Let's Make A Deal!

For those who would prefer to see the version at the CA Magazine website, please click on the image (left) to go directly to the article. Otherwise, it is reproduced word-for-word below:

Looking to buy a slightly used practice? Remember, the path to sealing the pact is full of pitfalls and impediments

Ben, an energetic, entrepreneurial CA with 17 years’ experience in small to mid-sized firms, has a dream of owning his practice. He would start one tomorrow if he knew he would have sufficient income to cover his living expenses. But the thought of grinding out a living in his basement until he has sufficient fee income to justify the cost of an office makes his stomach churn. So for now, he sweats it out as senior manager at a midtier CA firm.

Mary, too, thinks she would prefer to be in charge of her future. She’s the controller of a -million company, a successful family-owned business. Although the owners love

Mary, it is clear equity is for family membersonly. She struggles with her loyalty to her employers and boredom with the same old month-end, quarter-end, year-end routine and the fact that she has no ownership opportunity. She’s wondering if she should have stayed in public accounting where she most likely would have made partner by now.Ben and Mary are part of a rapidly growing group of energetic CAs who see a great opportunity in having one’s own practice. They value having control of their lives and careers, control over the hours they work and who they perform work for. They see an acquisition of a practice or block of fees as a way to eliminate the risk of starting a firm from scratch.But the path to buying a slightly used firm is laden with obstacles and pitfalls. So anyone looking to pick up an established firm needs to be clear on a few points.

Although there are similarities between firms — the mix of services, notice to reader, review and audit engagements, tax return completion and so on — few practices are the same. Smaller firms tend to lean toward notice to reader engagements, larger firms favour audit work, while mid-sized firms are somewhere in between.

Chances are you are not looking to buy or buy into a mid-sized or larger firm (although you might consider buying-in as one of 20 to 500 partners if you have been employed there for a number of years). It’s more likely you are looking at a smaller firm — from a sole practitioner to up to five or six partners.

Are you ready to be one partner among several, where mutual trust and respect plays a major role? If you need complete control, then a sole practitioner acquisition is the way to go.

Finding the right blend of services, clients, industries served, staff, salaries and fee scales can be time-consuming, and along the way you may have to kiss a lot of frogs before you find the prince of a deal. To help find that special firm you can do a number of things: search classified ads in professional magazines; make cold calls; network at association meetings; find an older practitioner who might be ready to sell; or engage a broker or agent.

Once you have zeroed in on a potential practice, the next stage is due diligence. Examine what you’re really getting. Be clear on the quality of work that goes into client files, the profitability of the firm, examine the softer issues such as people, the physical environment and the opportunities for growth.

To do so, get a full client list, by year-end, industry, service provided and fee. Review the top 10 to 12 files by fee; review the top five high-risk audits. Go over five otheraudit files. At random examine other au-dit, review or notice to reader files to get a suitable sample size of all the firm’s files. Go over three or four special project files, such as s.85 rollovers, consolidations, cash-flow forecasts or estate planning files.

Don’t forget to check the potential for up-selling and cross-selling services to clients; check the referral history and other possibilities. Look at the total time spent by the partners and estimated breakdown between client meetings, file review and working on the file.

Examine human resources issues, employees’ skills and future goals. Look at their length of service, what they do, their salary and charge-out rates, their next review date and possible increment expected.

Look at the cash-flow statement of the last financial year-end. Examine the income statement — 12 months to the last financial year-end; total draws for the year by partners; book value and fair-market value of the furniture and fixtures, office equipment and other assets. Go over all leasing information for the premises and equipment. Ensure all software is properly licensed and up to date.

