— To comment on this episode or to suggest an idea for another episode, contact Neil Amato at Neil.Amato@aicpa-cima.com.
Neil Amato: Welcome to a special edition of the Journal of Accountancy podcast. I'm your host, Neil Amato. This episode marks the third in a partnership between the Journal of Accountancy and the Small Firm Philosophy podcast, which is produced by the AICPA's Firm Practice Management team, also known as the Private Companies Practice Section or PCPS.
Today's episode features Small Firm Philosophy podcast host Jeff Drew discussing succession and related M&A trends with Terry Putney, a CPA who is one of the top advisors on accounting firm mergers in the country.
Jeff Drew: Welcome to the Small Firm Philosophy podcast produced by the AICPA's Private Companies Practice Section and distributed in partnership with the Journal of Accountancy podcast. I'm your host, Jeff Drew, a manager with PCPS. September is succession month on the PCPS editorial calendar, and so I am very happy to have as our guest today, Terry Putney, managing director with Whitman Transition Advisors.
Over his 44-year career, Terry has been involved with hundreds of mergers and acquisitions involving accounting firms. First is managing director for M&A with RSM McGladrey, and then as CEO of Transition Advisors, LLC. Terry and his business partner Joel Sinkin, have co-written nearly two dozen articles for the Journal of Accountancy since 2006, including a 12-part series on CPA firms succession. Terry, thank you for joining us today.
Terry Putney: Thanks, Jeff.
Drew: Well, we will jump right into it. What are the three biggest trends you see right now in terms of firms succession and related M&A activity?
Putney: Well, Jeff, succession for retiring partners, small- to medium-size firms really struggle with that and always have, and it continues to be probably the biggest driver for why firms seek to be acquired or merge upstream. But in recent years, there's been several other things that have occurred that are actually causing a lot of firms to consider that the strategy that wouldn't have in the past.
One of the big ones is access to talent. There's not a firm that I've worked with in the last two years I'd say that hasn't told me that they are struggling with getting enough people. We know that that's a big issue for the profession as a whole, and I think a lot of firms realize that maybe we just don't have the resources necessary to attract and retain the talent that we need and maybe if I hook onto a larger firm with more resources, I'll have more success in that area.
The other thing is, of course, there are big changes that are occurring in our profession, and even more that we are expecting in the future with respect to technology and niche services and the need to move away from compliance to advisory services. Most small- to medium-size firms are struggling with how to deal with those challenges. We're seeing a lot of firms say, look, I'm not going to be able to keep up in those areas and I really need access to more services.
My clients are demanding it, and I feel like I can't really serve them properly. Maybe I need to hook onto a firm that is better suited to deliver those services and to meet the technology changes coming down the road. The third thing is, I'd say that on the other side, on the buyer side or the acquiring side, M&A has now become a critical, important piece of growth for almost every large firm.
Most of the firms that we work with have told us that their strategy long-term is to grow 20% a year, but they know they can't do that organically. They actually expect as much as two-thirds to three-fourths of their growth to come through acquisitions. There's very few firms that we work with that aren't active in the M&A arena with respect to driving growth for their firm.
Drew: Would you describe today's accounting firm M&A market as a buyer's market?
Putney: As opposed to a seller's market?
Putney: I think over the last five years, it's clearly flipped to being a buyer's market. It's just really just basic economics, it's supply and demand. Because of the demographics of our profession, we continue to be very heavily – a lot of firms are owned by older partners. The baby boom generation continues to dominate the ownership of accounting firms.
Most small firms have done a poor job of planning for the future in terms of who the next generation is going to be. There's a lot of firms that find themselves in a position where they really need to merge up in order to deal with keeping their firm and their clients and staffs and all that intact. Even though merging, of course, you might imply wouldn't keep it intact, but at least keep the team together.
There's just more and more firms that are seeking that kind of solution, and as I mentioned just a minute ago, there are other things driving firms to seek upstream mergers. The number of sellers is starting to overwhelm the number of buyers, and so it's now become most of the firms that are very active with acquisitions have a lot of choices on who they want to acquire.
They can be a lot pickier and they can drive terms that they find more satisfactory for themselves, and as a result, it's clearly become a buyer's market. That trend has been going on let's say for the last five years.
