percent to 110 percent of annual fees. if you do the math, that’s a steal.
3. it acquires talent. the most difficult problem facing cpa firms for quite some time has been the shortage of talent, especially young talent, at both the partner and staff levels. many firms value the personnel they obtain in a merger as much as they do the acquired clients. the larger the buyer, the more likely it is that acquisition of talent is the #1 motivator for doing mergers.
4. it can obtain a new service, niche or specialty. this is a huge motivator for buyers, even more so in recent years. larger firms understand the power of service diversity and specialization, so they jump at the chance to acquire this expertise. unfortunately, smaller firms rarely have well-established niches and specialties.
5. merging in a cpa firm is low risk regarding cash flow. virtually all deals are structured so that buyers pay the sellers, over a period of years, based on collected revenues from retained clients of the seller. therefore, there is relatively little cash-flow risk to the buyer. as some put it, buyers pay for acquisitions from the seller’s own money!
6. merging in a cpa firm is low-risk regarding integrity. cpa firms are very high on the integrity scale. though there are certainly variations in the quality of work from firm to firm, it’s extremely rare to find a firm whose work quality and ethical standards are so low as to create an uncomfortable amount of risk for the buyer.
7. it fills a geographic void. this is much more typical of large regional firms that have exhausted the list of merger candidates in their own backyards. acquiring a firm in a target market is a great way to gain a foothold. advancing technology makes it easier for a buyer to manage a firm outside its own geographic location.
8. mergers enable buyers (and sellers) to afford “bigger firm things” sooner. some refer to this as building a critical mass. larger firms are better able to afford a sophisticated, expensive management structure that includes marketing plans, high-level administrators, university-style training, high-profile staff recruiting and others. smaller firms struggle to afford these features. so a $7 million firm that becomes $10 million overnight with a $3 million acquisition finds itself in a position to operate like a bigger firm.
9. it’s a great way to build the client base of a new partner. when some firms promote a manager to partner, it takes a while to build up a decent-sized client base. this process is speeded up when the buyer acquires the practice of a retirement-minded seller and assigns the clients to new partners.
10. it’s a buyers’ market. the aging of baby boomers has resulted in an avalanche of mergers fueled by the retirement of partners. we were all taught in economics class that when supply exceeds demand, it becomes a buyer’s market, and that is what is happening in the cpa industry today. buyers have more to choose from. they can cherry-pick their merger partners and in some cases reduce the purchase price.
11. it makes more money. put all these reasons together and the result is higher profitability for the buyer. multiple studies of cpa firm metrics consistently show that bigger is better: the higher the revenue, the higher the profitability. this doesn’t guarantee that higher revenues will translate to greater profits, but it usually works out that way.

what larger firms should expect

though it’s not universally true, larger firms will find many aspects of smaller firms to be below their standards. buyers need to ask:

• how severe are these weaknesses? do pluses outweigh minuses?
• can the smaller firm be re-engineered?
• are they willing to change?
• do we have the patience to make the turnaround?
• do we have the expertise to make the turnaround?

larger firms should expect to find the following at smaller firms:

1. inaccurate timekeeping. this is more common with firms under $1 million than over. small firms have the mentality that they will spend as much time as it takes to do the work, without regard to fees charged. their timekeeping practices are often subpar. they tend not to record billable time if they know the work can’t be billed. all of this makes it difficult for buyers to assess accurately the profitability of a seller’s clients.
2. partners working in the business, not on the business. partners do a lot more staff-level work at small firms than at larger firms. they pride themselves on being “hands-on” partners, to excess.
3. weak client-acceptance and retention procedures. small firm client acceptance procedures can often be described as accepting anyone with a pulse. generally speaking, they’ll do just about anything to get or keep a client.
4. small firms have “small firm” clients. more individual clients; fewer businesses. high number of low-value and/or standalone 1040s. more write-up work; fewer audits. little consulting.
5. weaker staff. staff at small firms tend to be dominated by paraprofessionals and “older” staff lacking both the desire and the talent to become partners. no firms find staff recruiting easy. small firms find it nearly impossible.
6. low staff billable hours. at one meeting, the buyer’s partners introduced themselves to the seller’s staff. one full-time staff asked: “how many billable hours will you expect from us? i work as much as i possibly can and i barely get to 1,200.” obviously, the seller had developed low standards and expectations for productivity. buyers need to assess the seller’s productivity.
7. lower work standards. not necessarily low, just lower than larger firms. almost every small firm merged into a larger firm goes through a process of bringing their work up to the standards of the larger firm.
8. lower profitability. generally speaking, the smaller the firm, the lower the profitability. this presents the acquiring firm with a great opportunity to increase the smaller firm’s profitability with superior practice management skills.
9. lower skill level of partners. it’s likely that some partners at a $2 million firm would not meet the criteria to be a partner at a $5 million firm. partners at a $5 million firm might not meet the partner criteria of a $15 million firm. and so on. larger firms invariably find themselves thinking long and hard about whether to make all the partners of the acquired firm equity partners at their firm.
10. loosey-goosey management style. partners at small firms say apocryphally, “i never saw a policy or procedure that i couldn’t violate.” these partners are used to being kings of their realms and don’t take kindly to someone telling them what to do, even if it’s a policy they agree with. the term “accountability” isn’t in their dictionary. will these partners fit in with your firm? can they successfully undergo an ego-ectomy?
11. clients with bad habits. as we said earlier, partners at small firms are desperate to bring in business and keep the clients they have. they fiercely avoid any semblance of conflict with clients. this often translates to lax billing and collections. larger firms should expect to see many clients of smaller firms paying their bills very late because the seller has allowed them to get away with this practice for many years.
12. small firm partners work so hard that they struggle to devote the necessary time to the merger. the smaller the firm, the more client work their partners do. plus, partners have lots of internal responsibilities. all of this makes it difficult for sellers to find the time to devote to the merger process, especially during tax season. larger firms need to decide if they can tolerate it.
13. small firm partners never want to retire. their work is their life. they don’t want to give it up. larger firms should make their expectations for when small firm partners retire crystal clear.
14. small firms often have sacred cows. these are longtime personnel who have a privileged, practically tenured position with the owners because of their longevity and loyalty to the firm. but time often erodes their skills, and a merger partner may not find these people worth retaining. common sacred cows are office managers, firm administrator and longtime (i.e., older) professional staff.
15. low technology proficiency. this is admittedly a generalization, but unfortunately, it’s true in many cases. larger firms should be prepared for a shockingly low level of technology literacy at smaller firms.
16. noncompete/nonsolicitation agreements with the staff. it’s very rare for firms under $5 million to have these agreements with their staff. in your due diligence, try to determine if any staff plan to leave and take clients with them. if you hire the seller’s staff, get them to sign these agreements. offering employment to the seller’s staff is sufficient remuneration to make the agreements binding. buyers need not remunerate them separately.

initial screening questions to ask sellers

contact information

date
contact name
firm name
address
telephone
email

 

basic data

annual fees
#partners/prof staff/total fte
ages of partners
practice breakdown · a&a · tax · consulting
specialties or niches
partner billing rates
average partner billable hours
1040s: · number of returns · average fee · minimum fee
software: · tax prep · audit · accounting

 

screening questions

1. why do you want to merge into a larger firm?
2. do your partners have specialties or are they all generalists?
3. how long do your partners want to work?
4. does your firm keep accurate time records?
5. how would you describe your staff? how strong are they? do any have potential for partner?
6. do you have remote workers? what is your remote work policy?
7. how would you describe the state of your firm’s use of technology?
8. software: · tax prep · accounting · other
9. office lease situation
10. we’ll want your firm to move into our office. is this ok?
11. i don’t want to start negotiating merger terms on this call, but can you tell me if you have any unusual must-haves?
12. would you like to meet informally to move to the next step?

 

posted on july 28, 2022