Valuations of Accounting Firms Combine 2 v 4 web.pdfprofitably add a small accounting firm than a large one. That’s because small firms tend to have less over-head. For example,

Valuations of Accounting Firms

Internal, Mergers, Sales-Large and Small

24 Journal of Accountancy October 2014 www.journalofaccountancy.com

N E E D R U B R I C H E R E

For CPAs looking to sell their accounting practice, it can be a bigplus to be in a small firm. That’s because small firms generallycan command higher multiples than big firms, and external sales

usually produce higher prices for accounting practices than internalownership transfers.

What partners need toknow to maximizeproceeds when sellingtheir practice

by Joel Sinkin and Terrence Putney, CPA

PricingIssues for

Those are two of the trends that will be ex-plored in a three-part series on valuation is-sues in accounting firms. This article focus-es on small CPA firms. The next two articles

will address valuation issues for large CPAfirms and internal transfers of ownership.

Here are a couple of definitions specif-ic to the series:

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Small Firm

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Pricing for Small Firm Sales_JOa 8/29/14 2:22 PM Page 1

www.journalofaccountancy.com October 2014 Journal of Accountancy 25

P R A C T I C E M A N A G E M E N T

buyer is willing to pay, is directly relatedto other terms of the transaction. The fiveprimary terms that affect the multiple are(1) the upfront purchase payments; (2) thenumber of years the remaining paymentsare made; (3) the period during which thepayments are subject to adjustment for re-tention of acquired clients and the extentof the possible adjustment; (4) the taxtreatment of the payments; and (5) the po-tential profitability of the practice for thebuyer. The more those factors favor theseller, the lower the resulting multiple willtend to be and vice versa (see “How toValue a CPA Firm for Sale,” JofA, Nov.2013, page 30).

Retention of acquired clients tends to

be the factor that most significantly affectsa small firm’s value. The reason for this isthat client relationships in smaller firmstend to be much more connected to thefirms’ owners. Those owners are oftenmuch more hands-on with clients, whooften can’t differentiate their relationshipwith the firm from their relationship withone of its owners. The larger the firm be-comes, the more likely it is that clients willsee their relationship as institutional. Inthose cases, the clients will have relation-ships with several key people in the firmand be less tied to a particular owner.

In virtually any deal that places valueon the transfer of client and staff relation-ships, provisions restrict the seller fromcompeting with the buyer firm for thoserelationships for a reasonable period fol-lowing the sale. Without this type of re-striction, the buyer has no assurance thatthe acquired relationships, which repre-sent most of the practice’s intangible value,can be sustained.

In most cases, the seller’s direct in-volvement in the transition of client rela-tionships is a key to transferring loyalty toa successor in the acquiring firm. To en-

sure that happens and to motivate the sell-er to execute the plan, most deals haveclauses that directly tie the seller’s purchaseproceeds to the buyer’s client retentionover a certain period. For example, assumea buyer agrees to pay a revenue multipleof one times for a $1 million practice. Thedeal calls for the buyer to pay over fiveyears based on the percentage of clientsthat stay with the firm for two years afterthe sale. If clients representing 80% of therevenue stay with the successor firmthrough the second year, the seller will re-ceive $800,000 for the practice.

Retention periods tend to fall into threecategories: (1) one-year retention periods;(2) two-or-more-year retention periods;

and (3) full-collection deals. The durationand nature of the retention period can af-fect the final sale price in a variety of ways.

One-year retention period. In dealswith this term, the final purchase pay-ments are based on the collected billingsfrom the seller’s clients for the first year fol-lowing the closing. While many sellers be-lieve a shorter retention period results inless risk for them (due to less time forclients to leave the buyer firm and lowerthe seller’s proceeds), that has not been theauthors’ experience. When the deal locksin the price after the first year, most buy-ers counter (if they will even consider thedeal) as follows:

� They offer a reduced price multiplebecause of increased perceived risk.

� They are less patient with the tran-sition and tend to institute changesquickly. Most buyers understandthey are much better off losing aclient during the first year thanshortly after the retention period ex-pires. An aggressive transition cancause greater client attrition.

Two-or-more-year retention period.Retention periods for less than the full

� Value is not meant to be consistentwith the conclusions that a CPAAccredited in Business Valuation(ABV) would reach in a formal busi-ness valuation performed for, say, lit-igation or an estate. Instead, valuerefers to the price to be paid for thepractice—which often is expressedas a multiple of revenues, as is dis-cussed in further detail later in thisarticle.

� Small firms, generally speaking, arethose with four or fewer owners.This is because the vast majority ofbusiness combinations involvingthe acquisition of firms with morethan four owners are at least partiallya merger rather than a sale.

In a merger, some or all of the acquiredfirm’s owners become owners in the suc-cessor firm. This is an important distinc-tion because, in a merger, the successorfirm’s owners’ agreement usually dictatesthe value of the equity for owners who area party to the agreement (though not al-ways, as will be explored in next month’sarticle on large firm valuations).

In transactions with smaller firms, it ismuch more likely the transaction will bein the form of a sale. The sale can be im-mediate, meaning the payment of the pro-ceeds commences at closing, or in the formof a two-stage deal, in which the proceedsare delayed for a few years, with the sell-ing owners continuing to work full timewhile transitioning the practice (see “ATwo-Stage Solution to Succession Pro-crastination,” JofA, Oct. 2013, page 40).

The primary factors that drive the valueof a small firm in a sale are (1) the termsof the transaction; (2) the number of buy-ers potentially interested in the practice;(3) the attributes that will affect the prof-itability for the buyer of the practice; and(4) the nature of the practice. This articleexplores those factors in more detail.

