plus consultant fee structures and integration committees.
by domenick j. esposito
8 steps to great
last year alone, over 200 firms merged up and this year is tracking the same. at this pace, a very large percentage of the approximately 14,000 multi-partner cpa firms (about 90 percent of which are under $10 million in revenue) will be looking at an upward merger in the next few years.
more on strategic planning: m&a: sometimes bigger is better | use compensation to shape partner behavior | the importance of m&a culture due diligence | are you attracting the new breed of equity partners? | quality work, quality service not the same thing | who will be the next category killer? | why is strategy execution so difficult?
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so let’s take a deep dive into what you need to know about merger combinations, which are as much about the addition of talent as they are about the addition of clients.
cpa firm valuations
the two typical valuation components in most merger combinations are capital and goodwill.
- capital is straightforward: it is a firm’s accrual-based capital adjusted for the fair market value of fixed assets, work in process and receivable reserves. it is paid as cash or a note (in some cases the note bears interest), over a relatively short term.
- goodwill is always expressed as a multiple of revenue; the generally accepted value of goodwill in the old days (circa 2001 to 2007) used to be one times revenue but today, as profits have declined, cpa firm valuations average about 80 percent of revenue. partners of the merged-in firm allocate firm valuation by using a “multiple of compensation” model based on relative partner compensation over a period of three to five years. average compensation is then multiplied by a factor to arrive at a partner’s share of goodwill that is paid out upon retirement over five to 10 years. some firms also provide an option to younger partners (i.e., offering the retirement benefit or deferred compensation plan offered to existing partners).
approaching the market
when approaching the market, most cpa firms retain a professional consultant who has significant credentials with m&a and strategy. fees generally are structured as follows:
- an upfront retainer, plus monthly progress bills and reimbursement for out-of-pocket costs
- a significant contingent fee paid upon closing for identifying potential candidates and for assistance in closing the transaction. it mirrors the “lehman formula” summarized below:
cumulative fee |
purchase price |
5% of | the first $1 million of firm revenue, plus |
4% of | the second $1 million of firm revenue, plus |
3% of | the third $1 million of firm revenue, plus |
2% of | the fourth $1 million of firm revenue, plus |
1% of | any amount in excess of $4 million of firm revenue |
identifying viable candidates and working the circuit
identifying candidates can be an exhausting process for the ceo so it is important to define what should and should not be looked at. some potential targets, local “tuck-ins,” will be obvious because of local geography. other potential targets are more strategic and require that the “circuit” be worked. once you have determined the desired geographic markets and strategic add-ons, you have to make contact, develop a relationship with the targets and narrow the candidates down to one or two firms.
making sure it feels right
before you decide whether to proceed to due diligence or not, you need to make sure that the targets feel right by chatting with the senior partners about respective histories, cultures, “sacred cows” or deal-breakers in a possible transaction and the potential upside and synergies that might be derived. this is the magic sauce that will make a potential merger combination very exciting.
once the senior partners get comfortable with each other, the next step is to create broader buy-in with a meet-and-greet with all the partners from both firms and establish several committees that focus on integration of the different areas in the practice:
- human resources and continuing education
- information technology
- marketing and sales
- finance and accounting
- partner matters
due diligence, closing the transaction, integration
due diligence consists of three components:
- culture fit (very important)
- commitment to technical excellence and quality client service
- kicking the financial and operational tires
when it comes to kicking the tires, most firms use a cpa firm combination program that drills down into the operational aspects of the target. once potential deal-breakers have been successfully dealt with, attorneys draft a letter of intent that is followed by a detailed combination agreement. the easier part of a merger combination is getting the contract signed; the harder part is the integration of the two practices, which typically takes about two years.
from an acquirer’s perspective, there are wonderful opportunities to grow firms through merger combinations and as long as the marketplace buys bigger is better, there is no better time than now to capitalize on the opportunities. a word of caution, however. i implore you – no matter how tempting it may be – don’t do a merger combination if 1 + 1 doesn’t at least = 3.
one response to “m&a candidates: valuations and vetting”
frank stitely
great advice and exactly what i’m seeing. prices go down as everyone heads for the exits at the same time.