A VALUE PROPOSITION

A number of other points to consider include:

• the financial statements — arrive at a number for materiality for use as a comfort level for reviewing items within these financial statements on a file-by-file basis;
• check for correct opening balances, rolled forward from the previous year;
• ensure all lead schedules tie in to the numbers on the balance sheet and income statement;
• review all third-party documentary evidence on the file that helps reach an audit opinion (such as responses to a circulation to receivables confirming amounts due at the cut-off date, copies of loan and/or leasing agreements and inventory lists and working papers, checking for reasonableness and completeness);
• ensure the closing bank balance is reconciled and there is a copy of the reconciliation in the working-paper files;
• review all prepayments and accruals for reasonableness;
• check the accounting fee actually billed for this work, compare it with the accrual and the actual charge in the income statement and check for any material discrepancies. Obtain adequate explanations of discrepancies;
• consider any suitable investigation work appropriate for all material items in the financial statements;
  for all files, review the tax returns for the corporation and the individual owners and compare disclosed amounts on the return with the source document;
• look at the notes on the file — especially review notes by the partner — and check for answers obtained from the client or staff member;
• check any journal adjustments;
• look at the work in progress printout for clients when the fee was generated and assess the size and complexity of the client and the financial statements. Assess if the amount of time spent on the file by staff and partners was adequate to cover the amount of work you consider necessary to conduct sufficient professional work on the file, and if appropriate, to arrive at an audit opinion;
• look for management letters on files and see if any disturbing or material issues have arisen and ask what action has been taken;
• ask to see when some of these clients paid their fees and compare payment date with the invoice date. Any settlements after 60 days should be followed up with the partner with a view to asking if there were any problems in receiving payment;
• ensure audit clients are not being provided additional services that might contradict the Sarbanes-Oxley Act;
• ask to see recommendations made by the last two practice inspection visits and en-sure all recommendations have been implemented;
• ask to see a certificate of professional indemnity insurance;
• ask if there are any claims pending or in progress against the firm;
• ask for a selection of staff human resources files if there are any and search for documented staff review notes, looking for strengths and weaknesses of each employee;
• compare individual salaries with hourly charge out rates;
• look at chargeable hours logged by all staff for a small number of weeks and obtain an annual report — look for those with exceptionally high and exceptionally low chargeable hours and ask why this is so;
• obtain a list of all clients lost in the last year and ascertain the reasons why they left;
• consider if the number of lost clients seems a high proportion of the total number of clients;
• review at least six or seven new client files and compare the accounting fee charged by this firm with the fee disclosed in the comparatives for the previous year to assess if the firm is winning work by undercutting the previous firm.
  
  As for staff, today, when finding and keeping good people is the No. 1 issue facing accounting firms, sometimes doing a deal makes sense if only to get access to a pool of talented professionals. That these people come with fees attached to them is just a nice bonus.

Before the deal is closed, the buyer should meet the key employees to ensure they have the appropriate skill sets for the job and are paid a fair salary for what they do. This is also a good time to assess if there are any potential problems. For example, is there a natural successor to the practitioner? If so, ask why that person is not involved in this process.

And don’t forget the brain dump. That isto ensure the seller transfers all information about clients. Not all the details are in the files. For example, determine if there have been recent discussions with the client and if there are any notes on the talks; who the client’s lawyers are; what the names and ages of a client’s children are; life insurance details and what succession issues have been discussed.

You might also consider a noncompete clause. It is a sensible precaution to take in the sale/purchase agreement, especially if one is buying the firm of a younger practitioner. Who knows what his or her future holds — that person may be tempted to return to public accounting, luring back clients that have been fully paid for by you.

Pay heed to the earn-out. Three to five years is the norm for an earn-out period. But remember, only clients that are retained each year qualify for a payout to the seller. Retention can be monitored client by client (time-consuming administration) or en-block. The average retention rate is about 85%. Don’t pay too big a deposit on closing, unless the price is being discounted.

However, the method used to calculate the earn-out amount due can cause a significant swing either in favour of the buyer or the seller. Take the following two cases.

In the first, Jerry is a 62-year-old sole practitioner billing $600,000 with three staff. He’s made a decent living and earned a solid reputation in the marketplace. Ideally he would like to see his time out and retire at 65, but he would be happy to accommodate the buyer if they wanted him to go sooner.

Jerry is looking to receive dollar-for-dollar for his practice ($600,000) preferably over three years and would be available as a consultant thereafter at $100 an hour.

