three big issues must be decided.
by marc rosenberg
how to bring in new partners
one of the benefits that new partners receive in exchange for their buy-in is that they will receive a buyout when they retire. this amount can be in excess of a million dollars at many firms. receiving a retirement buyout is one of the major reasons becoming a partner is so lucrative.
more: 11 best practices for partner compensation | fifteen steps to new partner buy-in | what buying in actually means | why buying into a firm is such a great investment | four philosophies for managing a cpa firm | how partner and staff actions impact profits | the business side of cpa firms
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the flip side of this is that new partners must agree to buy out older partners when their day comes. therefore, any plan for bringing in new partners must include a provision for a partner retirement/buyout plan.
the basis for these buyouts is the clear and substantial value of a cpa firm and the relative ease with which it can be sold to other firms at an attractive price. the main basis for this price is the value of a firm’s client base, which for cpa firms, is largely annuity-based. it’s considered an intangible value because it’s almost never included in the firm’s balance sheet. partner agreements routinely provide for the interest of departed partners to be purchased by the firm to avoid the need to liquidate the practice to generate funds to pay the buyouts.
no, it’s not a ponzi scheme
many new partners, when hearing how partner buyout plans work, fear they sound dangerously close to ponzi schemes. new partners pay out one partner after another after another, with their own payday feeling like a foggy uncertainly because it’s decades away?
while i can see how new partners without any experience operating a cpa firm buyout plan might be a tad apprehensive, let me seek to provide some comfort and show that this fear is greatly exaggerated.
to start with, here are a few statistics from the rosenberg map survey:
- 94 percent of all cpa firms with five or more partners have a partner buyout plan. for firms with two to four partners, this percentage is a bit lower: 78 percent. the main reason the percentage is lower for smaller firms is that, frankly, smaller firm partners’ exit strategy is more likely to be selling the firm instead of keeping it independent. some of these firms don’t bother to create a buyout plan that will never be used.
the point: new partners can take solace in the fact that the vast majority of cpa firms have a buyout plan in place and therefore it is a best practice.
- the vast majority of multipartner firms over $5 million in revenue are actually making buyout payments, which shows that the plans work and are affordable. more than four-fifths (82 percent) of firms with revenue over $10 million are making payments. for firms with revenue of $5-10 million revenue, 66 percent are making payments. it’s important to understand that if firms are not making payments, that simply means that no partners have retired yet under their buyout plan.
- annual payments to retired partners are very small, 1-2 percent of revenue. very affordable.
in addition to the statistical evidence that buyout plans are sound practices, new partners should be comforted knowing that properly written plans have several features that protect the firm’s cash flow by limiting any burdens the buyout obligations may cause:
- the main way that firms fund the buyouts is by no longer having to compensate the retired partner. in fact, these savings usually exceed the buyout payments.
- most plans have a statutory limit on total annual buyout payments, usually 5-10 percent of annual revenue. one of the main benefits of this provision is to protect the firm if too many partners retire at the same time.
one final piece of reassurance to new partners: in my 20 years of consulting to cpa firms, i’ve never heard one firm that found the buyout obligations to be unaffordable. however, it is true that when firms feel their future is uncertain because of impending partner retirements, including situations when too many partners plan to retire at the same time, they usually sell out to address this concern.
now that we’ve showed that the buyout plan will not become an onerous obligation, let’s look at ways cpa firms customarily operate that should reassure their partners that the buyout plan is viable.
- most firms grow every year. virtually all firms at least retain their revenue level from the prior year.
- this growth plus other factors often result in firms bringing in new partners every now and then, helping to assure a reasonable spread of partner ages, minimizing the likelihood that too many partners will retire at the same time.
new partners, along with current partners, need to proactively contribute to the firm’s efforts to develop staff into future partners. a new partner cannot possibly afford to pay the buyouts of all older partners if he or she is the only one left to make the payments.
- it’s natural to be concerned about the retirement of partners with lifelong, deep client relationships. if the firm’s partners have operated as lone rangers and very few or even no other firm members have been brought in to serve the clients and forge relationships with them, then the ponzi fear may be somewhat justified. it is difficult to retain clients after the departure of the main relationship partner.
however, even in this worst-case scenario, properly written buyout plans require proactive transition of client relationships for the departed partner to be eligible for buyout payments. if a reasonably decent effort is made at client transition, the vast majority of firms have a very strong client retention rate when partners retire, even when transition efforts are less than expected.
- the firm has provisions for new partner buy-in and buyout that are conservative and are not onerous.
if all of these ducks are in a row, there is little reason for new partners to fear the buyout plan becoming a ponzi scheme.
the buyout plan: three big issues to decide
- will the buyout be limited to capital only? or will it include a goodwill provision? (95 percent of all firms with retirement plans pay both capital and goodwill.)
- how will the goodwill be valued? should it be 100 percent of revenue? 90 percent? 80 percent? 60 percent? 40 percent?
- how will an individual partner’s buyout amount be determined?
goodwill valuation rates
there was a time when cpa firms routinely sold for 100 percent of revenue, and internal buyout plans used the same valuation percentage. but times have changed. for many years now, the average goodwill valuation rate used for partner buyout plans has hovered around 80 percent. why the decrease?
cpas have become more conservative, feeling that the world we live in has become increasingly precarious. the cpa profession in particular faces a never-ending series of challenges such as tax reform, technology reducing compliance work, and the need to replace retiring rainmakers. valuing goodwill at a lower amount eases the discomfort over the future that younger partners may feel.
with some important exceptions, firms are generally willing to continue paying buyouts to retired partners despite losing some of the retiree’s clients. the difference between a 100 percent and 80 percent valuation essentially amounts to a bad-debt reserve for client loss.
even though 80 percent may be the average, there are still many firms at 100 percent of fees. there are also many firms well below 80 percent. virtually all of the top 100 firms are at 80 percent or less. every firm needs to select a goodwill valuation rate the partners are comfortable with. most firms err on the side of being conservative.
buyout best practices and key concepts
- the value of a cpa firm is the sum of its capital and goodwill. the goodwill valuation method is critically important. see the previous paragraphs.
