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why do you want to merge? be honest.

then we can talk about how.

by marc rosenberg
cpa firm mergers: your complete guide

whether you’re looking to acquire a smaller firm, merge upward into a larger one or join forces with an equal, answering this basic question honestly and objectively is key to laying the groundwork for a successful merger.

more: four reasons to fear a merger
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the table below lists the main reasons that firms seek mergers. some of them benefit both buyer and seller. others provide the greatest advantage to one firm or the other, depending on the unique situation.

once you’ve determined your firm’s motivations for testing the merger waters, you can create a merger strategy that best fulfills your firm’s needs.

state of the cpa firm merger market

with 80 percent of first-generation firms never advancing to a second generation of owners, it’s no wonder that merger mania continues unabated. each year, the cpa industry experiences a large number of mergers and an even larger number of merger opportunities.

why firms merge

main reason for seeking the merger downward merger (buyer’s perspective) upward merger (seller’s perspective)
1. make more money x x
2. create exit strategy x
3. acquire talent x
4. gain access to talent, recruiting advantages x
5. add a specialty x
6. eliminate admin headaches x
7. buy market share x
8. bigger firms attract bigger clients x x
9. create synergy x x
10. being part of a bigger firm makes “big firm things” more affordable x
11. provide greater diversity of services; more things to sell x
12. find common niches x x
13. take advantage of larger firm’s infrastructure and resources x
14. avoid overreliance on one market or a large client x

 

“merger mania” is particularly prevalent among the top 100 firms in the largest 75 markets in the u.s. and canada, mainly because (a) larger firms have more resources to devote to merger activities and (b) the top 100 firms generally have a lot more to offer sellers than smaller buyers do.

sellers, however, tend to be hesitant to make a move. on the one hand, their intuition tells them that they really have little choice but to merge up as an exit strategy. on the other hand, they fear that the life they have known and loved for 30 years or more will cease to exist once they merge with a larger firm.

the result is sort of a merger paralysis. hesitant sellers have a hard time understanding this: if you, as the seller, have been successful for many years and don’t have any skeletons in the closet, you have little cause for alarm. buyers have little interest in spending the time and effort to “fix” a successful small firm that isn’t broken.

here’s what’s going on in the cpa firm merger market:

  1. it’s frenetic, fueled by baby boomer retirements and buyers’ voracious appetite for growth. buyers are flooded with opportunities. most buyers are evaluating multiple deals at any given time, so …
  2. buyers are more selective/strategic than ever before. more and more, buyers are looking for sellers that will be a good strategic fit. great staff with partner potential. specialties. new location. synergies. buyers have raised the bar for who they will look at. some sellers will be lucky to get a deal at anything close to a traditional price.
  3. large metro markets are somewhat picked over, and the universe of buyers in some cities has been depleted because of upward mergers. active buyers have talked to virtually all the players, or at least know who they are interested in and who they are not interested in …
  4. but “no” means “not yet.” things change. sellers who wouldn’t consider an upward merger a few years ago often change their mind. buyers must be persistent if they have their eyes on a target.
  5. staff is critically important to buyers. many buyers feel staff is just as important as the clients. an overdependence on aging partners turns off buyers.
  6. sales multiples are coming down, more as a reluctance to go above 1x fees rather than reductions below 1x. many large regionals are paying as little as 60-70 percent. however, we recently heard that in some markets the multiple is going up to 115-120 percent.
  7. larger and smaller buyers have differing strategies. larger firms are more willing to acquire a firm for its potential. small buyers want a return in the near term, and to get it, may push hard for a large compensation haircut to sellers.
  8. many buyers want a business client base, not a 1040/write-up practice. a heavy concentration of low-value, high-volume, standalone 1040s is a big turnoff to many buyers.
  9. wealth management is increasingly important to buyers in selecting sellers.
  10. buyers want sellers with clients that will grow with them.
  11. consulting. more and more buyers, especially top 100 firms, are acquiring consulting firms instead of or in addition to cpa firms.
  12. working past age 65-67. the longer the seller wants to work past “normal” retirement age, the more of a turnoff this is to buyers. many don’t want “old guys hanging around.”
  13. buyers have a revenue per partner threshold. many top 100 firms have rules of thumb for how many of the seller’s partners will become partners of the buyer. they generally look to maintain an average of $1.5 million or more of revenues per partner.
  14. partners are participating in buyers’ retirement plan. in a merger where partners continue working for many years, they often receive the value of their practice by participating in the larger firm’s retirement plan instead of getting bought out when joining the larger firm.
  15. deals often take longer to negotiate because of sellers struggling with pulling the merger trigger, buyers having so much to choose from and buyers being pickier. if both buyer and seller are below $10 million, they are superbusy with their clients and struggle to find time to negotiate.
  16. down payments are generally frowned on by buyers.
  17. deals are almost always done on collections, not billings.
  18. two-stage deals, in which the seller wants to keep working for a few years but have the buyout agreed on at closing, have become increasingly more popular.
  19. buyers and sellers need to be aware of how the math works.
    • if the seller is looking to be paid for their firm and wants to continue working full time for several years and maintain compensation levels close to what they previously earned, the cash flow does not work for the buyer.
    • in a two-stage deal, buyers should not start the purchase payments right away because the only way the cash flow will work for them is to cut the seller’s compensation so low that it’s not feasible for the seller.
  1. buyers are generally reluctant to bring in sellers as equity partners. partners at many sellers often don’t qualify as equity partners at larger firms. also, most buyers don’t want to merge in “old” sellers as partners.
  2. beware the uberprofitable solo. these are solos who earn extremely high incomes, often higher than the average income per partner of the buyer. this occurs because of their small, “thrifty” infrastructure and very low investments in their firm in marketing, technology, office space, training, etc. their profit model doesn’t fit with the buyers’ model. the buyers can’t possibly make the same profit on the seller’s firm as the seller did alone. these sellers must be willing to accept a pay cut.
  3. sellers that have marginal branch offices are not very popular with buyers.

