Don’t Let Employment Issues Derail Your Accounting Firm’s Deal – Part 2

Partners Russell Shapiro and Laura Friedel recently spoke at the 2023 BDO Alliance USA Conference on employment issues that impact accounting firm deals. In Part 1 of our two-part article, we share insights and tips on avoiding potential diligence deal killers, restrictive covenants, and other potential issues to help accounting firms avoid situations where employment issues could derail – or devalue – a potential merger or acquisition. You can read Part 1 here, where we share tips on transferring employees.

Tip #1: Be aware of potential due diligence deal killers.

Three issues, in particular, can be potential “deal killers,” and even if the deal moves forward, they could have a material impact on the purchase price:

1. Questions about the ownership of books of business. A seller can only sell something they own, so any question regarding whether the selling firm owns the client relationships can kill a deal (or at least result in a significant purchase price reduction). Look at the language in employee and partner agreements that reference “your” book or “your” clients. Even in the absence of language suggesting that an individual (rather than the firm) owns a book of business, as lack of explicit language indicating that all relationships are the firm’s property can have a material impact on the deal. The issue will also have a legal effect on which clients an individual can be prohibited from soliciting/working with.
2. Misclassification of independent contractors. Misclassification of independent contractors (namely, treating someone as an independent contractor where they don’t meet the legal standards to be one) is a high-risk issue generally, and in the M&A context, it can have serious ramifications. Buyers should determine early in due diligence whether the seller engages individual independent contractors and, if so, work with counsel to determine if they are properly classified as such. If they aren’t, the buyer will likely require a significant special escrow or purchase price reduction to cover the associated risk.
3. Exempt vs. non-exempt. The presumption is that all employees are entitled to overtime, and if the employer wants to establish that they are exempt (not eligible for overtime), they have to establish both that they meet the salary minimum and that they satisfy one of the job duties tests. This can create two issues in deals. First, misclassification of employees (by treating them as exempt when they should have been eligible for overtime) can lead to very significant liability. Where the buyer believes that this liability exists, it likely will insist on a significant escrow or purchase price reduction. Second and more problematic, where the buyer is going to “reclassify” employees post-closing (either because of perceived legal risk or to align to the buyer’s practices), there can be issues with employees who were previously treated as exempt and are suddenly required to track hours and be paid overtime. These employees are less likely to join and remain with the buyer because of a perceived “demotion.” In addition, having been reclassified, these employees are more likely to look back and realize that they should have been paid overtime during their time with the seller. To mitigate these risks, buyer and seller should pay close attention to how any reclassification is messaged and make sure that the purchase agreement is clear on who is liable if reclassified employees use their reclassification as evidence that they should have been receiving overtime pay in the first place.

To try and avoid these (and other) employment issues derailing your deal, firms considering selling should have an employment attorney conduct a review of employment law compliance at least 18-24 months before a transaction is anticipated so that the firm has time to correct any issues before due diligence begins. In addition, buyers should make sure to conduct adequate due diligence on employment compliance early in the process and prioritize obtaining meaningful responses from the seller.

Tip #2: Take care when assigning restrictive covenants.

The ability to enforce restrictive covenants (non-solicits and non-competes) is critical to accounting firm deals, but often insufficient thought is given to where covenants are set out, what covenants bind non-equity partners, whether covenants are assigned, and who will be responsible for responding to breaches.

Restrictive covenants are generally viewed with scrutiny – but the level of scrutiny depends on the circumstances under which the covenants are entered into. Covenants in purchase agreements, where the buyer is purchasing the goodwill of the seller’s business, are viewed with the least scrutiny and, thus, generally, can be broader and are the easiest to enforce. At the other end of the spectrum are covenants entered into with employees, which are viewed with the greatest scrutiny, need to be the narrowest, and are least likely to be enforced. Somewhere in the middle are covenants between equity partners in shareholders and partnership agreements. In the M&A context, this means that putting covenants in a purchase agreement (or layering the covenants in the purchase agreement over those in the shareholders, partnership or employment agreement) increases the likelihood of enforceability – which is in both parties’ interest if there is any kind of earn out, profit sharing or deferred compensation. For this reason, we strongly recommend that covenants be included in the purchase agreement or an exhibit to the purchase agreement rather than in an shareholders /partnership agreement or an employment-related agreement.

This is particularly true where a partner who had an ownership interest in the seller becomes an income partner with the buyer. Regardless of what an income partner is called or whether they sign the shareholders /partnership agreement, an income partner is generally considered an employee. That means that unless the covenants are in the purchase agreement (where they are given in exchange for the buyer’s purchase of goodwill) they will be viewed with the highest level of scrutiny and will need to be narrow if they are going to be enforceable.

Another key decision is whether or not the buyer assumes the seller’s existing restrictive covenants (in a shareholders/partnership agreement or an employment agreement). There are various reasons why the seller, the buyer, or both would want to rely on pre-closing restrictive covenants. For instance, they could want to enforce covenants against someone who left prior to or at closing, they could want to take advantage of the fact that the agreement was signed in the past (before new requirements for restrictive covenants were implemented), or they could prefer the language in the seller’s covenants to that in the buyer’s. If the covenants are not assigned to the buyer, the seller may have difficulty enforcing them. This is because courts often require that a firm trying to enforce a restrictive covenant show that it has a “legitimate business interest” in enforcing the covenant, and a seller which is no longer engaging in the business may have trouble establishing that their financial interest in an earn-out or deferred compensation is a “legitimate business interest.” For this reason, it is almost always to the parties’ advantage to provide for the assignment of restrictive covenants as part of the purchase agreement.

Finally, there is the question of which party – buyer or seller – should be responsible for enforcing restrictive covenants. If covenants are assigned, then the buyer would have the legal right to seek enforcement. If not, vice versa. But that doesn’t mean the buyer needs to call the shots or pay for the enforcement. In many situations what makes the most sense is to agree in the purchase agreement that the party that wants the covenant enforced pays for the enforcement and that the other will cooperate fully (including by filing suit if necessary). This approach serves to avoid disputes between buyer and seller down the road.

Tip #3: Don’t forget about other potential issues.

What happens to those partners who don’t want to join the buyer?

The best way to avoid this situation is to revise the shareholders/partnership agreement before the sale process begins to provide that partners who don’t sign on to the deal are deemed to voluntarily withdraw immediately before closing, and that the restrictive covenants in the agreement will continue to apply. If you don’t have that provision in your shareholders /partnership agreement, make sure that you consider and follow all of the requirements relating to partner separations – including especially notice and payments.

What happens if there are unexpected life events during the gap between signing and closing?

People can die, become disabled, and get divorced, just to name a few of the life events that can happen between signing and closing. Sellers should consider these possibilities in advance and make sure that the deal is structured so these events don’t disrupt closing. This includes being prepared in case key personnel announce that they are leaving the firm.

Should partners and employees have legal representation separate from the firm’s legal counsel?

When there are multiple tiers or levels of partners who will be treated differently under the terms of the deal, or where employees are being required to sign new employment agreements, it is often helpful for them to have separate legal counsel. Other situations where it makes sense to have separate legal counsel are when individual and firm interests don’t completely align and where separate legal counsel would put the buyer in a better position to enforce the agreement (for instance, where state law allows for certain provisions only if the individual had counsel). The bottom line is that if an individual’s interests differ from the firm’s, separate legal representation is probably appropriate.

If you are considering an accounting firm considering a sale or acquisition, please don’t hesitate to reach out. LP knows accounting firms. Our attorneys are trusted advisors for managing partners, executive committee members, key stakeholders, and HR professionals working in and for accounting firms.