1. The Terms of the TransactionAs mentioned earlier, the price paid for afirm often is expressed as a multiple of rev-enues. However, the multiple a seller iswilling to sell the practice for, and the

In most cases, the seller’s direct involvement in thetransition of client relationships is a key to transferring

loyalty to a successor in the acquiring firm.


26 Journal of Accountancy October 2014 www.journalofaccountancy.com

payment period can be defined manyways and must be drafted carefully. Forinstance, in a two-year retention deal, theretention adjustment may be based on theaverage of two years’ collections or on thesecond-year collections for clients retainedat the end of that year. Collections fromrepetitive services might be the only onesincluded in the calculation, with specialone-time services treated entirely differ-ently.

Two-year retention periods tend towork better than one-year periods becausebuyers understand that most clients re-tained after the first year have affirmedtheir transition to the successor firm. Thus,there is less risk of losing clients in sub-sequent years. A two-year-or-longer re-tention period can often lead to a betteroffer and a more gradual transition, re-sulting in better retention. It should benoted that very large clients (for instance,those individually making up more than10% of an acquired firm’s fees) may re-quire longer retention periods due to theconcentration of attrition risk.

Collection deals. An example of a col-lection deal is a transaction in which a sell-er is paid 20% of collections from a soldclient list for the full payment period of fiveyears (a 100% multiple). Using the samemultiple if the seller is paid over four years,the price would be based on 25% of col-lections during the payment period. Theadvantage this approach has for the buy-

ing firm should be obvious. The firm paysonly for the clients retained based on feesgenerated during the payment period.

This is advantageous for the sellingfirm. First, the seller often is in a positionto negotiate a higher multiple due to re-moving the risk of client attrition from thetransaction. Second, though some loss ofclients is inevitable, if the seller selects theright successor firm, there is a good chancefees will increase for the clients that are re-tained. In a collection deal, the seller usu-ally sees an increase in purchase proceedsdue to an uptick in fees, especially fromincreased services. It is not unusual for themost successful combinations to result inhigher fees and much higher purchaseproceeds than the seller would have re-ceived even if the price had been fixed atclosing.

2. The Number of Buyers Potentially Interested in thePractice; and3. The Attributes That Will Affect the Profitability for theBuyer of the Practice Why can owners of small firms expecthigher multiples for their practices thanmost of their big firm counterparts? Theanswer is pretty basic: the law of supplyand demand. There simply are many morefirms able and willing to snap up a firmwith four or fewer owners than there arefirms looking to acquire larger operations.

Consider the following reasons: � The vast majority of accounting

firms are small, as shown in the 2012AICPA Private Companies PracticeSection (PCPS)/Texas Society ofCPAs Management of an AccountingPractice (MAP) Survey. That studysplit firms into seven categories byannual revenue. Of those categories,only the top two, composed of firmswith at least $5 million in revenue,had an average number of partnersper firm of at least five. Only about6% of the firms that participated inthe survey had at least $5 million inrevenue. That leaves precious fewfirms with the resources to absorb anaccounting practice with five ormore partners.

� It is usually easier and quicker toprofitably add a small accountingfirm than a large one. That’s becausesmall firms tend to have less over-head. For example, the authors haveencountered many firms capable ofabsorbing a small firm with littleextra costs, if the small firm is nottied down by a long lease and doesnot demand the retention of redun-dant administrative staff. A $3 mil-lion or $4 million firm often can ab-sorb a $500,000 practice withouthaving to add office space or non-billable staff. Firms with five or moreowners usually require the acquiring

E X E C U T I V E S U M M A R Y

� Small firms generally com-mand higher multiples of rev-enue in sales than large firmsdo. Small firm deals also tend toproduce higher value than inter-nal transfers for ownership. � Four primary factors deter-mine the price paid for a smallfirm. These factors are the trans-action’s terms, the number of in-terested buyers, the firm’s profitpotential for the buyer, and thenature of the firm.� Client retention is essential

to maximizing proceeds from asmall firm sale. Most CPA firmsales calculate the amount paidto the seller based on the per-centage of clients the buyer re-tains during a certain period afterthe sale closes. Small firm clientstend to be more loyal to partnersthan to the firm as an institution. � CPA firm sales have threemain types of retention peri-ods. Full collection deals and re-tention periods of two or moreyears tend to produce higher

multiples for the seller than one-year retention periods. � It’s usually easier and quick-er to profitably add a small firmthan a large one. That’s be-cause small firms generally haveless overhead that acquiringfirms have to absorb. � Baby Boomer retirementsare putting more small firmson the sale block. This increasein supply is driving down values,though the demand for smallfirms remains high.

Joel Sinkin ([email protected]) is president, andTerrence Putney ([email protected]) is CEO,both of Transition Advisors LLCin New York City.

To comment on this article or tosuggest an idea for another ar-ticle, contact Jeff Drew, senioreditor, at [email protected] or919-402-4056.



firm to pick up the costs of addi-tional office space and administrativepersonnel. Those costs affect the ac-quired operation’s profitability. Thetarget for cost synergies in an ac-counting firm sale or merger is 10%to 15%. Those goals can be hit in alarge firm merger, but it usually takesa few years. Many firms won’t con-sider an acquisition that isn’t cashflow positive (net revenue minuscosts, including acquisition costs) inthe first year or two.

4. The Nature of the Practice Certain types of practices tend to com-

mand a lower multiple. Some client basesare viewed as difficult to transition becauseof the unique relationship between theclients and the seller. Litigation supportpractices are sometimes seen as creatingthis kind of obstacle.

