3 issues to decide and 25 main provisions to include.
by marc rosenberg
when firms call me for help on their partner agreement, i immediately ask this question: “do you want help with your entire partner agreement or just the retirement/buyout part?” two-thirds of the time, they want to address only the retirement plan.
more: 5 key reasons to have a partner agreement | protect your business with a solid partner agreement
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my practice in the area of cpa firm partner agreements consists of two parts:
- the partner retirement/buyout plan.
- everything else. i often refer to this as the general partner agreement.
we have written an entire book devoted to cpa firm retirement/ buyout plans. if you are interested in a comprehensive resource on crafting a proper retirement plan that adopts cpa firm industry best practices, visit cpa firm partner retirement buyout plans.
one of the benefits that new partners receive in exchange for their buy-in is a buyout when they retire. in almost all cases, this buyout is quite substantial, often in excess of $1 million.
the flip side of this is that they must agree to buy out older partners who retire before them. any plan for bringing in new partners must include a provision for a partner retirement/buyout.
three main issues for the partners to decide
- will the buyout be limited to capital only? or will it include a goodwill provision? (ninety-five percent of all firms with retirement plans pay both capital and goodwill.)
- how will the goodwill be valued? should it be 100 percent of revenues? ninety percent? eighty percent? sixty percent? forty percent?
- how will an individual partner’s buyout amount be determined?
industry norms for goodwill valuation
for the past 10 to 15 years, the industry average for cpa firms’ goodwill valuation has hovered around 80 percent of revenue. (note that this is for internal buyout purposes. external prices for practice sales are often higher, sometimes much higher than internal buyout valuations.) this applies to firms of all sizes. many partners are surprised at this because they have heard otherwise.
1. an ancient rule of thumb says goodwill should be valued at 100 percent of fees.
i have never been a fan of rules of thumb in any walk of life because they are not rules, just sweeping generalizations by someone that make no attempt to fit the actual situation at hand. sure, one times fees is still common, but a substantial number of goodwill valuations are well above or below 100 percent.
so why does the average cpa firm goodwill valuation – for internal retirement plan purposes – hover around 80 percent? there are two main reasons for this:
- a desire to be conservative. the partners who will write the buyout checks to retirees worry that the payouts may not be affordable. they are anxious about retaining the clients after partners retire, despite the best of transition efforts. if the younger partners are honest, they question whether some retiring partners deserve the substantial retirement benefits provided by the plan. finally, there is the fear that unfunded partner retirement plans resemble ponzi schemes, with newer partners continuously paying lots of money to buy out retired partners and wondering if their payday will ever come.
quite simply, the desire to be conservative represents a compromise between older and younger partners. instead of paying one times fees, they settle at 75-90 percent.
- client retention. ten to 15 years ago, it was common for firms to link the goodwill payout to retention of the retiring partner’s clients. if the firm retained only 80 percent of the retiree’s clients, then the payout was reduced to 80 percent.
but over time, firms began to see the difficulties in directly linking goodwill payouts to client retention.
- who caused the client to leave: the retiring partner, the partners inheriting the clients, or neither?
- linking retirement pay so directly with client retention was counter to running the firm as one company rather than a group of sole practitioners.
as a way to address these concerns, firms gradually did away with client retention penalties. (the latest rosenberg map survey shows that 80 percent of all firms do not have client retention penalties.) this indirectly has brought down the goodwill valuation. it’s better to have a lower valuation without client retention penalties than a higher valuation with penalties because it avoids arguments.
2. partners hear that firms sell for well over one times fees, perhaps 120 percent, 130 percent or more. so why shouldn’t our firm value goodwill way higher than 80 percent?
to answer this, it is important to understand the difference between valuing goodwill in an internal retirement versus an external sale.
- in an external sale there’s often a sizable pool of willing buyers. but in an internal retirement, there is only one buyer: the firm. the rules of supply and demand tell us that when there are many more buyers than sellers, prices increase. when there are few buyers, the reverse is true.
- client retention is stronger in an internal retirement than an external sale. this tends to equalize the actual revenue dollars retained.
- in an internal retirement, the remaining partners are super-busy managing their own clients and find it a hardship to take on the clients of a retiring partner. this causes partners to be ultraconservative on their internal goodwill valuation.
