7 key provisions.
let’s start with a very basic, standard concept in the business world: a partner is an owner.
more: why and how new partners buy in | ownership percentage and capital accounts | 5 key reasons to have a partner agreement
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in any business, not just cpa firms, ownership is not free. because partners are owners, they have to purchase a part of a company, for money, to acquire an ownership share.
why firms require a new partner buy-in
cpa firms are very valuable entities that, in most cases, are easily salable to other firms. thousands of cpa firms across the country have insatiable appetites to acquire smaller firms, which obviously solidifies the value of firms. so if a firm invites a staff person to become a partner and the person accepts that offer, the firm will quite rightly require the incoming partner to pay for a share of the firm ownership.
what exactly is the firm’s value?
there are two main components to a firm’s value: capital and goodwill.
- capital is the net capital on the firms’ balance sheet. firms commonly have accrual basis capital of 20-25 percent of their revenue, which is mostly cash and properly reserved wip and a/r.
- goodwill is the intangible value of the firm, which is rarely recorded on the firm’s balance sheet. it is almost always valued on the basis of a multiple of the firm’s annual revenue. a common valuation is one times revenue. (by the way, this makes no sense. most businesses are valued based on a multiple of their profits, not revenue. but don’t blame me – i didn’t invent this convention!)
to illustrate, assume a firm has annual revenue of $5 million. further assume two common rules of thumb: first, the accrual basis capital is 20 percent of revenue. second, the goodwill is valued at one times revenue.
the value of the firm is therefore:
the current logic and philosophy behind determining the new partner buy-in
firms traditionally determined the buy-in by magically assigning an ownership percentage to the new partner and multiplying it by either the firm’s capital or the firm’s capital + goodwill. in the latter case, which made more sense, even a small ownership percentage (5-10 percent) often resulted in an enormous buy-in of $300,000 to $600,000.
baby boomers willingly paid this because they did what they were told. also, this was the normal way firms set their buy-ins back then.
for the past 15 to 20 years, as younger people have contemplated becoming partners, the prospect of bringing in a suitcase of $300-600,000 in cash (just kidding) was abhorrent. these prospective new partners were neither willing nor able to come up with that kind of money. so over time, firms moved away from computing the buy-in by multiplying ownership percentage by the firm’s value. they replaced that by setting a standard amount that their partners felt was a meaningful amount of money for new partners to pay. today, this ranges from $25,000-$100,000 for small firms and firms in small cities to $100,000-$175,000 for all other firms. interestingly, large firms, say over $20 million, require roughly the same buy-ins as medium-size firms.
the key concept behind the new partner buy-in is this: new partners should have a meaningful amount of money invested in the firm and at risk, just like the existing partners.
as the buy-ins became set at a standard amount, firms largely severed the link between ownership percentage and buy-in.
at the same time, firms understood that once the new partner buy-in was reduced to a relatively nominal amount, they needed to make sure that new partners were not being “given” a share of the firm’s value that greatly exceeded what they paid for it. so partner retirement/buyout plans have been adjusted to avoid paying excessive buyouts.
terms of the buy-in
- even at a relatively nominal $100,000 or so, the buy-in amount is still a lot of money to most new partners. so firms have devised several terms to make paying it less onerous:
- provide for the buy-in to be paid over several years, mostly via deductions from the new partner’s compensation. the key is to make sure the new partner’s net take-home pay is not less than before he or she was a partner. committing this sin is demoralizing to the new partner.
- many firms require a small down payment, perhaps $10-$20,000.
- financing the buy-in:
- if the new partner chooses to get a bank loan for the buy-in, firms are not guaranteeing the loan. believe it or not, until the 1990s, they often did.
- firms allow the new partner to pay the buy-in over several years, making it an interest-free loan. a few firms charge the new partner interest on pay-down, but this is very rare.
- the buy-in is paid to the firm, not to individual partner(s). paying the new partner’s buy-in directly to the other partners (as happens at many small firms) creates several interrelated problems:
- often existing partners make special deals with the incoming partners to buy their shares in the firm. in many cases, the existing partners are free to set their own share price for the new partner, with little involvement from firm management. there is often a quid pro quo: the new partner pays the buy-in and receives an equal value of the existing partner’s clients.
this is a classic example of a firm operating like a group of solos instead of a true firm.
- because the deal is made outside of the firm, new partners have no record of ownership in the firm on the books. whenever a new partner pays a buy-in, a journal entry needs to be recorded:
if the new partner’s capital account fails to be credited, something is rotten in the state of denmark.
- when new partners pay existing partners to acquire part or all of their client base, often the existing partners’ ownership percentage is not reduced, which makes no sense. the result of this inane transaction is that the existing partners get paid twice for their retirement: once when the buy-in is paid to them and once when they retire. makes no sense but i see this more times than i would like.
other terms of the new partner buy-in
here’s a summary.
- capital. when partners leave the firm because of withdrawal, expulsion (with certain limitations), retirement, death or permanent disability, they are paid their capital account, usually over a period of years.
- voting. the key is to avoid disenfranchising a new partner by voting all issues based on ownership percentage. new partners typically have extremely small ownership percentages, which gives them no clout when votes are taken. to address this, firms do the following:
- try to avoid taking formal votes. instead, the partners should discuss the issue and try to arrive at a consensus.
- most votes are one person, one vote.
- for certain key votes (mergers, partner admissions, etc.), a supermajority is required to pass a vote. supermajorities commonly range from 67 percent to 80 percent.
- at smaller firms, generally fewer than seven or so partners, some form of protection is often needed for the senior, high-performing partners to prevent low-percentage owners from banding together to do dastardly things like reducing their compensation or even expelling them.
- a non-compete and/or non-solicitation agreement. signing this should be mandatory.
give new partners plenty of notice of the firm’s non-compete/non-solicitation covenants.
i have been involved in several situations in which new partners were informed at the last minute that they would be required to sign the firm’s partner agreement, which usually includes non-compete and/or non-solicitation covenants. the new partner, feeling sandbagged, refused to sign the agreement and wound up leaving the firm.
no one likes surprises, especially new partners being asked to sign a one-inch-thick partner agreement with lots of small print. perhaps as much as a year out, firms should go over the partner agreement with prospective new partners. make it crystal clear that signing the agreement is a non-negotiable condition to becoming a partner.
- the firm’s partner agreement. signing this should be mandatory too.
summary of key provisions to new partner buy-in plan