Another factor driving down the mul-tiple is a practice with a low profit margin.A common example is an outsourcingpractice with a relatively low markup onlabor costs. A practice with a 20% profitmargin (before owners’ compensation andbenefits) is not going to command thesame multiple as a practice with a 40%profit margin.

Certain types of practices also can

command a higher multiple, usually be-cause of the opportunity for significantsynergy that a specific type of buyer canexploit. For instance, practices that havea significant number of high-income andhigh-net-worth individual clients oftencan obtain a premium valuation from afirm that offers wealth management serv-ices. The same holds true for firms withclient bases that offer the opportunity forcross-selling high-value services by a spe-cific buyer firm. However, a buyer firmthat primarily focuses on business servicesmay view a firm with a concentration ofhigh-income and high-net-worth clientsas less valuable. Value is always in the eyeof the beholder.

TRENDS IN SMALL FIRMVALUATIONSA flood of Baby Boomer accounting firmowners nearing retirement has created asurge in the number of small firms seek-ing buyers. The net result is the authors areseeing firm values dropping to some ex-tent in almost every market nationwide.Whereas revenue multiples of 1.5 to 2were common 15 to 20 years ago, multi-ples today tend to range from 0.75 to 1.2.Again, the law of supply and demand is ineffect, and trends point to growth in thesupply of sellers seeking external solutions,which is outstripping growth in the num-ber of buyers interested in providing thosesolutions.

The good news for small firm ownersis that they likely will always be in posi-tion to command higher multiples thanlarge firm owners—thanks to the supply-and-demand issues explained in this arti-cle. In addition, because large firm acqui-sitions tend to be at least partially in theform of a merger, the value of the acquiredfirm is determined at least in part by thesuccessor firm’s owners’ agreement. As willbe explained in greater detail in the thirdinstallment of this series, internal valua-tions are usually lower than external val-uations. For those reasons, the authorshave seen many more small firms acquiredfor multiples of one times or higher—a bigplus for small firm owners. �

www.journalofaccountancy.com October 2014 Journal of Accountancy 27

AICPA RESOURCES

JofA articles� “How to Maximize Client Retention After aMerger,” April 2014, page 42� “Managing Owner Transition Through anOwners’ Agreement,” March 2014, page 42

Use journalofaccountancy.com to find pastarticles. In the search box, click “Open Ad-vanced Search” and then search by title.

Publications� Business Valuation Practice ManagementToolkit (#PPM1208P, paperback;#PPM1211E, ebook; and #PFVSBVTO,one-year online access) � CPA Firm Mergers & Acquisitions: Howto Buy a Firm, How to Sell a Firm, and Howto Make the Best Deal (#PPM1304P, pa-perback; and #PPM1304E, ebook) � Essentials of Valuing a Closely Held Busi-ness (#056605PDF, online access)� Navigating Mergers & Acquisitions: Guid-ance for Small and Mid-Sized Organizations(#PGN1302P, paperback; and #PGN1302E,ebook)� Securing the Future: Volume 1: BuildingYour Firm’s Succession Plan; Volume 2: Im-plementing Your Firm’s Succession Plan(#PPM1307HI, volume 1 & 2 set, paper-back; #PPM1305P, volume 1, paperback; #PPM1305E, volume 1, ebook; and#PPM1306P, volume 2, paperback)

CPE self-study� Critical Tools for Today’s Controller andCFO (#741277, text; and #163080, one-

year online access)� Introduction to Business Valuation(#745785, text)� Understanding Business Valuation(#732886, text)

Conference� Forensic & Valuation Services Conference,Nov. 9–11, New Orleans

For more information or to make a purchaseor register, go to cpa2biz.com or call the Institute at 888-777-7077.

Private Companies Practice Section andSuccession Planning Resource CenterThe Private Companies Practice Section(PCPS) is a voluntary firm membership sec-tion for CPAs that provides member firmswith targeted practice management toolsand resources, including the SuccessionPlanning Resource Center, as well as astrong, collective voice within the CPA pro-fession. Visit the PCPS Firm Practice Centerat aicpa.org/PCPS.

FVS Section and ABV credentialMembership in the Forensic and ValuationServices (FVS) Section provides access tonumerous specialized resources in the foren-sic and valuation services discipline areas,including practice guides, and exclusivemember discounts for products and events.Visit the FVS Center at aicpa.org/FVS.Members with a specialization in businessvaluation may be interested in applying forthe Accredited in Business Valuation (ABV)credential. Information about the ABV cre-dential program is available ataicpa.org/ABV.



transitionadvisors LLCLeading CPAs Through Transition

with Succession and M&A Strategies

transitionadvisors.com • 866.279.8550Joel Sinkin - [email protected]

Terrence Putney, CPA - [email protected]

Pricing Issues for

Midsize and LargeFirm Sales

Big deals come with more complexity, but size has its advantages.by Joel Sinkin and Terrence Putney, CPA

Pricing Issues_Sinkin_Nov14q8_Joa 10/3/14 4:25 PM Page 1

The reasons for that are examined in thisarticle, the second in a three-part series oncalculating the price that should be paid forowners’ equity in accounting firms. The firstarticle (“Pricing Issues for Small Firm Sales,”JofA, Oct. 2014, page 24) covered the fac-tors that determine the final sale price forsmall accounting firms. The final article,which will be published next month, willexamine the valuation issues with internaltransfers of ownership.

For this series, the authors use the fol-lowing definitions: � The term value refers to the price to be

paid for the practice—which often is ex-pressed as a multiple of revenues. Valueis not meant to be consistent with theconclusions that a CPA Accredited inBusiness Valuation (ABV) would reachin a formal business valuation.

