The insider: well planned and structured agreement key to successful internal succession.

When CPAs think about retiring and selling their practices, one of their first questions is "To whom can I sell my practice?" There are two primary answers: Select someone in the firm or bring a likely successor into the firm; or find a third party, such as another firm or sole practitioner.

What follows is a look at agreements addressing internal succession transactions.

Eighty percent of the firms facing succession issues in the next five years have failed to create a plan, even if they have partners in place who are capable of purchasing the retiring partner's interest and continuing to operate the firm, according to a recent AICPA survey.

In response, the AICPA has provided some tips on how to groom future firm leaders (see Page 28).

But, imagine your firm has identified the right successor, how do you negotiate the buy-sell agreement?

LET'S MAKE A DEAL 

In the case of internal succession, the purchase price for an owner's interest is usually based on either a percentage or multiple of the retiring partner's compensation prior to the retirement, or of fees received from the retiring partner's clients during a certain time period after the partner's retirement.

When using the percentage of compensation basis, the purchase price often is based on the average compensation paid over a three to five-year period preceding the sale. As an alternative, some firms use the average of the three highest year's compensation during a 10-year period preceding the sale.

That average is then multiplied by a factor of between two and three, which represents the longstanding belief about a CPA firm's profit: one-third of revenues covers salaries, one-third covers overhead and one-third represents profits for the partners.

Once the purchase price is agreed upon, determining the payment period is the next step. This timeframe can range from as short as three years to as long as 15 years, with most firms falling somewhere between five and seven years.

Buyers concerned with the affordability of the payment often will require that the annual payment be capped at a percentage of the firm's annual revenue for each year of payment, usually 5 percent of gross revenue. Other firms will base this cap on a percentage of the firm's remaining partners' compensation, frequently 15 percent.

BUYER CONCERNS

Prior performance is no guarantee of future performance, as brokers say, so buyers will often be concerned that there is no guarantee that clients will transition to them, remain with the firm or continue to be profitable for the firm.

To address this concern, buyers often will condition the payment of the full purchase price on the clients remaining with the buyer for a certain time period, generally between two and five years. If clients are lost during that time period, the purchase price will be adjusted. If clients are lost after that time period, the purchase price is not affected.

To help facilitate the transition--and keep the client comfort level high--buyers will often require the selling CPA to remain with the firm for a transition period of one to three years. In internal succession, buyers will sometimes consider the purchase only if the selling CPA has already successfully transitioned client relationships and responsibilities to other firm members, including the buyer.

As a result, many of these transactions, especially for smaller firms or single partner firms being bought by key employees, are structured so the seller actively encourages clients to remain with the buyer.

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In these cases, the purchase price is a percentage, paid over a period of years, of revenue from retained clients. The objective is to ensure that departing partners take efforts to secure client transition and retention so they will receive the maximum purchase price.

For the buyer, this helps ensure the practice they acquire will be profitable.

During negotiations, buyers often make it the responsibility of the selling CPA to introduce the buyer to the clients; include the buyer in all client meetings; and transition client work to other firm members. In fact, for a transition to be successful, this is often the primary job description for the selling CPA, both before the actual purchase is closed and for a period of time afterward.

Also, the buyer will ask that the seller achieve certain benchmarks, often measured by client retention, to receive the full purchase price. In these agreements, client losses will reduce the purchase price in the same manner that it is determined.

In these cases, the basis for determining the purchase price is often 20 percent of the revenues from the purchased clients during each of the succeeding five years. In some cases, this may be 33 1/3 percent of the revenues for each of the next three years, if the selling partner does not want to guarantee client retention for more than three years.

This structure, however, raises various issues. For example, assume that the seller's clients have generated annual revenues of $400,000. Is this a cap on the purchase price? What if those same clients generate an average of $500,000 in the next five years due to the buyer's efforts and expansion of services? Is the total purchase price paid over five years $400,000 or $500,000?

Buyers prefer that this cap is an amount equal to revenues received from the clients being transferred during the year prior to sale, while sellers prefer that the amount be determined annually, based on actual revenues from these clients.

Correspondingly, is there a floor for the purchase price? The answer will vary with each situation and depend upon the buyer and seller's relative bargaining power.

CLIENT ISSUES

Another key issue is the definition of clients. In most transactions, the seller must prepare a list of clients who are being transitioned and the revenues from each are used to calculate the purchase price.

