bonus: ten surprises at the end of negotiations that can threaten a deal.
by marc rosenberg
cpa firm mergers: your complete guide
the scope of due diligence will differ depending on the deal and should be tailored appropriately. the letter of intent issues, combined with the six areas outlined here, result in a comprehensive list of due diligence procedures that should serve the needs of most cpa mergers.
more: why solo cpas need pcas | where mergers go wrong | what your merger letter of intent needs | 61 things buyers should explore with sellers | thirteen ways to woo potential firm buyers | one times fees isn’t the only way | four reasons to fear a merger
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the six types of due diligence are financial and operational, clients and services, technical product and work quality review, personnel, risk management and legal.
financial and operational. this primarily relates to reviews of a firm’s financial statements and performance, service and industry mix, production statistics, firm tax returns, statistics, subsidiary records such as wip and a/r reports, and the like.
given that the ultimate goal of any transaction is a successful financial outcome, it is no wonder that financial due diligence often eclipses the other areas. however, the other areas are equally important. we’ve all heard the saying: “a picture is worth a thousand words.” well, in the realm of due diligence, i’ll suggest this: “numbers speak volumes.”
i have always been a big proponent of exchanging financial and production information as early in the process as possible, typically immediately after the get-to-know-you meeting, before negotiations begin. because numbers speak volumes, if one firm’s review of the other’s data discloses a deal-breaker, the merger can be called off at an early stage, saving both firms a lot of time.
my experience in consulting with cpa firms has shown that the way partners describe their firm’s financial performance can differ significantly from reality. people have a natural tendency to overstate their strengths and play down their weaknesses.
but the gap might also be caused by a basic lack of understanding of how to interpret a cpa firm’s financial metrics. (it’s hard to believe this of cpas, but it happens!)
here’s a common example. in conversation, i’ll question firms about their realization percentage (the percentage of total time worked on a client project that is actually billed). this figure typically ranges from 80 to 95 percent. the response i’ll get may be 90 percent. but when i add up the billable hours supposedly worked by all personnel (accurate time records aren’t always maintained at smaller firms) and multiply the hours times the individual billing rates, the resulting billable time amount often exceeds the actual billings by a wide margin. so clearly, the realization rate is well below 90 percent.
this disparity is usually the result of the firm’s personnel working many billable hours that are not recorded because the owner knows the time can’t be billed.
the moral of the story: numbers don’t lie. perform your own review of the actual numbers to provide an accurate assessment of your merger partner’s financial performance. don’t assume that everything your merger partner tells you is accurate.
a nuance to this moral: don’t rely on your merger partner to compute ratios accurately. double-check their computations. examples:
- realization percentage. this percentage is time billed divided by time worked on clients. as discussed above, small firms often fail to include all time worked in the denominator, thus resulting in a misleading ratio.
- staff-to-partner ratio. the headcount measures must be in full-time equivalents, not number of people employed. four people working half-time is two ftes.
- net firm billing rate. this is total firm billings divided by total firm billable hours. we’ve seen firms use collections instead of billings. we’ve seen firms use billable hours by so-called “professional staff,” thereby excluding paraprofessionals and administrative staff. the denominator should be billable time by all personnel, from partner to receptionist.
to underscore the importance of computing your own ratios, in the rosenberg map survey (a survey of over 300 firms done annually since the 1990s), we instruct participating firms not to compute any ratios because we want to compute them. we adopted this procedure early on because of the huge number of mistakes firms were making in computing their ratios.
we have discussed the financial, production and operating data to be reviewed. in addition, these software issues should be reviewed:
- backup systems in place for all computers
- all licenses and user agreements
clients and services. at the heart of any cpa firm merger are the clients and the services provided to them. accordingly, information about the clients is critical and should include a review of the following information:
- who are the clients? review a list of clients with the last two years’ revenue by service category and industry, including charge hours, realization rate, etc. it is usually acceptable to follow the 80-20 rule on this: the list should be limited to the 20 percent or so of clients that comprise roughly 80 percent of the firm’s revenue.
- summary of how clients came to the firm. referral? merger with another cpa firm? expanded services from an existing client? business development by a member of the firm?
- significant clients lost in the past 24 months.
