plus the impact of ownership percentage on partner issues.
by marc rosenberg
how to bring in new partners
let’s go over structuring a new partner buy-in step by step.
more: what buying in actually means | why buying into a firm is such a great investment | the business side of cpa firms | it shouldn’t take so long to make partner | three types of skills you need to become a partner | seventeen basic expectations of partners | nine ways to woo a prospective partner
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1. calculate the value of a cpa firm as accrual basis capital plus goodwill. goodwill is commonly expressed as a percentage of the firm’s annual revenue. this total value should not be given away to anyone without being paid for. bringing someone in as an owner in a profitable, viable business for little or no buy-in makes no sense.
2. define the criteria for making someone a partner. the first step in bringing in a new partner should be for the firm to satisfy itself that the candidate meets its criteria. in best practices at the finest firms in the country, four stand out from the others:
a. trust. the partner group should trust new partners to execute sound judgment in their conduct as partners. to be ethical and mindful of their obligation to protect the firm at all times. to always adhere to the firm’s core values and policies. if you don’t trust people to be your partner, you should never be partners with them, regardless of their strengths in areas that will benefit you financially, such as bringing in business.
b. ability and willingness to take on the financial obligations of an owner. this mainly pertains to paying the new partner buy-in, sharing in the obligation to pay buyouts to departed partners and in general adhering to the provisions of the firm’s partner agreement.
c. credibility with clients and staff. new partners should have the executive presence to earn the respect and confidence of clients, especially when they take over client duties from a predecessor partner. credibility also extends to staff; new partners should be seen by the staff as both earning and deserving of the partner position.
d. bringing in business. the ability to originate clients is a controversial threshold for new partners. some firms require it; others don’t. one thing is for sure: all firms prefer that new partners have skills for bringing in business.
3. determine the buy-in.
a. few large buy-ins. many years ago, a new partner’s buy-in was almost always determined by multiplying the newly awarded ownership percentage times the value of the firm (capital plus goodwill). using this approach today results in buy-in amounts of hundreds of thousands of dollars at most firms, an amount young partners are neither willing nor able to pay.
to structure the buy-in so it’s affordable to the incoming partner, the firm has to sever the link between ownership percentage and the buy-in. this is simple: arbitrarily decide on a more affordable buy-in amount. based on our work, the vast majority range between $100,000 and $175,000 for both large and small firms.
in a recent survey by the rosenberg associates, only 11 firms out of 348 set their buy-ins at $500,000 or more.
virtually all the rest were $200,000 or less. if your firm wants to charge a huge buy-in to new partners, and they are willing to pay it, then that’s your decision. but that barrier may limit your pool of qualified candidates.
the key is this: all partners in the firm should have a meaningful amount of their own money at risk, invested in the firm. people will act more like owners when they have their own money invested in the firm.
b. how the buy-in is paid. virtually all firms work out an arrangement whereby the new partner pays the buy-in via a salary reduction. a common payback period is five to eight years. whatever the arrangement, it’s important to ensure that new partners take home more cash than they did when they were managers.
c. no guarantees. if new partners choose to borrow money from a financial institution to pay the buy-in, firms do not guarantee the loans. many years ago it was common for firms to make these guarantees, but firms long ago got out of the banking business.
d. to whom the buy-in is paid. at most firms, the buy-in is paid to the firm. at a minority of firms, almost always small firms with, say, two or three partners, we have seen new partners “buy” their ownership directly from existing partners.
paying buy-ins to the firm instead of directly to partners is consistent with the one-firm concept and a best practice. many problems are created when buy-ins are paid directly to individual partners:
i. buy-ins arranged between two partners are outside of the control of the firm, counter to the one-firm concept.
ii. when new partners pay the buy-in directly to a current or retiring partner, it is often accompanied by the transfer of the “giving” partner’s clients to the new partner. this precludes the firm from being able to decide how to transfer clients in the best interest of the firm.
iii. if the firm uses a formula to allocate partner income, and the new partner is the recipient of a substantial client base, this will create a compensation windfall that is not fair to other partners.
iv. if ownership percentage is an important factor in determining voting, compensation, buyout and other things, a buy-in handled between partners instead of firmwide could alter the relative partner ownership percentages in ways that could be unfair to the firm’s other partners.
v. more often than not, the terms of each buy-in differ from those of the last, which turns the buy-in process into a negotiated transaction that often is not in the best interest of the firm and almost always results in inconsistencies.
