There are a number of reasons behind the rampant procrastination of CPA firm owners regarding succession planning, but arguably none approach the tandem of the fears of a loss of income and a loss of control.
The thought of merging or selling their firm constitutes, in the minds of practitioners, at least a partial loss of income. So, their rationale for postponing any type of ownership transition is that if they just work X number of years they won’t be sacrificing any compensation for what, in their opinion, is a goal with a one- to six-year timeline.
Along those same lines, many equity stakeholders and firm owners have become accustomed to being the proverbial “master of their domain.” The concept of someone other than themselves assuming the ownership reins and dictating strategy often leaves a bad taste in their mouth – both figuratively and literally.
Fortunately there’s a deal structure that can overcome both objections – retaining both present level of income and reasonable autonomy for practitioners who are roughly one to six years from slowing down from full time: the two-stage deal. However, if their timeline is longer than that, they would probably be better served under the structure of a traditional merger, where an equity stake in their firm is exchanged for a similar ownership portion of the successor firm.
The Two-Stage Deal
This type of deal is designed to have an owner affiliate with a successor firm now and begin that critical client transition, while the practitioner retains control of their practice and defers any reduction in income until the time they decide to slow down from a full-time schedule.
The case study below demonstrates in detail how the two-stage deal works:
John is the owner of a CPA firm that generates $500,000 in annual revenues. He wants to work three more years full time before he slows down to a part-time basis.
John has a staff of three people and including perks and benefits, nets about 40 percent. After meeting several potential successor firms, John eventually affiliated with a $3 million, multipartner practice.
During stage one, which would last the three years, John wanted to maintain a full-time schedule. The successor firm agreed to assume all the overhead and administrative tasks that John traditionally performed.
Because John was netting 40 percent, the successor firm agreed to pay him during stage one his 40 percent annual compensation, provided his time commitment remained steady and he didn’t require any additional labor after the merger. Should either of those two scenarios occur during stage one, then John’s compensation would be adjusted accordingly.
One of the advantages to John under the two-stage deal is a less significant reduction to his income should he lose a large client during the transition. So, for example, if John had not merged upward and lost a $20,000 client, he would assume the full $20,000 brunt of that loss. However, if he lost a $20,000 client under a two-stage deal, the “hit” to his bottom line would only be 40 percent, or $8,000.
In addition, John now has the resources of the larger firm, which includes a larger platform of services that can usher in numerous cross-selling opportunities.
After three years – or earlier if John decides to end it sooner at his discretion – stage two of the buyout commences, contingent on the agreed-upon terms and John’s buyout timeline. When stage two kicks in, John reduces his role to part time. Therefore, under this structure, the successor firm would not have to pay for the practice and John’s full-time compensation simultaneously.
Stage one helps keep the seller whole in income, maintain reasonable control, and create a gradual transition of the clients. In stage two, the buyout is typically structured with a retention element thus having a better transition, as stage one enables, means the successor’s retention rate should be strong, creating more revenue for the buyer and a higher purchase price for the seller.