Drew: Is that the biggest change you've seen in the M&A market over the past four or five years, just the sheer volume of it?
Putney: Well, one of the things that's interesting, when I first started doing this work, about 20 years ago, most firms were fairly confidential in their approach to what their future might be if it involved M&A. Especially on the sell side. Everybody was concerned if I start letting everybody know I'm interested in potentially selling or merging, it's like putting a for-sale sign in front of my office.
The reality now is that firms are much more proactive seeking this kind of strategy. I think people are much more open about considering this or much more open to take meetings than they used to be. Almost everybody has been approached by somebody, and they're just used to having the conversations. The level of activity has increased dramatically because of that. That's one thing that's clearly happened in the last four or five years is the level of activity.
Of course, we can't ignore the fact that private equity now is entering the marketplace. Whereas, I don't think private equity is going to be relevant to the vast majority of firms out there, it's definitely having an impact on the way the larger firms see M&A. I would say that at least the top 50, if not the top 75 firms in the country based on size, have had several conversations with a private equity firm. Not because they sought them out; it's the private equity firms that are seeking them out.
There's probably somewhere between 10 and 15 private equity firms right now that are active in the marketplace even though only three, four have actually done a deal. The large firms are looking at M&A differently. The deal structures starting to reflect that somewhat, and the way they assess value is changing. That's another thing that's happened just recently, that you really have to take into account.
Drew: For small firm partners who are closing in on retirement, what do they need to do to get ready, and how long before retirement should they start the process?
Putney: This is a very good question. I would say that the vast majority of small firms are probably going to eventually have to deal with some kind of merger or acquisition in order to solve their succession problems. It doesn't necessarily mean they're going to sell. It doesn't even necessarily mean they're going to merge up. Sometimes they'll be able to solve it by acquiring another practice or by bringing in somebody who's near partner ready and take over for the retiring partner.
But the thing is that unfortunately, most firms procrastinate. This is the biggest procrastination I see in the profession. It's even more so than procrastinating some of their client work as we know, which accountants have been known to be famous for doing. You wait till the last minute and all of a sudden now you've lost a lot of your options, and you probably have potentially diminished the value of your firm.
The longer you provide the process of assimilating your practice into another firm while you're still involved, the better solution you're going to have, the better outcome you're going to have, and potentially the greater value you're going to create.
Those of us that are waiting until the last minute to say, "Hey, I just did my last tax returns. Somebody take this thing off my hands," are really at the mercy of whatever they can find, at the mercy of how well that transition goes and in some cases, it doesn't go well. Whereas if you can provide yourself at least three, four, or five years of a head-start in terms of the assimilation of your practice into another firm, you're going to get a much better answer.
One of the techniques that works that way, because most practitioners are saying to themselves, I like the way things are now, I don't want to change. I'm really happy. I know eventually, I've got to do something, but I really don't want to go through that change. One of the techniques that we use is a deal structure called a two-stage deal. In a two-stage deal, you combine your firm with another firm and you start operating under their umbrella, under their roof. Oftentimes, you merge offices. It doesn't have to be that way, but often it is.
It looks like a merger to the outside world. But legally you've actually sold the practice. What ends up happening is that you and the buyer firm agree on how long you're going to be in that stage of basically transitioning but working full time. During that timeframe, hopefully, the two of you can work out a deal where your compensation, your income from the practice won't change as long as you maintain the volume of the practice and your time commitment to the practice.
Oftentimes that could be like you say three or four or five years. Then at the end of that three or four or five years, now, you go through the selling process. The thing that makes that work is that you've spent that first, three or four or five years transitioning your clients, your staff, all of your referral sources, everything that's important to your practice has transitioned to the new firm so that the day you walk out the door, it's a non-event for your clients and staff and constituents.
As a result, you really don't have a lot of transition risk. You don't have a lot of risk that clients are going to leave because you've made the changes; they made the change while you were there. That technique is one that allows you to get ahead of the curve and start this process early without giving up all the things that are important to you at the end of your career.
Drew: Now, PCPS's membership, we've got well over a thousand sole practitioners.And so obviously, their situation is somewhat different. Can you describe the ways that they can transition their clients and also fund their retirement? What kind of deals should they be looking for?