� Large accounting firms are those withfive or more owners. That’s becausefirms of that size are much less likelythan small firms to be sold outright.With larger firms, at least part of the ac-quisition is likely to be structured as amerger, with some or all of the ownersbecoming long-term partners in thesuccessor firm. In those cases, the valueof their equity usually is determined bythe successor firm’s owners’ agreement,though not always. One factor adding to the complexity of

large firm acquisitions is the frequent needfor different deals for groups of owners inthe acquired firm. For instance, a six-owner firm may have four owners whowill sign on as partners with the acquir-ing firm. The other two owners may beseeking a short-term transition of their du-ties and monetization of their ownership.The deal for those owners may be treatedas a sale in a transaction that is mostly sep-arate from the agreement governing theadmission of the rest of the owners as eq-uity partners in the acquiring firm.

Another alternative is a two-stage dealfor owners seeking transition within five

years but who want to continue workingfull time for a while (see “A Two-Stage Solution to Succession Procrastination,”JofA, Oct. 2013, page 40). In some cases,owners of the acquired firm who are notadmitted for other reasons (sometimes fornot meeting the acquiring firm’s book ofbusiness or skill requirements for part-ners) may also go through a sale to dealwith their equity.

USE OF ACQUIRED FIRM’SOWNERS’ AGREEMENT TERMSMost large firms have an existing owners’agreement. Some of those agreements con-tain terms for the buyout of retiring part-ners that are not financially viable, makingthe internal succession plan impractical.However, a lot more internal successionstrategies fail because the firm’s poolof internal successors cannot re-place retiring partners. If the mo-tivation for a firm seeking anupstream merger is findingreplacements for retiringpartners, it may be-come reasonableto use the termsof the acquired firm’sbuy-sell agreement forthe buyout of ownersleaving soon after themerger. This is becausethe primary concern ofthe owners in the sellingfirms is not what theywill be paid but that theywill be paid.

For example, a firmowner might be moreconfident that a $20 mil-lion firm could pay forhis or her buyout than a$5 million firm. Let’s saythe buyout in the acquiredfirm’s owners’ agree -ment calls for the ownerto receive $100,000 for

the next 10 years. The owner’s stake inthe acquired firm might be worth morethan that on the open market, but to en-sure that he or she receives payment, theowner would be happy to keep the pay-ment structure outlined in the acquiredfirm’s owners’ agreement.

DEALING WITH IMBALANCESBETWEEN AGREEMENTSA problem the authors routinely run intois differences between the method of valu-ing equity in an acquired firm and the firmit is merging into. For example, in a recentdeal, a firm with five partners used the per-centage of equity owned by a partner mul-tiplied by the firm’s revenues to determinethe value of a partner’s interest at retire-ment. The firm had five owners, and oneowned 60% of the equity.

The acquiring firm used a compensa-tion multiple to determine retirement

buyouts. The majority owner in the acquired firm would have been

required to take a substantial re-duction in the retirement buy-

out using the acquiring firm’smethod. However, the ac-

quiring firm concluded itwould eventually sub-

stantially overpay re-tirement benefits to

all the mergingpartners if it

used the acquired firm’sbuyout method for themajority selling ownerand its standard arrange-ment for the other merg-ing partners.

The solution was tohave all the mergingpartners sign on to thesuccessor firm’s part-nership agreement. Aseparate agreement wasestablished, creating apremium for the ma-jority selling partner(who did not becomean equity partner in thesuccessor firm) using

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www.journalofaccountancy.com November 2014 Journal of Accountancy 51


It’s no simple task for accounting firm owners to figure out how muchthey should be paid when they are looking to sell. The job is espe-cially complex for firms with at least five owners.


52 Journal of Accountancy November 2014 www.journalofaccountancy.com

the value he would havebeen paid from hisold firm. A discountwas allocated to the

remaining fourpartners merg-

ing into thesuccessor

firm equal to the“premium” paid tothe majority part-ner in a side agree-ment with them.

LARGE VS.SMALLAs covered in thefirst part of this se-ries, the multiplespaid in small firmsales tend to behigher than thosein large firm trans-actions. The payoutperiods also tend tobe shorter. The mainreason for that isthat acquiring firms

tend to absorb less overhead with smallfirms than they do with large firms. Thishelps the acquisitions become profitablemore quickly.

For example, the acquirers of smallpractices often have enough excess capac-ity in terms of staff/partner time and infra-structure that they can absorb the practicewith little incremental increases in over-head. In contrast, it is unlikely anyacquirer can absorb a $10 mil-lion firm with 60 employeesand 10 owners without in-heriting the overheadcosts associated withadministrativestaff, leases, etc.To keep the cash flow ofthe deal positive, the trans-action is more likely to havea lower multiple and longerpayout period for the por-tion of the deal that istreated as a sale.

Not all the terms areworse for the seller in largefirm transactions. Dealsinvolving larger firms tendto have shorter retentionperiods. There are two rea-sons for this.

First is the nature of therelationships clients havewith the firm. A larger firmtends to have more “brand-loyal” clients. These are

clients that do not depend for their serv-ices on a personal relationship with an

individual at the firm, usually apartner. The clients of smaller

firms are much more likelyto be loyal to a partner in

the firm. Once thatpartner leaves, there

is more risk thecl ient wil lleave, too.

To motivate the tran-sitioning owner to prop-erly transition clientrelationships, the trans-action will normally betied directly to the feesgenerated by the seller’sclients for up to the en-tire payout period. In theacquisition of a largerfirm, there often is lessperceived risk of clientloss due to the exit of oneperson from the firm.The acquiring firm maybe much more willing tostructure the terms usinga shorter retention peri-od and even allow someclient loss with no ad-justment in price.



