you’re probably not an owner.
by marc rosenberg
how to bring in new partners
there are two components to the value of a cpa firm: 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.
more: why buying into a firm is such a great investment | four philosophies for managing a cpa firm | public accounting as a business, 101 | 16 steps to creating a partnership path | six ways new partners differ from managers | the four essentials for every new partner | tell potential partners what it takes
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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 nonsolicitation 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 nonsolicitation agreements and incorporate a nonsolicitation covenant in their partner agreement.
the enforceability of this provision in partner agreements is, for the most part, legally indisputable. the enforceability of nonsolicitation agreements for staff, on the other hand, is subject to state laws, which vary widely. most nonsolicitation agreements provide for liquidated damages if they are violated.