- partner buyouts are a form of deferred compensation. as compensation, they should be primarily performance-based (perhaps not as much as partner compensation, but close). as with partner compensation, a partner must earn the buyout by contributing to the firm’s revenues, profitability and overall success. the buyout should not be based on non-performance-based methods such as ownership percentage or pay-equal.
the two cadillac systems for computing partners’ buyouts are heavily linked to their compensation – which, we hope, is performance-based and therefore a measure of what they contributed to building the value of the firm. if a firm’s partner compensation system is not performance-based (if it is based on ownership percentage, pay-equal or seniority), then there is great risk that individual partners may receive buyouts in excess of what they deserve or earned, in the eyes of those who will write the buyout checks.
- the math must work. the acid test of a well-conceived, financially viable retirement plan is whether, when a partner retires, the remaining partners earn more money (or at least no less) than prior to the retirement. the main reason this is possible is that the remaining partners no longer have to compensate the retiring partner. if the math works, the money saved on the retiree’s compensation will be enough to fund that person’s payments, pay the salary of the partner’s replacement and perhaps have a little left over to increase the remaining partners’ compensation.
if this is not the case, then the plan may not be financially viable.
let’s illustrate an ideal scenario where the math works. assume the following:
-
- the retiring partner’s compensation is $350,000.
- his or her goodwill-based benefits are $1 million over 10 years, or $100,000 per year.
- the firm will hire an experienced staff person, at a compensation level of $150,000, to replace the retiring partner.
summary of the annual cash flow (or, how the math works):
+ saved compensation of retiring partner $350,000
– retirement benefits (100,000)
– salary/benefits of experienced person (150,000)
+ net additional income to remaining partners $100,000
- a partner buyout plan is not a savings plan. there is a natural tendency to view the firm’s partner retirement plan as a personal savings plan, but that’s not how these plans work. a savings plan is a pile of money that increases in value over time that can be 100 percent withdrawn for any reason at any time by the owner.
cpa firm retirement plans are quite different. designed to encourage partners to stay with the firm for the long haul, they strictly limit departed partners’ ability to withdraw benefits if they leave early in their tenure with the firm. there are two reasons for this:
- retirement within the first 10 to 15 years or so of a partner’s tenure with the firm could result in windfall benefits to the individual.
- partners are very hard to replace. firms really need to retain their partners over a long period. often the early departure of even one partner can damage the firm for years to come.
to ensure that a partner buyout plan does not function like a savings plan, cpa firms typically adopt several restrictions on making buyout payments.
- the plan must have safety valves. well-written retirement plans adopt several tactics to make sure the annual payment of all buyout payments will not be a strain on the firm’s cash flow:
- the math must work. see item #3 above.
- vesting conventions are adopted for goodwill (not capital). they require that a departing partner achieve both a certain number of years as a partner and a certain minimum age in order to be 100 percent vested. when these conditions are not met, payouts are reduced.
- there is an annual limit on all buyout payments as a percentage of the firm’s revenues; 5-10 percent is common.
- the payout term is long enough so that the annual payments are affordable; 10 years is most common.
- no interest is paid on goodwill payments.
- some firms reduce benefits if the departing partners’ clients leave after they retire. this is usually restricted to large clients or services.
- well-written plans have strict requirements for notice and client transition in order for the retiring partner to receive benefits. if these requirements are not met, then the firm, at its sole discretion, can reduce the benefits.
- the plan has provisions for retired partners to continue working, either full-time or part-time. at least 90 percent of cpa firm partners want to continue working after their “retirement.” they love it so much they can’t let go! firms’ partner agreements adopt a wide variety of provisions governing how this works. but the main requirement should always be this: regardless of the terms of the post-retirement work arrangement, the partner must provide value to the firm in the eyes of the remaining partners. partners do not have an inalienable right to keep working as long as they want.
- internal vs. external goodwill valuations. a common perplexity is this: if cpa firms are commonly sold for one times revenue, why should a firm’s internal buyout plan use a goodwill valuation well below 100 percent of revenue? there are three simple answers:
- supply and demand. when firms are sold, there are many buyers, so that usually bids up the price. but internally, there is only one buyer, the firm. so that keeps the price lower.
- firms have a strong desire to be as conservative as possible. client retention is usually higher when partners retire than when a firm is acquired. so based on net revenues retained, 100 percent can equal 80 percent.
- the net value retained could be higher when partners retire internally at a lower valuation rate instead of selling the firm to a buyer at a higher valuation (sales) rate. this is because client retention is almost always higher when partners retire than when the firm is sold to an outside buyer.
here is an example:
| net value retained | sell to outsider | sell internally |
| fee volume of firm | $700,000 | $700,000 |
| actual client retention | 60% | 95% |
| fees retained | $420,000 | $665,000 |
| price | 100% | 80% |
| net buyout | $420,000 | $532,000 |
so, as strange as it seems, on a net basis, an 80 percent valuation can exceed a 100 percent valuation.