� Large firm sales are muchmore likely than small firm salesto be at least partially a merger.In those deals, younger partnersfrom the acquired firm becomepartners in the acquiring firm, whilepartners ready to cash out cometo terms on a buyout or sale oftheir stakes to the acquiring firm. � Owners’ agreements oftenare used to determine partnercompensation. Many times, merg-ing partners will sign on to theterms of the acquiring firm’s own-ers’ agreement. In other cases, theacquired firm’s agreement is used,or different terms are negotiated.

� Large firm sales usuallyhave smaller revenue multiplesand longer payout periods thansmall firm sales. This is be-cause acquiring firms almost al-ways have to add overhead toaccommodate large firm acquisi-tions. As a result, it takes longerfor the acquiring firm to see a re-turn on investment, which leadsto the payouts to the acquiredfirm taking place over a longerperiod of time. � Large firm sales tend to haveshorter client retention periodsthan small firm sales. Large firmclients are more likely to be

brand-loyal than small firmclients, who tend to be partner-loyal. Brand-loyal clients are lesslikely to change accounting firms.Also, in more large firm mergers,at least some partners with theacquired firm stay with the suc-cessor firm, maintaining a pres-ence that can help retain clients. � A couple of main factorshave created a buyer’s marketfor larger firms. The return of or-ganic growth after the recessionhas relieved the pressure onlarge firms to expand throughM&A. More importantly, the risingtide of partner retirements, cou-

pled with the shallow pool ofavailable replacements, is push-ing firms to seek upstream merg-ers to shore up succession.

Joel Sinkin ([email protected]) is president, andTerrence Putney ([email protected]) is CEO,both of Transition Advisors LLC inNew York City.

To comment on this article or tosuggest an idea for another article, contact Jeff Drew, senioreditor, at [email protected] or919-402-4056.


The second reason is tied to the ten-dency the transaction will be structured atleast partially as a merger. At least some ofthe owners in the acquired firm will be-come long-term partners in the successorfirm. These partners will often be in a po-sition to directly mitigate the risk of clientloss and frequently even succeed to theclient relationships that were managed byretiring owners who are being bought out.This approach can drastically reduce thepotential for client loss and allow the dealfor the selling owners to contain less re-tention risk for them.

However, note that the specific cir-cumstances affecting a firm’s potentialclient attrition will dictate how this is han-dled. For example, if a selling owner man-ages an extraordinarily large client in termsof fees, or if the firm has operated insilos—essentially several sole practitionerssharing space and managing separate anddistinct books of business—the retentionterms may be the same as those for a$500,000 one-owner firm.

MORE AND MOREA BUYER’S MARKETWhile for years it was a seller’s marketplace,this is no longer the case in many markets.This is especially true for most large firmsseeking sales or mergers. The larger a firmis, the fewer viable acquirers are available.Immediately following the economic down-turn in 2008, most growth-oriented ac-counting firms turned to mergers andacquisitions as an alternative to organicgrowth, which went dormant as the econ-omy faltered. A feeding frenzy of sortsemerged for firms of all sizes. The M&Amarket tilted toward sellers. Two things havehappened since. The economy improved,and large firms began to grow again organ-ically. More importantly, many more firmsof all sizes, other than the largest, are nowexperiencing succession pressure due to in-sufficient talent below the partner level.

The firms that are potentially relevantacquirers of large firms remain motivatedto grow through M&A. However, the ratioof buyers to sellers has decreased becausesome of the acquiring firms have them-

selves been acquired, and the supply ofavailable firms seeking an upstreammerger has increased dramatically. As a re-sult, most acquirers of large firms havetighter criteria for a deal. Another result isthat acquiring firms are pushing the termsthey are willing to use in the transactionmore in their own favor. Hence, the au-thors are seeing much more of a buyer’smarket among large firms.

CONCLUSIONFor large firm owners contemplating a sale,it’s seller beware. The market favors buy-ers, and small firms are seen as more at-tractive for upstream buyers. Nonetheless,large firms can have advantages at buyouttime, with more “brand-loyal” clients andthe possibility that retained owners fromthe acquired firm may smooth the transi-tion for retiring partners’ clients. �

www.journalofaccountancy.com November 2014 Journal of Accountancy 53


AICPA RESOURCES

JofA articles� “Pricing Issues in Small Firm Sales,”Oct. 2014, page 24� “How to Maximize Client Retention After aMerger,” April 2014, page 42� “Managing Owner Transition Through anOwners’ Agreement,” March 2014, page 42� “Alternative Deal Structures for Succes-sion,” Jan. 2014, page 42� “How to Value a CPA Firm for Sale,” Nov.2013, page 30� “A Two-Stage Solution to Succession Procrastination,” Oct. 2013, page 40

Use journalofaccountancy.com to find pastarticles. In the search box, click “Open Advanced Search” and then search by title.