4. clarify what new partners get for their buy-in. this is a question new partners ask, justifiably, when they are informed of the buy-in requirement. firms should be prepared to respond.
a. first and foremost, new partners essentially get to be a member of the “club.” they get to become owners of an organization that operates a highly profitable, growing, prestigious firm that will provide them with an income stream for 20 to 40 years that is well above what most people earn.
b. many firms pay interest on partner capital accounts as a layer of the partner compensation system, often at percentage points above the prime interest rate. this, of course, applies only in cases where the firm’s compensation system has a tier for interest on capital.
c. partners get their capital back when they leave the firm.
d. they share in the value of the firm and its substantial increase in value over their decades as a partner. when they retire, they will receive a stream of payments that may total as much as three times their compensation.
e. they get the recognition of being a partner and, along with it, a say in how the firm is run and a vote on decisions.
5. eliminate the term “ownership percentage” from your vocabulary. there should be no connection between the new partner buy-in amount and the person’s ownership percentage.
6. determine partner compensation primarily by what partners contribute to the firm’s growth, profitability and success each year. this applies to new partners as well. the key is that the firm’s partner compensation system should be performance-based.
many firms award new partners a promotion raise, but it is relatively modest. the range of 10-15 percent is common.
in the first several years after someone becomes a partner, many firms adopt an informal policy of erring on the side of being generous. this is an attempt to move the new partner’s compensation up several notches.
7. account for capital. regardless of whether the firm is a corporation or a partnership, there is a substantial amount of accrual basis capital in a firm. each partner owns some portion of that capital.
there are several methods for determining how much capital each individual partner “owns.” they are listed in order from most common to least common.
a. the old-fashioned partnership accounting method. if the firm is a partnership, this is self-explanatory.
b. each partner’s share of capital is in the ratio of his or her ownership percentage. this is inherently unfair because over time, ownership percentage ratios rarely correspond to how each partner performs relative to the others.
c. each partner’s share of capital is in the ratio of his or her partner compensation. two important caveats:
i. the firm must have a performance-based partner compensation system, not a pay-equal system or one based on ownership percentage.
ii. the partners must feel that the system and the results are reasonably fair (not perfect!).
d. corporations value the shares of stock owned by each partner, and that is how each partner’s share of total capital is calculated.
a partner should never be allowed to withdraw capital except for purposes of death, disability, withdrawal or expulsion from the firm.
at most firms, there is a difference between their accrual basis income and the actual cash distributions made to the partners. the gap between the two is because of cash-flow considerations. the actual cash distributions should be in the same ratio as the income-sharing ratios determined by whatever income allocation system is adopted by the firm. in other words, partners should not be allowed to overdraw because they “need the money.”
8. plan for goodwill-based buyout payments. this is a major financial benefit of being an equity partner. when the partner leaves the firm by retirement, death, disability, withdrawal or expulsion, his or her interest in the firm is purchased by the firm. the payments are called partner buyout payments.
9. understand what a new partner does not get.
a. a windfall
b. a huge promotion raise
c. assets, unless the partner pays for them
d. a right to participate in the management of the firm
e. waivers from being accountable for performance and behavior
10. define what happens if the firm is sold or merged. the proceeds of a firm sale should be allocated in the same way as if each partner retired under the firm’s partner buyout plan. ownership percentages should not be used.
11. specify how the role of new partners changes from when they were managers.
12. allow voting. the importance of voting tends to be overstated. firms rarely take votes. instead, they discuss matters, reach a consensus and make a decision. so a vote is really more a right to sit at the decision-making table and influence others.
13. have a nonsolicitation agreement. well-written partner agreements prevent partners from taking clients and staff if they leave the firm. most partner agreements provide liquidated damage penalties for doing so. new partners must sign this agreement.
14. consider a non-equity partner alternative. firms may not wish to automatically promote a manager directly to equity partner. many firms promote their managers to non-equity partners and then have them meet more stringent requirements to become equity partners.
