Russell Shapiro | Laura Friedel | Mary Wasik
Published on July 22, 2019 in Accounting Today
While the governance structure of an accounting firm has little immediate client-facing impact, a firm must be well-governed to retain its people and provide consistent, high-quality client service. Who has decision-making power, how they are chosen and when they relinquish power are all necessary governance provisions in a well-written partnership agreement.
In this article, we’ll examine common CPA firm governance structures and the reasons for each, to prompt critical analysis about your partnership agreement provisions. Note that the partnership nomenclature used in this article similarly applies to corporations and limited liability companies.
What if there’s no partnership agreement in place?
I have seen a number of firms without a partnership agreement, or agreements that are so outdated that they are not signed by all current partners. That’s not a good way to operate your firm for a number of reasons. If a firm doesn’t have a partnership agreement, state law will dictate the terms of the relationship. These default provisions will likely have little to do with how the partners generally intend to govern their relationship. For example, without an agreement in place, under the laws of many states, all partners (regardless of their percentage) have an equal voice in running the firm. It’s easy to see how the lack of a partnership agreement could lead to costly legal battles down the line. A carefully considered agreement specific to your firm is always preferable.
The vast majority of firms do have partnership agreements, and in those agreements, the partners elect to cede certain powers to an executive committee and/or a managing partner. Having defined roles for managing partners and executive committee allows for greater efficiencies in the day-to-day management of a firm.
But the executive committee and managing partner powers are not all encompassing. Partners retain certain prerogatives and rights, which typically include the election of the managing partner and executive committee members, as well as approval rights over major transactions and expenditures. Major transactions will often include the merging in of a smaller firm, new partner admissions, partner expulsions and significant financial matters, like borrowings in excess of approved amounts and capital expenditures over a certain amount. Partners always have the right to approve a merger up and similar organic transactions.
Managing Partner Prerogatives
The managing partner is responsible for day-to-day firm management. Some firms, however, may elect to give the managing partner more rights and decision-making powers than others. This is especially the case for founding partners who typically by agreement retain effective control of the firm.
For firms that have delegated significant power to the managing partner, the partnership agreement will set forth specific decisions that the managing partner has the authority to make in their own right, beyond day-to-day business decisions. For example, the partnership agreement may provide that the managing partner has authority to bring in lateral partners or consummate small mergers, without the approval of the executive committee or the partners at large.
Executive Committee Prerogatives
The executive committee, if there is one, is generally the governing body of the firm with the authority to make or delegate all decisions — the exceptions being partner-reserved decisions as discussed above and perhaps prerogatives of the managing partner.
As firms grow, governance tends to become more centralized, meaning there is less authority for the partners and more authority for the executive committee. This is a more efficient way to manage as the firm adds partners, but it inevitably means that partners lose autonomy. The election process itself also becomes more complex in an expanding firm.
Nominating and Election Provisions
Larger firms may elect to form a nominating committee for the managing partner role and executive committee positions (and potentially for other committees). In addition, more complex partnership agreements will address terms, term limits and staggered terms for any elected officials to ensure there is equitable distribution of power among the partnership. Again, as firms become larger and more complex, requirements for department, office and diversity representation on committees may be addressed in the agreement.
Voting in Elections
How partners vote on major firm decisions is also addressed in a partnership agreement. The most common approach to voting is by percentage ownership interest, where a partner’s vote is proportional based on their percentage ownership of the firm.
Other voting mechanisms include per capita voting (which equates to one vote per partner), voting by capital account balances and voting based on the previous year’s compensation. Firms should decide which approach is right for them based on the size of their firm and composition of the partnership. However, agreements do not have to bind a firm to only one voting mechanism. It’s not uncommon for a firm to have different types of voting for different matters. Additionally, some matters may require a simple majority, whereas others may require a supermajority. For example, the approval of a major expenditure can be made by majority, and others, like the removal of a partner, may be subject to supermajority approval (usually 66.67 percent). When working with an attorney to draft your agreement, ask if they can prepare a chart of partner-reserved decisions showing the required vote.
Classes of Partners
Depending on the size and structure of a firm, there may be different classes of partners. These classes may each come with their own rights and privileges, especially as they relate to income sharing and voting rights. Many firms have income partners and equity partners. Income partners typically do not have voting rights, capital requirements or retirement payments.
Contrast this with the growing number of firms that are implementing two-tier equity partner structures. Both classes of partners are considered owners. They usually have different capital obligations, income sharing, voting rights and retirement payments. There is meaningful risk on this issue as the lower-tier partners may be viewed as employees and not owners under age discrimination and other laws. Suffice it to say, things like requirements to put capital at risk, sharing of profits and losses, and voting and control rights go into the analysis of whether a “partner” would be considered an owner or an employee. In two-tier structures, the lower-tier partners will often be able to serve on committees and have other responsibilities.
Governance decisions are necessary for smooth day-to-day management of your firm, as well as how the firm makes major decisions. Whether it makes sense for your firm to have a large and diverse executive committee or a managing partner with broad decision-making power, knowing what is best for your firm and clearly laying out your chosen structure in your partnership agreement are key to longevity and success.