Publications� 2014 Valuation Handbook—Guide to Costof Capital (#PBV1402P, paperback)� Business Reference Guide 2014(#BBP9780974851891, paperback)� Business Valuation Practice ManagementToolkit (#PPM1208P, paperback;#PPM1211E, ebook; #PFVSBVTO, one-year online access) � CPA Firm Mergers & Acquisitions: Howto Buy a Firm, How to Sell a Firm, and Howto Make the Best Deal (#PPM1304P, paperback; #PPM1304E, ebook) � Essentials of Valuing a Closely HeldBusiness (#056605PDF, online access)� Securing the Future: Volume 1: BuildingYour Firm’s Succession Plan; Volume 2: Implementing Your Firm’s Succession Plan(#PPM1307HI, volume 1 & 2 set;#PPM1305P, volume 1, paperback;#PPM1305E, volume 1, ebook;#PPM1306P, volume 2, paperback)� Understanding Business Valuation: APractical Guide to Valuing Small to MediumSized Businesses, 4th edition(#PBV1201P, hardcover)

CPE self-study� Critical Tools for Today’s Controller andCFO (#741277, text; #163080, one-yearonline access)� Introduction to Business Valuation(#745785, text)� Understanding Business Valuation(#732886, text)

Conference� Forensic & Valuation Services, Nov. 9–11,New Orleans

For more information or to make a purchaseor register, go to cpa2biz.com or call the Institute at 888-777-7077.

FVS Section and ABV credential Membership in the Forensic and ValuationServices (FVS) Section provides access tonumerous specialized resources in theforensic and valuation services disciplineareas, including practice guides and exclusive member discounts for productsand events. Visit the FVS Center ataicpa.org/FVS. Members with a specializa-tion in business valuation may be interestedin applying for the Accredited in BusinessValuation (ABV) credential. Informationabout the ABV credential program is avail-able at aicpa.org/ABV.

Private Companies Practice Section andSuccession Planning Resource CenterThe Private Companies Practice Section(PCPS) is a voluntary firm membership sec-tion for CPAs that provides member firmswith targeted practice management toolsand resources, including the SuccessionPlanning Resource Center, as well as astrong, collective voice within the CPA profession. Visit the PCPS Firm PracticeCenter at aicpa.org/PCPS.




transitionadvisors.com • 866.279.8550Joel Sinkin - [email protected]

Terrence Putney, CPA - [email protected]

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Here’s a scenario playing out in partner meetings across thecountry. Dewey, Kowntem & Howe LLC (DKH) is a five-partner, second-generation firm. John Howe is one of the

founding partners. Over the years, the firm bought out ChuckDewey and Alice Kowntem using terms the three partners agreedto when they formed the firm. It was difficult paying for those buy-outs, but the firm got through it. Because of the way the firm re-allocated equity following Chuck’s and Alice’s buyouts, John’sequity share is now 65%.

Dramatically differentdemographic and marketconditions require newstrategies to pay for buyouts.

by Joel Sinkin and Terrence Putney, CPA

How toPrice an Owner’s

Interest in a CPA Firm

John announced at a recent partnermeeting that next tax season would behis last. However, his partners let him

know that they didn’t think they couldafford the buyout terms dictated bytheir operating agreement. John was

owner’s interest in a cPA firm_JoA 11/2/14 5:14 Pm Page 1

shocked and hurt to learn his partners didnot share the same commitment to theagreement he had made when buying outChuck and Alice.

What went wrong for John?The tremendous number of Baby

Boomer owners of CPA firms is causingmany firms to reconsider the agreementsthey negotiated 20 or 30 years ago. Youngerpartners often are wondering how the firmwill survive as they take on the burden ofpaying several senior partners simultane-ously on what appear to be onerous terms.

This article addresses current trendsand techniques for setting the price forownership stakes in internal ownershiptransfers in CPA firms. The two previousarticles in this three-part series addressedvaluations of small CPA firms (“Pricing Is-sues for Small Firm Sales,” Oct. 2014, page24) and larger CPA firms (“Pricing Issuesfor Midsize and Large Firm Sales,” Nov.2014, page 50).

The concept of price in this articleshould not be confused with the value thata CPA Accredited in Business Valuation(ABV) might place on an accounting firmin a formal business valuation. This arti-cle addresses the set of terms for the buy-out of an owner and the business plan that

backs up the transition of that owner’s keyresponsibilities.

Although many internal buyout termsare structured in a way that tries to mimicthe external market, the trend is clearly to-ward lower prices for internal transfers.There are several reasons for this, in ad-dition to the increasing reluctance ofyounger partners in firms to take on largeretirement obligations. Those are:

� An owners’ agreement is, in essence,a put option. The firm and yourpartners are contractually obligatedto buy you out once you have metthe criteria in the agreement. Thereis no such obligation in an externaltransaction. Just like in the stockmarket, where acquiring a put op-tion has a cost for the person re-ceiving the option, your cost for thatfeature may be a lower sales price.

� One of your firm’s objectives in aninternal buyout is its long-term vi-ability as an independent entity. Oth-erwise, you would sell. The trade-offfor that is terms that make that pos-sible. You aren’t typically as interest-ed in the viability of the buyer in anexternal transaction once you havebeen paid.

� The terms for an internal sales trans-action are normally different fromthose for an external one. A key dif-ference is that internal payments areoften fixed at the date of retirementwhereas external transactions almostalways have post-closing contingen-cies. That difference, as well as otherdifferences in terms, explains a lowervaluation with regard to the pricing.

TRANSITION: THE UNDERLYINGBASIS FOR VALUEOne of the things that bothered JohnHowe’s partners about his buyout was theclose relationship he had with some of hismajor clients. John had always bragged thatno one could ever replace him, and he madeno effort to introduce his clients to his otherpartners. As an example, one of John’sclients was billed about $150,000 per yearin fees that were generated to a great extentby the time John spent personally advisingthe client’s owners. DKH’s agreement re-quired no adjustment for business lost afterJohn’s retirement. John’s partners fearedthey would, in essence, be paying for clientsthey wouldn’t keep.

An accounting firm’s value is made upof two asset pools: tangible and intangible.