what makes a firm most attractive

these apply to all types of mergers.

  • reasonable profitability
  • talented people; stars; youth
  • partners who leverage and delegate, evidenced by a healthy staff-to-partner ratio, showing that partners delegate
  • specialties and niches
  • clients who will stay; relatively young clients
  • partners who will work for several years and not retire immediately after the merger (though smaller buyers often prefer retirement-minded sellers)
  • an urban (vs. rural) location
  • strong average fee for 1040s
  • special expertise the buying firm could use
  • a client base that is more business-oriented than 1040-focused
  • nice group of high-fee business clients
  • a client base with potential to purchase diverse services of a larger firm
  • heavy audit, review, compilation and corporate tax business (vs. bookkeeping and write-up)
  • uses the same tax and audit applications as the buyer
  • track record of growth
  • lower volume and high rate structure (vs. high-volume, low-rate operation)
  • wealth management practice

what makes a firm least attractive

  • unclear if some important clients will stay
  • partners who are set in their ways; control freaks
  • partners who are personally so attached to the clients, both the work and the relationship, that transition to buyer’s personnel is doubtful
  • incompatibility of work ethic
  • overpartnered situation; unproductive/weak partners
  • partners doing a ton of staff-level work
  • advanced age of the partners
  • seller’s partners want to work well past 65
  • heavy focus on low-fee 1040s and/or write-up work
  • low profitability
  • low billing rates, though some buyers see this as an opportunity
  • seller’s work standards far below buyer’s; this raises questions concerning the true profitability of the seller’s work
  • onerous, long office lease
  • poor or non-existent timekeeping
  • sloppy practice; messy office, work goes out late, high wip & a/r
  • low realization (under 80 percent)
  • sacred cows
  • skeletons in the closet
  • undesirable and/or unprofitable branch offices
  • lack of staff nonsolicitation agreements
  • poor malpractice history/exposure
  • weak use of technology
  • lots of debt
  • unrealistic buyout expectations of smaller firm partners
  • unwarranted perks and personal expenses run through the firm

keys to a successful merger

  1. culture and personality fit. don’t sacrifice this to get slightly better financial terms. the exception is retirement-minded sole practitioners who won’t be working much longer.
  2. give it time; don’t rush things. don’t fall victim to love at first sight. most successful mergers take several months to negotiate with multiple meetings. it takes time to do it right. yet don’t drag negotiations on, which causes “deal fatigue,” a sometimes fatal condition.
  3. valid reasons for the merger: each firm’s merger objectives can realistically be achieved with the other.
  4. sound practice management to ensure that the merger goals are actually realized after the merger.
  5. ability of the seller’s owners to survive a dangerous operation: an “ego-ectomy.”
  6. agreement on the vision for the new firm.
  7. congruity of values. how compatible are the firms’ management styles, teamwork vs. solo mentality, delegation, accountability, low vs. high billing rates, degree of firm specialization, growth objectives, appetite for risk, offerings of traditional vs. nontraditional services, etc.?
  8. agreement on what each firm expects from the other and what each partner expects of the others. this includes financial issues, how services will be provided to clients and what individual partners’ roles will be.
  9. examination of firm compatibility issues and agreement on how to resolve differences:
    • production metrics such as billing rates, realization and billable hours
    • management style: formal vs. loosey-goosey
    • quality of each practice: work products, workpaper practices, technical skills of personnel
    • staff compensation, benefits, perks, titles, size of offices, etc.
    • policies and work practices, including such things as office hours and remote work
  1. thorough performance of due diligence procedures: workpapers, internal operations, merger economics and legal issues. for many, performing due diligence is as unpleasant as proofing our exams before turning them in to the teacher. you’d be surprised how many mergers proceeded nicely until the due diligence stage, which unearthed issues that were unacceptable to one firm.
  2. avoid taking on someone else’s horrific problems.
  3. ask the right questions. ask tough questions tactfully and professionally. but ask them.

major merger terms

all of the following are common terms the merger partners must agree on.