15. sign the partner agreement. new partners must sign to formalize their admission to your firm’s ownership ranks.
new partner buy-in common practices
| feature | common practices |
| 1. total value of the firm | accrual basis capital + intangible (goodwill) value |
| 2. most important criteria for partner promotion | 1. trust
2. willingness and ability to take on retirement obligations 3. credibility with clients; executive presence to take over client relationships 4. often, bringing in business |
| 3. buy-in | 1. set initially at $75-175k
2. $10-20k down payment for some firms 3. pay buy-in via draw or salary reduction 4. pay over 5-8 years, making sure new partners’ take-home pay exceeds take-home amount when they were managers 5. if they get bank loans, no firm guarantees 6. buy-in is paid to the firm, not to individual partners |
| 4. what do new partners get for their buy-in? | 1. become member of the club, with substantial income stream for 20-40 years
2. interest on capital, if this is part of comp system 3. capital returned upon leaving the firm; increases as the firm grows 4. vesting in the value of the firm 5. a vote (really more a seat at the table) |
| 5. ownership percentage | 1. the term is used minimally in the firm
2. keep to a minimum the impact of ownership percent on (a) buy-in amount, (b) partner comp, (c) partner buyout and (d) voting |
| 6. partner compensation | 1. ideally, new owner should receive a 10-15% promotion raise.
2. make sure the system is performance-based. 3. err on the side of being generous to new partners in the early years. |
| 7. capital | 1. use the partnership method of accounting for tracking the amount of each partner’s capital
2. no withdrawals of capital allowed 3. paid upon leaving the firm |
| 8. goodwill-based payments at retirement/buyout | 1. though 1x fees is common, industry avg. = 80%.
2. multiple of comp method is most common. aav method works well if no previous plan. |
| 9. what new partners do not get | 1. windfalls
2. assets that they do not purchase 3. the right to participate in firm management 4. a waiver on partner accountability |
| 10. if the firm is merged or sold | allocation of proceeds is the same as if every partner did a normal retirement. |
| 11. how the role of a new partner changes | 1. may not change too much at onset. depends on whether the firm can replace the manager role the new partner was occupying.
2. many new partners take over clients worked on as a manager. 3. bring in a new manager to free up new partners’ time to function like partners. 4. develop the leadership skills of managers. 5. most firms expect new partners to actively bring in new business to some extent. 6. many firms expect new partners to develop a niche or specialty service. |
| 12. voting | 1. most firms almost never take formal votes.
2. reality: voting gives the new partner a seat at the table and opportunity to influence others. 3. voting everything on ownership percentage “disenfranchises” the new owner. 4. one person, one vote for most matters. several exceptions. 5. founders must be protected from minority partners tossing them out. |
| 13. nonsolicitation agreement | new owner must sign a nonsolicitation agreement against taking clients and staff. |
| 14. non-equity partner alternative | many firms require prospective equity partners to spend 1-3 years as ne partners before becoming equity partners. serves as a training period and a time to see if the new partner is a good fit. sometimes the non-equity position is permanent. |
| 15. partner agreement | must sign. |
impact of ownership percentage on partner issues
| area of impact | impact of ownership percentage | explanation |
| 1. allocation of partner income | minimal | · probably at least 80% of partner income should be allocated based on performance.
· exception: interest on capital · some firms like to pay a segment of income equally or near equally to all partners. ok if the amount is small. |
| 2. retirement/ buyout payments to a departed partner | none | · preferred partner buyout methods such as multiple of compensation or the aav method have no component for ownership percentage.
· bulk of a partner’s accumulated buyout should be considered deferred compensation and, as such, have a significant performance component. |
| 3. determination of buy-in amount | none | · buy-in determined as a fixed amount at partners’ discretion
· buy-in amount has nothing to do with ownership percentage |
| 4. voting | none | most votes should be conducted on a one-person, one-vote basis on certain supermajority issues. |
| 5. sale of the firm | none | proceeds to each partner should be based on relative accumulated retirement benefits. |
alternative new partner buy-in methods
the method described earlier in this post is a cpa firm industry best practice. we have seen alternatives that some firms prefer, though each has disadvantages.
- all partners have equal ownership percentage. this works great if the firm has minimized or eliminated the impact of ownership percentage, per the chart above.
- the firm arbitrarily determines a new partner’s ownership percentage. the buy-in is computed by multiplying the ownership percentage times the value of the firm. some firms use a firm value that includes only capital, which can result in a reasonably sized buy-in amount. others use capital plus goodwill, which usually results in unrealistically large buy-ins.
- ownership percentage is periodically adjusted by the firm’s management. i see this only at very large firms. with this method, the firm’s compensation committee adjusts partners’ ownership percentage periodically based on their performance. some percentages are increased, while others are decreased. partners with increases must contribute more capital; those who experience ownership decreases have capital repaid to them.
in this case, ownership percentage is really a way for the firm to allocate the most income to the higher performers and the least income to the weaker performers.