- specialized services or higher-risk services.
technical product and work quality review. each party to the merger needs assurance that the other’s professional work products, workpapers and practices meet the other party’s quality principles and are in compliance with professional standards.
there are two concerns. first, the firm performing the due diligence seeks assurance that the other firm’s professional competence is at an acceptable level and will not lead to potential quality problems.
second, if the work of the firm being reviewed is below the reviewing firm’s standards and expectations but still within an acceptable range, can the firm raise its quality level while still serving clients profitably?
typically, if additional work is needed, it is not the type that clients will see value in and be willing to pay more for. clients may not agree to pay higher fees merely to obtain work performed at an imperceptibly higher work standard.
as a practical matter, the vast majority of due diligence on technical work quality is done by the buyer on the seller’s work, for a couple of reasons. the technical work of larger firms is almost always more sophisticated and standardized than that of smaller firms; the buyer naturally wants to determine if the seller makes the grade.
in addition, the buyer is acquiring the seller to enhance its practice, not to purchase severe technical deficiencies that will need to be corrected, or worse, give rise to future liabilities.
in short, the buyer needs complete assurance that it’s making a technically sound investment.
although the lion’s share of technical due diligence is typically performed by a buyer, there are good reasons for the seller to do due diligence on the buyer’s work as well. by reviewing the buyer’s work products, workpapers and processes, the seller will get a feel for what will be required for it to comply with the buyer’s standards. if the gap is severe, the seller may not wish to subject itself to these changes.
in many cases, technical due diligence is performed by professionals with greater quality control expertise than the chief negotiators in the merger. sometimes it may be advantageous or even necessary to retain a consultant to perform due diligence that can objectively assess the technical practices of both buyer and seller.
personnel. the merger partner’s personnel are its most valuable asset besides its client base. accordingly, understanding matters related to the firm’s partners and employees is a critical part of due diligence. the following should be reviewed:
- do any employment agreements exist with any personnel, including noncompete and nonsolicitation agreements?
- is there is an established plan or policy for determining employee compensation? any special compensation arrangements with a partner or employee?
- what systems are in place for reviewing employees’ performance? how do they receive feedback?
- what are employee benefits? remote work policies? any special benefits for the partner group or individual partners, including loans or pension, 401(k) or deferred compensation plans? determine unused vacation and sick time and agree how they will be handled post-merger.
- what significant disciplinary issues have been documented with employees or partners? any violations of firm policy and quality guidelines? any voluntary, unexpected or regrettable departures, especially to competitors? also review salary history, negative performance reviews that could be grounds for termination and any other documentation that could result in legal exposure.
- what are the current and anticipated future obligations to retired partners not reflected in the firm’s financial statements?
- what are the key personnel policies? is there an employee handbook? any unwritten policies (e.g., flexible work arrangements)? what is the firm’s severance policy, if any?
risk management. the importance of risk management is often understated in the due diligence process. effective risk management practices suggest that a firm will be a sound investment for the buyer. here are some important risk management procedures to review:
- what are the firm’s client acceptance and retention practices? what terms appear in standard engagement letters?
- how does the firm identify and clear independence concerns and conflicts of interest?
- how are the risks associated with engagements typically identified and managed?
- is there an internal quality review process? is it effective?
- how is individual professional competency assessed and assured? is there a system for tracking cpe? how is professional competency addressed in performance evaluations?
- what is the vetting process for new or expanded service offerings?
- what are the firm’s document storage and retention practices?
- what are the personnel policies for code of conduct, ethics, social media, firm and client confidentiality?
- review the firm’s insurance policies. is there pending litigation? if yes, determine the extent of insurance coverage.
- ascertain the status of ongoing irs examinations with clients and the extent of any potential firm liability.
legal. this is an area where attorneys often play a significant role. a partial list of issues that are often included in legal due diligence:
- what is the organizational and equity structure of the firm?
- what are the condition and quality of the organizational documents (e.g., partnership, shareholder and buyout agreements)? do they properly address key issues such as partner retirement, transfer of equity, partner withdrawal/termination, governance and firm management? do they contain any impediments to the merger’s success?
- is the firm properly licensed and registered with the state? are the firm and its partners and employees in good standing with state regulatory agencies?