  1. how will the deal be structured? will it be a “merger,” an outright sale? a true merger or a two-stage merger?
  2. agreement on key dates and milestones such as:
    • effective date of merger
    • when technology will be converted
    • when seller’s staff will be told of the merger
    • when seller’s clients will be told of the merger
  1. price:
    • sales price, often expressed as a multiple of fees
    • basis for computing price: billings, collections throughout entire payment term; collections in initial years and fixed during latter years, etc.
    • basis for computing price: differences in treating annuity clients vs. one-shot deals
    • minimums and maximums
    • clarification of extent that derivative new business arising from existing clients counts toward purchase price; examples include referrals by clients, clients starting new businesses, clients needing special work like an irs audit
  2. term of payout
  3. down payment, including how amortized
  4. wip and a/r handling, including the extent that collections are applied first to buyer or seller, after the merger
  5. purchase of seller’s fixed assets by the buyer
  6. how many of the seller’s partners will become equity partners with buyer?
  7. role of seller’s partners in buyer’s management
  8. if this is a true merger, what will the sellers’ required capital contribution and ownership percentage be?
  9. tax treatment of payments: ordinary income vs. capital gains
  10. compensation of sellers:
    • full-time and part-time compensation
    • extent of compensation guarantee
    • perks and benefits
  1. work plans of the seller, both full-time and part-time; when seller will stop working completely
  2. buyer’s commitment and obligation to make best efforts to retain seller’s clients, including how billing rate increases are approved
  3. buyer’s commitment and obligation to make best efforts to retain seller’s staff, including their compensation and benefits
  4. agreement on noncompete and nonsolicitation agreements
  5. malpractice tail coverage
  6. does buyer assume seller’s office lease?
  7. will there be a de-merger clause?

nonfinancial terms

the merger terms we’ve cited are primarily financial in nature, but we always emphasize the importance of nonfinancial terms. in some cases, the nonfinancial terms are as important as financial terms. they should rarely be sacrificed for a few more bucks. examples of nonfinancial terms:

  1. culture and personality fit, including compatibility of policies and practices. this term is hard to define, but you know it when you see it. an exception is small solos who are selling their firms and looking for a rapid exit.
  2. often, for sellers who wish to work for several more years, it’s really important to find a “nice home” for their clients and staff.
  3. partners of small firms often want to keep working until they are much older than the buyer’s customary retirement age. in this case, the seller must get comfort on this from the buyer.
  4. the roles the sellers will play at the buyer firm in terms of business development, training, delegating, being a generalist vs. a specialist.
  5. many small firms suffer immensely from staffing and recruiting problems and really count on buyers to ease their pain.
  6. many small firms have stagnating or even declining revenue. they often look to merge so that the buyer can help with business development.

how mergers can go wrong: what to watch out for

  1. failure to clarify precisely why each firm wants to merge, what each wants out of the merger, what needs to be done to make these goals a reality and whether or not both parties’ objectives are realistic.
  2. failure to agree, in advance, on what will be expected of each partner regarding how they work and what they produce.
  3. failure to discuss and agree, in general terms, on a common vision: where each firm would like to see the combined firm go (growth, services offered, specialization, etc.).
  4. failure to complete due diligence, especially in the technical quality area. i’ve seen several mergers in which the buyer wasn’t thorough in their due diligence, only to be shocked after the merger was completed to discover that the seller’s personnel lacked sufficient technical skills.
  5. incompatibility of issues that should have been discovered during due diligence and measures for resolving them agreed upon:
    • basic production metrics, such as billing rates, realization and billable hour targets
    • unreliable time records. smaller sellers often fail to record billable time that they know will never be billed. buyers should avoid situations in which a seller spends way more time to service clients than the records state.
    • policies and work practices. sellers may manage their firms very informally, with inconsistent practices, whereas buyers are usually more formal.
  1. carryover of dirty laundry: unresolved partner conflict, unproductive partners, sacred cows, etc.
  2. failure to integrate the two firms as one. instead, each firm operates exactly as they did before the merger.
  3. resistance to undergoing an ego-ectomy. seller’s partners refuse to be held accountable because they never have been before.
  4. insufficient capacity of the combined firm to handle the new increased workloads.
  5. undesirable clients. smaller firms generally accept any client with a heartbeat. larger firms are more targeted in their business development efforts.
  6. buried perks. these need to be identified before the merger. you don’t want the seller’s partners complaining about losing these hidden benefits after the merger.
  7. failure to have staff sign nonsolicitation agreements. be careful about the possibility of staff leaving and taking clients.
  8. at many very small firms, the partners treat the firm as an extension of their personal lives. this takes many forms, such as:
    • entering into business deals with clients
    • keeping weird hours, like starting work at 11:00 a.m.
    • working from home or at a second home excessively
    • submitting all sorts of personal items for reimbursement

these items need to be identified up front and an agreement reached on how they will be dealt with after the merger.