Putney: Well, again, what I've just described, I think in the two-stage deal is meant to do that, and it works really well with a sole practitioner. The thing to keep in mind is that both sides are looking for the same thing. They're looking for the maximum value from the practice. From the buyer's side, they don't want to buy a practice or merge a practice in and where the clients are going to leave; that doesn't work for them, even if it's a contingent deal.
You could say, well, they're not going to pay for whatever leaves. I can tell you that most of the buyers we work with are concerned when there's going to be potentially too much attrition within the client base. Of course, the seller is looking for that because almost every deal has a contingency that's based on client retention. In terms of a practitioner who's looking to maximize the value and go through the retirement process, what I just described as the two-stage deal I think is the best way to do it.
If you do it properly, you're going to create a retirement benefit for yourself and you're going to maximize the compensation you earn at the end of your career. Now, if you try to do an internal deal and I've worked with a lot of firms who are attempting to promote somebody from within or bring somebody in to take over for them, that can work. The thing you have to keep in mind is that that person doesn't bring really any resources to the table. You've got to make sure that you and that person work together long enough where they are in a position to take over for you.
But at the same time, you've got to keep the capacity of the firm intact. The day you walk out the door is usually a huge drop-off in productive capacity for the firm and you've got to make sure you take that into account, but you can do it internally. It's been done many times and I think a lot of practitioners probably are in the position they're in because they bought out somebody. But again, when you're getting towards the end of your career, and you haven't given yourself a lot of time, it's probably better to think about doing something with a larger firm. Because you get access to much more in the way of resources and capacity than you can in an internal deal.
Drew: What are the most important traits firms should be looking for in merger candidates, both the ones wanting to be acquired upstream and the ones looking to grow?
Putney: The most important thing regardless of which side of that transaction you're on is having a really good understanding of what you're trying to accomplish and what's important for you. Firms that are looking to acquire that are new to this strategy oftentimes are thinking, "Well, I just need to acquire somebody. I need to grow, I need to find more revenue."
The quality of that revenue and how well it fits within your practice and how well it fits within your future of your firm is something that you oftentimes learn the hard way. I acquired the wrong firm where I got too far into a deal when I realized this really isn't going to fit for me. Makes sure that you've given yourself enough time to think this through and identify what it is you're trying to accomplish.
On the sell side, I'll provide you an example. There can be a huge difference between merging into a firm that has an existing presence in your market. Where you're going to combine your office with theirs, as opposed to a firm that maybe is going to be new to the market through a merger with your firm.
In the former case, you're going to have instant access to all the resources, but you're also going to have to fit in. You're going to be basically assimilating to whatever culture exists in that firm already. In the case of the second, where the firm is new to your market, the advantage a lot of firms think is, "Well, I'm probably not going to have as much change right away because our office is still going to be the one that's operating and it's going to stay more the same." That's probably true.
But you also aren't going to have this as ready access to the resources that maybe you need to solve whatever problem you have. Both of them can look like an upstream merger, but they can have incredibly different outcomes. Those are examples of how you really need to think this through in advance so that you're really going down the right path.
We've all been told that deals fall apart because culture doesn't fit. A lot of people say, "OK, that makes sense to me." But they don't know what culture means. Because it's an elusive concept, it feels like, "Do I like the people I'm talking to? Does this place make me comfortable?'' Those things are important.
But they really aren't the things that are going to create a successful merger. What I always try to get firms to focus on when it comes to culture are three questions. First question is, what's it like to be a client in my firm versus what's it like to be a client in the other firm? Examples are, in your firm, maybe the clients are used to dealing strictly with a partner all the time. The other firm, they have a lot more leverage and therefore, a lot of clients don't really talk to partners very often, they talk to lower level staff people.
In some firms, the client interaction is strictly through portals, and there's very little face-to-face interaction. While in the other firms, clients come to the office and meet with the practitioners frequently. How often are they billed? How our services delivered? Those are all things that create a client experience, and they're also part of the culture of both firms.
If those things are dramatically different, then you can have a really hard time with the merger working out. The second question is, what's it likely to be a staff person in both firms? Leads you to the same questions. Does your staff sit in offices, do they sit in cubicles? Are they working from home? Are they working primarily from the office? What kind of accountability do they have? What career opportunity do they have? Those kinds of questions.