- other than public accounting, does the firm provide any services that are regulated (e.g. wealth management, broker-dealer, insurance brokerage)? are the firm and individuals properly licensed in these areas?
- does the firm have malpractice insurance? what are the limits and retention amounts? is it adequate for the firm’s practices, client base, risk profile, etc.?
- are there any current liability proceedings besides malpractice? if yes, these should be carefully reviewed.
- are there any impediments to the seller obtaining tail malpractice coverage?
- what are the exact state and nature of past, present and potential future malpractice cases and other client, employee (or partner) and vendor lawsuits and/or complaints?
- if the firm performs audits, has the firm been peer reviewed on a regular basis? what were the results?
- are there any current or past regulatory investigations of the firm, its partners or employees, or its clients, including irs audits?
- have any noncompete, nonsolicitation or other restrictive covenants been imposed on the firm or its partners or employees?
- what material contracts and agreements does the firm have (e.g. office leases, consulting contracts, referral agreements, vendor agreements)?
- what are the firm’s and the individual partners’ credit ratings? get references from banks, attorneys, financial advisors, etc.
- are there any liens against the firm’s assets?
- who maintains ownership of technology?
- what are the significant legal expenses for the past two years?
- do any partners or staff have criminal records? has anyone ever been indicted or convicted by any court of any punishable offense, such as fraud, theft, embezzlement or any other felony involving moral turpitude? is there any current activity that could lead to indictment or conviction?
- have any partners ever been declared bankrupt?
- have any partners or staff been the subject of disciplinary actions by the aicpa, state cpa societies, regulatory bodies, etc.?
- have there been any other unusual incidents, practices and events that, when discovered, might cause the merger partner to break off discussions?
with the exception of financial due diligence, as a general rule the other types of due diligence take place after the deal terms have been negotiated. most firms don’t want to invest the considerable time and expense required to perform due diligence until there is a high degree of certainty that the merger will close.
surprises at the end of negotiations that can threaten a deal
due diligence is all about dotting the i’s and crossing the t’s. it also helps avoid the kinds of surprises that can threaten a deal after it has been informally approved by both firms.
these are some surprises that i have experienced in recent years:
- a solo did a few small audits and did not get them peer reviewed. “i didn’t get to it.”
- the seller had not been properly registered with the state. their firm was registered but not the individual owners.
- the seller never carried malpractice insurance, so tail insurance couldn’t be obtained.
- a staff person from the seller decided not to work for the buyer. secretly, he was contacting clients to set up his own practice.
- bad or nonexistent time records masked unrecorded billable time of the seller, thus hiding write-offs. while this practice wasn’t in writing, it was widespread throughout the firm.
- in the latter stages of the merger process, the seller stalled the buyer’s repeated requests to talk to the staff. the buyer became increasingly perturbed. only when the buyer delivered an ultimatum did the seller admit that they were not comfortable exposing their staff to the buyer until a merger agreement was signed. if the seller had been open about this in the beginning, the tension level would have been lessened.
- seller’s income statement showed billings that were substantially in excess of collections. this meant that actual annual revenue was significantly overstated because of terrible collection problems.
- one seller had a longtime “entitled” partner. the gravest manifestation of this was that he spent 10-12 weeks a year working from a second home halfway across the country. of course, he insisted that he was working, not vacationing. another partner had the habit of arriving at the office at around 11:00 a.m. every day. when asked why, he said he gets up early to exercise at home and while doing this, he’s always “thinking” about the firm.
- related to #8, i’ve seen sellers with partners or staff who officially worked full-time but actually worked considerably less. this was masked by the offenders coming to work late, leaving early and working remotely with little accountability.
- review of the partner production data revealed that one partner worked hours that most people would feel were padded. his billable hours were 2,500 and total work hours 3,300. when the buyer asked about this, the seller reluctantly said that the partner had refused to delegate work to staff and was a workaholic, due at least partially to an unhappy marriage. worse yet, the firm and this partner had argued about this for many years with nothing resolved. when the buyer pressed the matter, the partner decided to leave the firm rather than be forced to change his ways. the fact that the seller was not forthcoming about this greatly disturbed the buyer and threatened the deal.