learning from actual merger experiences

as you might suspect, in the 20 years we’ve consulted to cpa firms, several dozen mergers of our clients have taken place. we often meet with the managing partners of some firms a year or so after their mergers to ask them how the merger went, what they would do differently and what advice they would give to firms contemplating a merger.

here are some choice morsels.

  1. the first meeting with a merger candidate, even if it’s informal, is the most important.
  2. go out on top. negotiate from a position of strength. don’t wait until you have to merge. don’t wait until your firm is in such obvious decline that it has the look and feel of a decrepit firm with little to offer.
  3. the managing partner needs to be committed to the merger and work hard to make it succeed. merger implementation is hard work and takes several years to complete. the managing partner must continually be on the alert for complaints and address them before they fester.
  4. seek a merger partner who really wants you. a firm that is truly excited about joining forces will put greater effort into making the merger a success than one who is blasé about it. err on the side of choosing a merger partner who is long on attitude and offers perhaps slightly less attractive financial terms than a firm that offers the best terms but is nonchalant about the merger.
  5. get your house in order before you look for a merger partner. pay off debt, retire underperforming partners and clean up wip and a/r. get current with your client work. straighten up the office.
  6. when deciding whether to accept partners from a merger candidate, apply the same high standards you’ve set to make someone a partner at your own firm.
  7. avoid negotiations where the other firm’s negotiator always needs to go back to his or her partners before making decisions.
  8. if a big reason for the merger is synergies, the combined firm needs a strong leader with the skills to take full advantage of these synergies. synergies don’t result automatically. someone has to make them happen.
  9. be crystal clear about what each firm expects to happen after the merger is completed.
  10. do quality control due diligence. don’t assume the other firm’s work standards are acceptable. don’t assume the other firm has passed their peer review. don’t assume the other firm has been properly registered as cpas with the proper authorities.
  11. be patient with merger implementation. it often takes three to four years to totally complete a merger.

finding sellers

in mergers and acquisitions of most businesses, it’s always much more difficult to find sellers than buyers. cpa firm merger consultants and brokers can do a great job finding buyers, but they are limited in their ability to dig up sellers. this is because the vast majority of cpa firm mergers and sales take place when buyers or sellers know each other and get together on their own without the help of a consultant.

one way to identify sellers is to do an email or snail mail solicitation. the steps in the process:

  1. create a database of prospective sellers.
  2. write a letter and send it to the database. the letter should be compelling enough to stir sellers’ emotions, making them receptive to the buyer’s follow-up call.
  3. the letter must emphasize that the buyer is not asking the seller candidate to merge. the goal is simply to meet each other and talk. confidential. informal. no exchange of financials. just talk.
  4. do a second mailing three weeks later.

follow-up phone calls can be very effective. no one likes making cold calls, even a merger consultant like me, but i have made these follow-up calls from time to time and they have produced results.

i have conducted this type of letter campaign a dozen times over the past 15 years or so. to my surprise, i was successful at identifying interested, viable merger candidates about one-third of the time.

planting seeds

firms that are serious about merging in smaller firms on a regular basis understand that doing mergers is all about planting seeds.

every day of every year, at least one firm tests the merger waters in every major city. if your efforts to identify sellers are made continuously throughout the year, every year, sooner or later you will find at least one interested merger candidate and probably more.

the vast majority of sellers that eventually do merge make many attempts to get started, each more serious than their previous foray:

  • some don’t initially acknowledge your meeting invitation. this simply means the firm wasn’t ready to talk. you need to be ok with this lack of response. at least you’ve gotten them to start thinking about you.
  • a potential seller you meet with may decide not to merge. you should be ok with that. understand that when sellers say, “no,” they are really saying, “not yet.”

a final piece of advice: we have seen buyers reluctant to contact a potential seller because they fear it would be too pushy and the seller might be offended by their overture. or perhaps buyers know a seller well and assume that the seller is not interested in merging. remember this axiom: “if you don’t ask, you don’t get.” be proactive. be persistent. but always be professional.

a winning merger strategy requires patience and persistence. keep reaching out to firms. keep talking to firms. keep following up as time marches forward. eventually, as you expand your pool of eligible merger candidates, you are bound to hook up with a firm that is serious about merging with you. veteran buyers tell us that for every firm they merge with, they had discussions with 10 others. patience and persistence.

plant those seeds!