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Unwinding the Marriage: The Case for a De-Merger Agreement

Sep 20th 2017
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As couples prepare to marry, pre-planning for a divorce is traditionally not part of the process. Newlyweds looking forward to this next chapter of their lives optimistically try and abide by the marital vow “till death do us part.”

Sadly, in some cases things begin to sour as suspect personality traits that were absent during the dating phase surface and arguments flare up with alarming regularity over everything from finances to meal menus. Then, after a while, both realize that it’s time to unwind their personal “merger.”

The same scenario can sometimes apply to newly affiliated CPA firms.

During the negotiation stage, both the buyer and seller firms usually have their respective focus squarely on the synergies that would be created as a result of the union, i.e. more cross-selling opportunities, a larger platform of services, and of course, mutual growth.

But not long after the ink on the contract is dry, things can unravel, and quickly. One of the many danger signs of a potentially failing merger is when one or more of the seller partners can be heard saying, “We didn’t agree to that,” in response to a mandate of the integration process. Or some of the older partners become resistant to begin transitioning their books of business to the successor firm.

Unless something is done to correct the situation, the merger — like the marriage scenario described above — is in danger of falling apart. That’s when a de-merger agreement can become a critical part of the overall planning process.

Much like a pre-nuptial clause, a de-merger agreement can protect both firms in cases of “irreconcilable differences.”

While some critics of de-mergers correctly point out that for as long as the agreement remains in place (usually no more than two years), both firms will not be fully committed to the affiliation. Others will cite the dangers of not having one.

Why You Need a De-Merger Agreement: A Case Study

Recently, we were retained to help resolve a merger between a $2 million firm and a $9 million firm. On the surface the combination of the two presented an opportunity for growth and cross-selling synergies but things had spiraled downward barely six months into the union. Cultural differences and internal strife had emerged, and, failing to reach a compromise, each firm agreed to call it quits.

However, there was no de-merger agreement in place at the time of the official signing, and the situation rapidly went from bad to worse.

Initially, both agreed to take back their original clients. But both the $2 million firm and the $9 million firm also had clients they wanted to “trade.” At the same time, several employees of both firms considered switching teams.

The situation escalated when the larger firm insisted the smaller practice to compensate them for the new clients they had developed post-merger, by claiming that the smaller firm would not have had the opportunity to develop new business without the greater resources provided by the bigger firm.

A lease further complicated an already unworkable scenario as the smaller practice moved out of the new office accommodations for the combined practice and the successor firm was now unable to afford both the lease and the overhead.

Meanwhile, the smaller firm had surrendered much of its hard assets and had no place to go. As you can imagine, had a de-merger clause been in effect it would have saved each firm a lot of aggravation not to mention unforeseen out-of-pocket expenses.

Protecting the Firm and the Clients

There are steps that can be taken to protect the firms and their clients. While each merger is unique and requires specific considerations, a primary object of any de-merger plan should focus on protecting the original client relationships of each firm.

Identify each firm’s clients and create restrictions which prohibit competition for those clients for an agreed-upon period of time.

Most client relationships are easy to assign to each party. This is normally handled by attaching lists of existing clients to the merger agreement on the date of the merger.

Sometimes, clients are shifted to partners or staff of the other firm. This may be due to special expertise, pending partner retirement, or capacity or location considerations.

Even when it’s not intended, a client may prefer to remain with the new firm instead of staying with its original firm (after a de-merger has taken place). Rather than attempting to force the client to accept a solution that is not in its best interest, it is better for all parties if the firm losing the client “sells” the client to the firm retaining the relationship.

As an example, let’s say ABC Practice, which has $1 million in revenue, is affiliated with DEF Accountants, which has $2 million in billings. After a while the two decided to de-merge.

Both firms then determined which clients had shifted their allegiance. ABC retained $1.2 million, and DEF retained $1.8 million. Based on a pre-agreed upon valuation, ABC would be required to purchase the $200,000 in clients.

A De-Merger Caveat

De-merger language needs to include how to manage new clients developed post-merger, staff, investments made including leases and technology, as well as the two firms’ original clients.

That said, a de-merger clause may not always be beneficial. In a merger for succession, a de-merger can provide the successor firm a free “look” and invoke the clause if they aren’t happy right out of the gate. Imagine giving up your location, hard assets, starting the transition and then having the buyer decide to back away.

Also, merging two larger firms together can be — unless it involved two separate offices — a difficult process to unwind. 

Lastly, having a de-merger clause can actually make it more likely to de-merge. This sounds a bit counterintuitive, but sometimes parties that have a de-merger clause focus on protecting their relationships with clients in the event of a de-merger.

So, instead of integrating the firms, they hold back — making it more unlikely that the merger will be successful.

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