- since there is no consultant’s fee or broker commission in an internal retirement, the goodwill valuation for an internal retirement can be more conservative.
what methods do firms use to determine the goodwill-based benefits of a departing partner?
this chart shows the kinds of systems used by firms across the country. the data is taken from a recent edition of the rosenberg map survey.
as you can see, the two most common methods are the multiple of compensation and aav (average annual value) methods. these methods have one important thing in common: they are much more performance-based than the other four methods.
here are definitions for the two most popular partner retirement systems:
multiple of compensation method. this is the most common method used by firms, especially those with six or more partners. the method is quite simple: retirement benefits for a partner are equal to his or her compensation immediately prior to retirement times a predetermined multiple.
assume the firm chooses a multiple of 3.0 and that the compensation of a retiring partner is $400,000. the computation is simply:
3 x $400,000 = $1,200,000, paid out over a certain number of years.
many firms choose a multiple of 3.0 because at “vanilla” or normal firms, 3 times compensation equates to a valuation that is often very close to one times revenue. if the firm wants to value goodwill at a more conservative 80 percent of revenue, then a 2.4 multiple might be selected (3.0 multiple x 80 percent).
aav method. average annual value doesn’t adequately describe the system. perhaps a better name is the cumulative benefits method.
the fundamental philosophy of this system is that (a) new partners are not entitled to any portion of the goodwill value of the firm that was built up before they became partner unless the new partner pays for it and (b) new partners and existing partners share in the value of the revenue growth of the firm after they become partners.
here is an illustration of the aav method.
assumptions
- the firm has annual revenue of $5 million.
- the firm chooses to value goodwill at one times fees, which comes to $5 million.
- there are four partners. then a fifth partner is admitted.
- the firm grows at 10 percent per year.
- total partner income is 1/3 of fees.
- partner income is allocated as follows: partner a 30%, b 30%, c 15%, d 15%, e 10%.
observations
- new partner e starts out with a zero balance because he or she didn’t purchase any of the firm’s goodwill built up before e became a partner.
- the annual increase in revenue is allocated to the partners in the ratio of their income allocation percentages. the aav system works best if the partner compensation system is a performance-based system. this way, income is shared based on the ratio of partners’ contributions to the firm’s profitability, which will ideally be reflected in their income-sharing percentages.
- new partners build up their retirement benefits year by year. a retiring partner’s benefits are reallocated to the remaining partners as payments are made. this is how the benefits of newer partners increase fastest.
partner retirement/buyout: 25 main provisions
a few nuances
is mandatory retirement of equity partners enforceable? yes, for the vast majority of firms, but the keys are (1) the size of the firm and (2) the extent that partners are “owners” or “employees” under the law.
the eeoc (equal employment opportunity commission) has been pursuing mega cpa firms such as the big 4 and huge law firms such as sidley and austin. the eeoc claims that at these mega firms, most of the partners in substance function as employees, not owners, even though they legally are owners. six specific criteria (such as decision-making and management responsibilities) have been established to test whether a partner is an employee or an owner.
on the face of it, these cases would seem to have scary implications to the thousands of cpa firms with mandatory retirement provisions. but attorneys familiar with this issue think the eeoc’s focus is on mega firms, not the smaller firms that comprise 99.9 percent of all firms.
can a partnership agreement provide for a reduction of retirement benefits if a retired or withdrawn partner fails to (a) provide the stipulated notice and/or (b) properly transition clients to other firm personnel? yes, for the most part. we have seen hundreds of partnership agreements that have provisions requiring notice and client transition by retiring or withdrawing partners, but unfortunately, they lack teeth because they fail to specify penalties for non-compliance. therefore, the notice and transition requirements are difficult to enforce.
when i point this out to firms, they quickly respond that it is difficult to put in writing the definition of “proper client transition.” it may be difficult, but it can be done.
if a firm’s partner agreement is silent on paying goodwill-based retirement benefits, do departed partners have a legal claim to receive these benefits nonetheless? the answer is mostly yes, which will surprise a lot of people.
if the partnership agreement does not address the subject of buyout payments to departing partners, the applicable state partnership law will govern. in the absence of language stipulating the payment of goodwill-based benefits, most state partnership laws state: departing partners are entitled to be paid their pro-rata share (often based on ownership percentage) of the greater of the liquidation value of the firm’s assets or the firm’s going concern value, which includes a factor for goodwill. this means that firms whose partner agreements are silent on goodwill payments are still at risk if partners depart and sue for payment or value in the firm. firms that don’t wish to pay goodwill to departed partners should include specific language stating exactly what they will pay departing partners.
if the partners vote to change the partner agreement and reduce partner retirement benefits, and it disadvantages retired partners receiving benefits, is it enforceable in a court of law? quite possibly no. the court will protect against amendments that (a) single out one partner or (b) reduce retirement benefits for all partners unless a majority of those near retirement age agree.