The third, of course, is, what's it like to be a partner in one firm versus the other? Which leads to all questions like, who am I accountable to? What am I accountable for? What's my role in the firm? AmI primarily going to be managing client relationships without doing a lot of the genuine work or am I expected to do a lot of the work? What billable hours am I expected to have? What's important in terms of partner performance in one firm versus the other?
When you go through those kinds of questions and assess culture that way, you lead yourself to a much more concrete outcome of whether or not the deal's likely to work.
Drew: That's something that you and Joel addressed in articles on JofA. In the show notes, I will provide some links to articles that you guys have done where you go into more detail on some of the subjects you've touched on today.
Putney: I think we wrote an article strictly on that issue for JofA on culture.
Drew: Yes. That's exactly what I was thinking of. Is that one. Another thing I know you've written about and that you would get asked about a lot is what is a fair multiple when determining firm valuation in an upstream merger?
Putney: It's interesting, whenever I do speaking engagements on M&A, I get asked three questions. The first question I always get asked is, what's the multiple? The second one is, what's the multiple? And the third one, is what's the multiple? Everybody tends to focus on that because then they make assumptions about what that means, and if I say the multiple is 80% or I say the multiple is 120%, they think they know everything they need to know about what their firm is worth.
The reality is that right now the multiples are ranging anywhere from 70% to about 115% on sales. But the thing to keep in mind is, if you're merging into a firm and you're going to become a partner in that firm, you're likely going to be signing onto the successor firm's owner agreement. If so, your value is probably down the road, and it's going to be defined by their owner agreement, which could be anything.
It could be based on revenues times a percentage ownership, or more likely a multiple of compensation or something like that. In a merger, this question is almost irrelevant, because it can range so dramatically from firm to firm on how they deal with partner retirement. But in an genuine sale, as I said, that range that I threw out is the relevant range. Well, that's a big range.
The thing to keep in mind is that the genuine value of a deal is going to be driven by way more than just the multiple. There are five components to valuation, major components in the terms – actually there's six if I break one of them down into two. The first is, what kind of down payment are we talking about? I would say until recently, down payments had gotten down to where they're almost nothing.
But now because of private equity and how much cash they're throwing at deals, and because firms are starting to look at value a little differently, we're starting to see more down payments being made on deals. But certainly, it's not unusual to see a deal with no down payment. I'd say that's still the majority of small transactions have no down payment.
But also then how are we going to deal with working capital upfront? That's part of the cash upfront. We're going to let the seller keep their working capital or are we going to ask the seller to let us use it for a little while. The second thing is the profitability of the practice, that's primarily from the buyer's perspective.
But needless to say, if a practice is the only generating 20% profit margin for the partners, they're probably going to get a whole different deal from a practice that's generating a 40% profit margin. Looking at the profitability of the practice is important. But also part of that is the tax treatment of the deal. If I'm going to get paid as an asset deal, where the seller can treat it as a capital gain, that is much more beneficial to the seller, but a lot less beneficial to the buyer who's going to deduct those payments over 15 years.
As opposed to a consulting agreement or some kind of retirement, deferred-compensation agreement where it would be deductible as paid. Another feature, of course, is how long the payments are being made. If I'm getting paid overtime for five years as opposed to 10 years, that's a whole different transaction. That also can have a major impact on the value of the deal.
Finally, how are we going to deal with client retention? If we're going to have the client retention be fixed, maybe we're going to fix the price of the deal after the first two years as opposed to the first five years, or do it on a pure collection basis over five years, that's a whole different transaction as well.
One of the things to think about is, if I was to pay you based on 10% of the collections for the next 20 years, that's a 200% multiple. Well, most buyers would say, "Shoot, I do that in every deal." Most sellers would say, "I don't want that deal, that's not how it work for me." But it's a 200% multiple. You have to keep in mind that the multiple is only a small part of the overall terms and don't get caught up in thinking that that's the most important thing.
Drew: Is there something I should have asked you but didn't?
Putney: Yeah, how do you get a hold of me? That's what I would ask. My email address is email@example.com. I'd be happy to answer any questions that any of your listeners have about their specific situations.