Ben, the buyer, has found Jerry through an agent. The two hit it off immediately. Ben has up to $120,000 in savings and hasaccess to a line of credit that he had previously arranged through his bank.

Ben is used to dealing with the same types of clients and services/needs and has a similar bedside manner in how he treats his clients as Jerry. It seemed the perfect fit.

After discussing issues and negotiating on a few items, Ben and Jerry agreed on a deal at $1 for $1 over three years, based on retention, with 15% down on closing.

Jerry would bill his work in progress and collect his receivables. Office equipment, desks and other tangible assets were sold at a value of $25,000, and Ben assumed the office lease from Jerry with the consent of the landlord.

The percentage of clients retained over the three-year period was: year one, 95% retained; year two, 97% retained; year three, 92% retained.

But what if, instead of the payout being calculated on the basis of 1/3, 2/3, 3/3 on a rolling net retained basis, the payout was based on 1/3, 1/3, 1/3 of each year’s retained business?

The net effect of the first method is that for any client who stayed for years one and two but left in year three, no payment is due to the seller. This can add up to a chunk of change.

In the second case, Mary found a practice where the practitioner, Chris, was looking to retire. He was billing $600,000 and wanted to use the dollar-for-dollar method to calculate the price, based on retention over three years.

Mary and Chris had a number of exploratory meetings and agreed basically to the same deal as Ben and Jerry, except they would use 1/3, 1/3, 1/3 to calculate a payment to the outgoing practitioner.

If we assume the exact retention statistics for Mary and Chris as for Ben and Jerry, their payout figures will look like this:

Total amount due under Mary and Chris’ arrangement is $543,856.
Total amount due under Ben and Jerry’s arrangement is $508,668.
Thanks to negotiation skills, that’s a difference of $35,188 — the price of a decent car.

Should interest apply? In many cases a monthly installment will be paid by the buyer to the seller on account of the annual lump sum due, in order to ease cashflow for the buyer. In such cases, interest should not apply. However, if only an annual payment is made, it is only fair that an interest charge also be due.

Ignoring compounding, at 5% a year for example, this could be in the region of:

(In both methods for Year 1, as $90,000 was paid on closing the deal, only $100,000 is subject to interest in the first year, being the amount due to the seller at the end of the first year if no installment payments are made.)

Add the interest to the difference in calculation method above, and that’s a really nice car.

Both Ben and Mary were able to find a practitioner who best met their requirements in type of client serviced, industry and style of servicing. Even though both outgoing practitioners were a little behind the times in their billing rates, Ben and Mary saw this as an opportunity to incrementally increase fees over and above inflation over a three- to five-year period, and by going the extra mile for their clients, Ben and Mary were able to generate additional fees from the clients they purchased and enjoy a higher referral rate than the previous practitioners.

Both had an eye on the future in structuring their respective deals and saw the potential to do other things for clients, once they got to know them well. The end results were impressive, as both practitioners took the first three years to get to know their newly acquired clients and slowly weave their way into their respective clients’ lives to the point where they became an essential part of the client’s team. Having achieved that level of trust, anything they proposed their clients listened to, if not always acted upon.

Ben and Mary increased fees across the board to effectively increase rates by 20% at the end of the first three years, producing $101,733 additional revenue with no additional costs.

Ben was able to generate $113,545 on average a year in additional services (such as s.85 rollovers, estate planning, etc.) and Mary was able to generate an average of $144,990 a year from the same source.

In addition, after three years, each practitioner was generating substantial amounts of new business from referrals. Ben was averaging $160,000 a year, while Mary achieved an average of $187,500.

The end result was that each practitioner now averaged a cost per dollar revenue from these sources after three years of just 57¢ per dollar. Or put another way, they were generating $1.73 in revenue for every retained dollar of business they acquired, at the purchase price.

A few last words of advice before you start on your mission: don’t get carried away in the excitement of being able to do a deal. Remember, act in haste, repent at your leisure. It is very rare for the first potential deal that comes to your attention to be the one.

Take your time, listen to suggestions and make the move when the numbers and all other factors make sense.

© MFA Group 2006