26 Journal of Accountancy December 2014 www.journalofaccountancy.com

The accrual-basis net equity in most firmscan be considered the tangible value. Theintangible value can be made up of theclient list, workforce in place, brand name,and goodwill. Usually, the client relation-ships the firm has are considered to be thebulk of the intangible value. In most trans-actions, whether internal or external, thetotal price of the transaction is the sum ofthe firm’s tangible book value and intan-gible book value, however intangible valuemight be determined.

What often is missed in the evaluationof value is that it is also tied to the firm’sability to transfer client relationships froman owner who is selling or retiring, to otherkey people in the firm, probably partners.The value should reflect how effectivelythe transfer can be made under the cir-cumstances and the risk that the transitionmight eventually fail.

Many internal buyouts fix the pay-ments at the date of retirement. Thatmakes sense if the firm has brand-loyalclients or a strong plan for the transitionof partner-loyal client relationships and theplan is given time to be executed. For in-stance, a logical approach to this might beto require a retiring partner to (1) providea minimum of two years’ notice ahead ofa retirement date or of when he or she in-tends to otherwise sell his or her owner in-terest, and (2) execute a formal transitionplan. If either requirement is not met, the

payments might become contingent or besubject to a predetermined discount. (Seethe JofA article, “The Long Goodbye,” Aug.2013, page 36, for more information onthe timing of initiating the transition.)

Smaller firms tend to have many morepartner-loyal clients, which means theirclients are loyal to an individual partner in thefirm (like John Howe). A properly executedtransition in this type of firm is critical.

BACKWARD- PRICINGANALYSISYou may have helped clients evaluate po-tential acquisitions. Can you imagine sug-gesting to a client that it acquire a businessknowing the terms of the deal would notbe cash flow positive for a significant time?The buyout terms for the owners need tomeet the same test. When an owner retires,the firm has the compensation that ownerused to be paid as “capital” to help pay forthe buyout and transition. Capital needsto be used for three things: (1) The owner’slabor has to be replaced; (2) his or herowner interest has to be paid for; and (3)an adequate amount of additional profithas to be left over to motivate the re-maining owners to undertake the in-creased responsibility and assume the riskof the obligation.

In John Howe’s case, his partners per-formed a backward-pricing analysis. Theresult was that John’s intangible value

(based on using one-time revenues for thefirm multiplied by his 65% owner interest)was $1.95 million, which was calculated as65% of the firm’s $3 million in annual rev-enue. However, owner compensation inthe firm was much more equally allocatedthan the equity, and John’s compensationwas about $300,000 annually. On top ofthat, John was to be paid $390,000 for hisshare of the firm’s tangible book value,which totaled $600,000.

Because the payment term required forJohn’s capital account was one year andthe payment term for his retirement wasfive years, the firm would pay $390,000per year for five years for retirement on topof another $390,000 in the first year forthe capital. The negative cash flow for thefull five years was significant. Said one ofthe remaining partners: “I’ll spend the nextfive years paying John off, making lesscompensation, and the firm will be bor-rowing. Then it will be my turn to retire.Why am I not excited about this plan?”

Often this problem can be addressed bychanging the buyout’s terms, although itmay also be necessary to change the totalpricing scheme. For instance, rather thanpaying John’s capital account upfront orduring the first year, DKH might consid-er stretching the payments over five oreven 10 years. The same holds true for re-tirement payments. Retirement paymentsmade over five or fewer years seldom meet


� There is downward pressureon pricing for internal transfersof ownership in CPA firms.Among the factors are the enor-mous number of Baby Boomeraccounting firm partners at ornear retirement age, decades-oldbuyout agreements with termsthat now seem onerous toyounger partners, and youngerpartners’ reluctance to take onlarge amounts of debt to meetthose terms. � Two asset pools, tangible andintangible, make up an account-ing firm’s value. The tangible

value can be considered to be theaccrual-basis net equity, while theintangible value can consist of theclient list, workforce in place,brand name, and goodwill. Thefirm’s client relationships generallyrepresent most of the firm’s intan-gible value. � Unlike most outside sales, in-ternal buyouts often fix pay-ments at the date of retirement.This works if the clients are firm-loyal rather than partner-loyal.Being able to transfer clients isessential to the buyout’s successand value to the firm.

� A good way to assess a buy-out package is to do a back-ward-pricing analysis. This canshow what the cash flow will befor the deal at the proposedterms. � Many firms are stretching outcapital account and retirementpayments to as long as 10years. This improves a firm’s cashflow.� As firms increase in size, theytend to change their method ofcalculating buyout payments.The migration usually goes frommultiple of book of business to

percentage of ownership to multi-ple of compensation.

Joel Sinkin ([email protected]) is president, and Terrence Putney ([email protected]) is CEO,both of Transition Advisors LLC inNew York City.

To comment on this article or tosuggest an idea for another arti-cle, contact Jeff Drew, senior ed-itor, at [email protected] or919-402-4056.



the objectives of the backward-pricinganalysis. Increasingly, firms are stretchingpayment terms to 10 years or more.

MARKET TRENDS FORINTERNAL BUYOUTSThere are three common ways of pricingan owner’s interest in a CPA firm. The 2012PCPS Succession Survey for multiownerfirms discovered the following (percent-ages are of respondents with an agreementto pay a retirement benefit):

� 16% set value based on an owner’smanaged book of business.

� 37% set value based on ownershipmultiplied by a value for the wholefirm.

� 22% set value based on a multiple ofthe retiring owner’s compensation.

� The remaining 25% use anothermethod, which likely includes afixed value or a hybrid of the abovemethods.

The authors’ experience is as firms in-crease in size, they tend to migrate fromthe book-of-business method to the own-ership method and finally to the multiple-of-compensation method.

