when each is most common.
by marc rosenberg
cpa firm mergers: your complete guide
after settling financial and operating issues, we turn to two-stage vs. one-stage mergers.
more: buying a solo | 23 questions for mergers of equals | selling your firm? what to expect | one times fees isn’t the only way | four reasons to fear a merger
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in the end, it’s all about the math.
a one-stage deal is the more common, traditional of the two deal types and is in every way an acquisition by the buyer, regardless of how it may be described to others. payments to the seller commence on the effective date of the sale and continue throughout the payment term. in some cases, the seller may continue working full or part-time for the buyer and phase out over a period of time that is always shorter than in a two-stage deal, perhaps one to three years.
a two-stage deal is a hybrid of a true merger and a sale:
- stage 1. the seller continues working full-time and controls their clients for a period that ranges from three to six years. the seller almost never has equity in the buyer. client transition may take place either toward the end of stage 1 or the beginning of stage 2, depending on the negotiated arrangement. no payments on the purchase price are made during stage 1. compensation is negotiated. the terms of the buyout are agreed on, in writing, at the effective date of stage 1.
- stage 2. the seller “retires” and begins or completes client transition, and the buyer commences payments of the purchase price. the purchase price is based on the revenue at the start of stage 2, not at the beginning of stage 1. in most cases, the seller works part time at the onset of stage 2 and phases out rapidly after client transition has been completed.
when each deal is most common
sellers opting for one-stage deals are usually older, often much older, than those preferring two-stage deals. they want to retire sooner, many in one to three years, than two-stage sellers.
those preferring two-stage deals are often younger, though usually no younger than their late 50s. they want to have their cake and eat it, too: they see the end is getting near but still want to work full time for several more years, continuing to work as they always have but with fewer headaches. equally important, they lock in the sale of their firm to a reputable, well-managed buyer sizable enough to provide a viable, almost guaranteed exit strategy comfortably.
benefits of a two-stage deal
- sellers get the best of both worlds: they are able to continue working full-time for a certain number of years, doing what they’ve always done as they control their clients. at the same time, they have secured their buyout.
- sellers get the comfort and security of knowing they have backup and support should they become ill or wish to slow down. a two-stage deal is much preferable to a practice continuation agreement.
- sellers can spend the last several years of their career focusing on what they love and do best – working with their clients – and minimizing administrative headaches like hiring and training staff, keeping up with technology, and worrying about the printer breaking down.
- sellers can reap the benefits of being part of a more diverse, larger, better-managed firm. benefits include more services to sell, access to more and better-trained staff, more efficient technology, and the ability to collaborate with technical specialists in audit or tax.
- in a one-stage deal, sellers have to adapt to the buyer immediately and inalterably, which can be traumatic. in a two-stage deal, sellers have three to six years to mesh with the buyer’s practice, forge effective relationships with the buyer’s personnel and introduce new staff to their clients.
- as a result of #5, there is better client retention than with a one-stage deal. this is particularly important with small sellers who have decades-long relationships with super-attached clients.
- waiting until stage 2 for the buyout to begin means the sales price will be higher (to the extent that the seller’s revenue increases during stage 1).
two-stage mergers have become a viable choice. until 10-15 years ago, the majority of all mergers were one-stage. it was pretty simple: 65 was a common retirement age, and more cpas wished to retire at 65 than do today.
but in recent years, our experience is that over half of all sellers want to work past 65, some well past it. a number of factors have contributed to this change:
- people are living longer and healthier because of advanced medical care. today, 65 seems to many a premature retirement age. we hear a lot of partners say, “today’s 70 is yesterday’s 65.”
- the past 20 years, with a few hiccups along the way (like the 2008-09 recession), have been great years for cpa firm growth and profitability, and sellers don’t want to give it up, even if they’ve saved enough to retire sooner.
- the labor shortage has given small firms severe headaches, denying them viable exit strategies and sufficient staff to delegate work to. the two-stage approach largely relieves the 58- to 65-year-old cpa who isn’t ready to retire of these two headaches during the final years of their career.
- as has been the case for several decades, cpa firm partners tend not to have meaningful hobbies besides golf, which they can’t do 50 hours a week, 12 months a year. in short, partners approaching retirement age fear they will have little to do if they retire at 65.
- buyers really like the two-stage approach because it gives them a longer window of time to transition the seller’s clients. also, it lets buyers make the seller more profitable by tapping into cross-selling opportunities and better practice management (more aggressive pricing, billing practices, etc.).
words of caution
some buyers are in too much of a hurry. i’ve seen some buyers foolishly negotiate a two-stage deal and insist on starting the buyout beginning with stage 1. they say they want to “get the payments out of the way.” but the problem is that to make the cash flow work at the onset of the deal, the buyer has to dramatically reduce the seller’s compensation, making the deal untenable to the seller.
sellers should not expect to have their cake and eat it too. similar to the above, at no time during either stage should the seller insist on the buyout to begin while receiving 100 percent of their previous compensation. of course, they are free to try negotiating for full compensation, but this will, more than likely, alienate the seller, who can’t make the cash flow work.
beware of the initial cash-flow lag. because payments to sellers are based on collected revenue (vs. billings) in virtually all deals, it’s only natural that in the first quarter or so after the effective date, the buyer will experience a cash-flow deficit resulting from a lag in collections while expenses remain normal. (obviously, staff and overheads need to be paid promptly from day one.)
this is a particular problem in two-stage mergers because the initial compensation to sellers is almost always higher than in a one-stage transaction, where the seller often begins working part-time and hence is paid a much lower compensation. to address this cash-flow imbalance, we have seen some buyers negotiate a reduced compensation to the sellers for the first quarter and then make up for it in future months as the revenues begin to be collected.
it’s important to remember that in m&a deals, sellers never sell their wip and accounts receivable to the buyer. as a result, in the first few months after the merger date, sellers receive a nice cash-flow stream from the collection of these assets, thus offsetting any reduced level of compensation from the buyer during the first quarter.
the common thread of these scenarios: the math must work. an important way that buyers (mostly those with revenues under $20 million) can afford the purchase of a smaller firm, whether in a one-stage or a two-stage deal, is by paying lower compensation to the seller. most buyers are unwilling and unable to make buyout payments while compensating the seller handsomely. the math doesn’t work.