While ongoing matters for existing clients, such as annual tax returns and financial statements, are simple, issues such as expansions of services for clients (e.g. preparing financial statements for tax clients); expansions of clients' operations; new work resulting from changes in client circumstances; or referral of new clients by existing clients must be taken into account.

Buyers often argue that new or expanded services provided to existing clients, as well as referrals from existing clients, are the result of the clients' satisfaction with the buyer's services and should not be reflected in the purchase price.

Of course, sellers can argue that the expansion of a client's operations or change in client's circumstances are endemic to the client and should be included in the purchase price.

The resolution will depend upon the relative bargaining power of the parties and will vary case by case.

An important aspect in this area, however, is how to deal with those clients who cease using the services of the purchaser.

The split may be client-driven (e.g., the client selects another firm) or buyer-driven (e.g., performance mistakes are made or fees are raised significantly). There are also situations where the clients and buyer simply aren't compatible and they part ways.

If the client lost is a result of the buyer's actions, should there be a reduced purchase price? If you're the buyer, you may think so, but this would penalize the seller, who had no role in the client departure.

One way of dealing with this is to classify client separations as "good," those in which the buyer is not at fault and which don't reduce the purchase price, and "bad," in which the client separation is the result of some improper action by the buyer, such as significant fee increases or mistakes, and which do reduce the purchase price.

In "good" separations, unless the purchase price is adjusted, the buyer will feel they have paid too much, while the seller argues that the client losses aren't the seller's fault and the seller should not be penalized.

Many transactions are structured so that, if the purchase price is to be reduced due to "good" separations during the transition period, the seller will have the option, without violating any covenant not to compete, to either service these clients or attempt to sell them to another buyer.

EXPECT THE UNEXPECTED

Even with well-planned transactions, the unexpected can occur.

For example, the buyer might resell the practice or die before making full payment of the purchase price. Sellers may want to protect themselves by demanding security for the unpaid purchase price or life insurance on the buyer.

But realize that while buyers might agree to life insurance, they often will reject any security for the purchase price because they don't want to encumber their other assets if the practice proves to be unsuccessful.

IN THE END ...

Successful transitions are the result of careful advance planning, which includes a well-drafted agreement that addresses all crucial points. Sellers, looking to receive the full purchase price, need to select the buyer who is most likely to be successful. Buyers can position the practice for a successful transition by evaluating the clients, their attachment to the seller and the seller's prior actions in delegating client relationships and services.

Jonathan A. Karp, CPA, Esq. is a shareholder of Los Angeles-based law firm Reish, Luftman, Reicher & Cohen. He has chaired and spoken at numerous California CPA Education Foundation programs, including the Succession Planning for the CPA Firm Conference. He is co-chair of the Management of an Accounting Practice Committee for CalCPA's Los Angeles Chapter and has served as vice president and board member of the chapter. You can reach him at [phone] or [e-mail].

BY JONATHAN KARP, CPA, ESQ.

RELATED ARTICLE: Nurturing Future Leaders 

Here are some practical guidelines for nurturing future leaders:

* Give people throughout the organization the power and responsibility to do their jobs autonomously. This doesn't mean that each functional area should set up its own rules and regulations. In fact, that is not recommended. Instead, give your staff--and particularly potential leaders--the time, guidance and encouragement to develop the kind of initiative and independence that will serve them well as they advance within the firm.

* Identify managers or other staff with potential. Once you have staff members working independently and you understand what kind of talent you have, the firm should develop formal or informal processes for judging how well younger employees manage people and situations. Depending on budget and size of staff, you may also consider providing training for the most promising candidates.

* Mentor promising staff. Though employees need the technical skills, they also must understand what it means to handle clients and run a business if they are to take over one day. Give them responsibility, and if they run into problems, help them understand how to resolve them. Introduce them to clients and to the kinds of challenges that come up in the field.

* Include junior staff in decision making. Top management still must make key decisions, but consider how the firm can include younger staff in selected decisions and perhaps delegate some choices to them.

* Set up a timetable for new leadership. Will the new managing partner, for instance, take over when all the senior partners have retired, or will the reins be passed sooner? Many consultants recommend that a new managing partner be put in place while older partners are still on the job. These partners should offer advice and support without trying to interfere with the new leader's authority.

--AICPA