The multiple-of-compensation methodis inherently linked to the other two meth-ods when considering how it portrays thefirm’s overall value. The classic averageratio of owner compensation to revenuesis 33%, so three times compensation istheoretically the same as one times rev-enue. The key difference is the compen-sation method allocates value on the basisof a much more dynamic metric, com-pensation, rather than what might be con-sidered an arbitrary metric, ownershippercentage. Many firms believe compen-sation reflects a more current measure-ment of contribution to the firm’s value.

Whereas, 10 years ago, CPA firmsusing the book-of-business and owner-ship methods routinely valued revenue atone times and even more, and firms usingthe compensation method used a multi-ple of three times or higher, the trendtoday is for much lower valuation multi-ples as demonstrated by the followingdata from the PCPS survey:

� 43% of those respondents using rev-enue multiples use one times rev-enue, 8% use more than one timesrevenue, 22% use between 80% ofrevenue and one times revenue, and24% use less than 80% of revenue.

� 35% of those respondents using com-pensation multiples use three timescompensation, 12% use more than

three times, 17% use 2.5 times, andthe remaining 35% use less than 2.5times.(Note that, in most agreements, theabove multiples address only the re-tirement or intangible value, withcapital accounts or book value paidin addition to these amounts.)

The authors have worked with dozens

www.journalofaccountancy.com December 2014 Journal of Accountancy 27

AICPA RESOURCES

JofA articles� “Pricing Issues for Midsize and Large FirmSales,” Nov. 2014, page 50� “Pricing Issues for Small Firm Sales,” Oct.2014, page 24� “How to Maximize Client Retention After aMerger,” April 2014, page 42� “Managing Owner Transition Through anOwners’ Agreement,” March 2014, page 42� “How to Manage Internal Succession,”Feb. 2014, page 38� “How to Value a CPA Firm for Sale,” Nov.2013, page 30� “How to Select a Successor,” Sept. 2013,page 40� “The Long Goodbye,” Aug. 2013, page 36

Use journalofaccountancy.com to find pastarticles.

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CFO (#741277, text; #163080, one-yearonline access)� Moving Up the Value Chain: Best Prac-tices for Taking Your Firm to the Next Level(#BLI165020, one-year online access)� Understanding Business Valuation(#732886, text)

For more information or to make a purchase,go to cpa2biz.com or call the Institute at888-777-7077.

Survey report� 2012 PCPS Succession Survey for mul-tiowner firms, tinyurl.com/qzhabug

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Private Companies Practice Section andSuccession Planning Resource CenterThe Private Companies Practice Section(PCPS) is a voluntary firm membership sec-tion for CPAs that provides member firmswith targeted practice management toolsand resources, including the SuccessionPlanning Resource Center, as well as astrong, collective voice within the CPA pro-fession. Visit the PCPS Firm Practice Cen-ter at aicpa.org/PCPS. The SuccessionPlanning Resource Center is available attinyurl.com/SuccessionCenter.



of firms over the past 20 years, and thereis a common theme. Primarily in an effortto (1) make the prospects of taking overfor retiring partners more attractive toyounger partners, and (2) increase theprobability that firms can make good ontheir retirement obligations to former part-ners, many firms have modified the pric-ing multiples in their agreements to reducethe overall retirement benefit. The alter-native route some firms have taken, espe-cially smaller firms where selling is anoption, is to look for a third-party buyerif (1) the younger partners are unwillingto execute the terms of their firm’s owneragreement, or (2) the senior partners lackconfidence that the younger partners willbe able to make all the payments.

When assessing what is right for yourfirm, the best approach is the backward-pricing analysis discussed above. Howev-er, the survey data can provide insights tohow your agreement compares to the mar-

ket and what other firms may have doneto address affordability.

DEATH AND DISABILITYMost agreements will require an owner’sinterest to be acquired in the case of deathor permanent disability, and often theterms and pricing will be the same as anorderly retirement. However, consider thefollowing. The disruption this kind ofevent causes the firm, and the potential forlost business, is not much different thanif an owner were to abruptly quit. Theclients will experience a sudden loss oftheir trusted adviser and, if the client baseis predominantly partner-loyal, the effectcan be dramatic.

Fortunately, insurance usually is avail-able for this type of event. The authors rec-ommend that insurance be used as muchas possible to cover the obligation the firmwill have to the owner to mitigate the ef-fects any loss of business might have. If in-

surance is not obtained, it may be advis-able to treat the buyout under the sameterms as would be used for a terminationwithout adequate notice.

CONCLUSIONSo how did DKH resolve its problem withJohn? He delayed his retirement by a year,and the firm instituted an aggressive planfor his transition. Under the assumptionthat John probably was more replaceablethan he thought, the remaining partnersagreed to fix his payments at the date heretired if he executed the transition planto their satisfaction. Rather than askingJohn to take a substantial reduction in thepricing of his retirement, DKH suggest-ed extending John’s retirement paymentperiod to 12 years (it was five years) andhis capital account payout to five years(previously capital was to be paid up-front). John agreed, giving this story ahappy ending. �





Visit our website to access recordings of past webinars. Topics include:

How to Value Your Accounting PracticeKeys to Your Partnership Agreement

Tax Season Implications for M&A of Accounting FirmsInternal Succession

Buying Out Retiring PartnersInnovative Approaches to M&A Deal Structure

www.transitionadvisors.com/video.php

Documents

Valuations of Accounting Firms Combine 2 v 4 web.pdfprofitably add a small accounting firm than a large one. That’s because small firms tend to have less over-head. For example,