Russell Shapiro Provides Insight on Key Topics in M&A
August 20, 2018
In the world of accounting firm M&A there are many areas that could prove challenging and even put deals at risk. From evaluating characteristics that are valued in a target firm, to avoiding mistakes – read insights from Russell Shapiro on how you can position your M&A for success.
Q: What are the factors that go into pricing a transaction? What terms are you typically seeing?
A: Most transactions are priced one way or another, from 80-100 percent of annual revenue. However, certain things can affect that pricing. Those things include profitability, in-place succession, and expertise. Most transactions are simply asset transactions where partners of the smaller firm become partners of the larger firm and the larger firm absorbs the obligations to retired partners. The merging-in partners will have retirement benefits from the larger firm based on the new firm’s retirement formula. Sometimes there is a grandfathering under the old firm’s formula or credit is given for the time spent at the old firm, especially for the older partners. The merging-in partners will make a capital contribution to the new firm. Occasionally for tax reasons you might see a stock deal or a merger. Usually, the larger firm wants to avoid any liability for the prior firm’s obligations so stock deals are less common.
Q: What characteristics are looked for in a target?
A: Most buyers are looking for a firm with stable partners and good profitability. Often times larger firms are looking to increase their geographic footprint and for firms in particular cities. Sometime there is a niche practice that is of interest. Some firms are also looking to grow to get to a certain critical mass.
Q: How do you assess potential exposure to an acquiring firm if the target has a claim against it?
A: We had a recent transaction fall apart after a lawsuit was brought against the target. The buyer was concerned that there was potential successor liability and it did not want to take on the risk of being brought in as a deep pocket defendant. A lot goes into a successor liability analysis, though it is often difficult to assess risk or even the merits of a lawsuit. We had a similar matter where the buyer was more aggressive and was willing to try to find a way to get additional coverage against the suit. In this case, we got the loss run from the insurance company, and quotes for “known loss” coverage to protect the buyer. Typically, the acquirer’s insurance will not protect it against successor liability, but will defend you.
Q: Have you ever done a merger of equals or near equals and if so, what challenges did you face?
A: Mergers of equals or near equals (let’s say the smaller is 50 percent of the larger) are the most difficult, time consuming and expensive deals to get done. They could also be very successful. Essentially, you are creating a third firm. There is a lot of discussion around governance as there will be power sharing at every level (from departments to the Executive Committee). There may be compensation protections. However, there will be burn-off periods for both the power sharing and compensation protections. No money changes hands. If the firms have different capital and retirement systems, they will have to be reconciled and there is often grandfathering of certain payment rights for partners who are close to retirement. All of these changes result in a new partnership agreement. I recommend a detailed outline developed over several meetings. This is in addition to the regular transaction considerations and due diligence on both sides, including what software to use, harmonization of manager/staff compensation and benefits and billing rates. Furthermore, the partner dynamics become even more acute as partners try to maintain their positions. And sometimes the most difficult issue, believe it or not, is what to name the new firm.
Q: What is your view of de-merger clauses?
A: From to time to time I am asked about including a de-merger clause. This would be a provision in a merger agreement that allows one or both parties to “reverse” the transaction for some period of time if it is not working out. Regardless of which side I am on, I recommend against such a provision. My view is that if you are getting married and you decide you want a divorce, you can negotiate at that time. I don’t think you should go into a relationship assuming it will not work out. Furthermore, a de-merger clause is very difficult to negotiate and creates a lot of negative energy. Once you start to discuss the elements of a break-up, all sorts of issues come in to play: who controls client relationships, does staff stay with one firm or another, and what about new hires, new equipment and jointly developed clients? I had one significant transaction that fell apart in part due to the insistence of the de-merger clause. It was not the stated reason, but there was so much loss of confidence and trust in the transaction that the relationships between the managing partners deteriorated and the then a small thing did it in. As with every general rule, there are exceptions. A de-merger clause, limited to one year, might make sense when a smaller firm is bringing in a sole practitioner.
Q: What type of firm approval is needed to approve an acquisition? Should a partnership agreement provide flexibility to change terms for merged-in partners?
A: This is probably a more minor point, but in my view it is important for acquisitive firms to have a partnership agreement that allows the executive committee to approve acquisitions under a certain size, including bringing in new partners in connection with the acquisition, without the consent of the partners generally. The EC should also have the authority to modify retirement dates and terms and other provisions in order to be able to negotiate the deal.
Q: What are the biggest mistakes that you have seen firms make?
A: From my perspective, I have seen too many deals fall apart before closing because there was never really a deal at the term sheet stage. Things were glossed over that should have been addressed. Other problems arise when a firm agrees to allow retiring partners dictate what the firm can do after they retire. Sometimes retired partners are given these rights because they insist on assurance that their retirement benefits will be paid; however, these post-retirement rights can ham-string the ability of the firm to do a deal altogether.
Q: For how long should acquiring firm’s guarantee compensation, if at all, and what parameters will you put around that?
A: In my view the market is to guarantee compensation for one to two years. Usually, there is a minimum amount of business that must be maintained in order for this to be effective, usually around 95 percent of prior year revenue.
Q: If the acquiring firm is involved in one or more lawsuits, what do you do to give comfort to a target candidate?
A: I represented a number of merging firms going into significantly larger firms that had litigation issues. For one thing, it is difficult to assess the merits of a case. Think about Arthur Anderson. The buyer revealed their cases to us, and they gave us what their insurer thought of the exposure. We then did diligence on their insurance coverage. Finally, in addition to being indemnified against the claim, we negotiated a provision that said that if the firm had to come out of pocket to fund a settlement or a judgment, the merging-in partners compensation would not be impacted.
Q: What have you observed as to why firms look to merge-up?
A: In my experience, most firms look to merger up because they do not see the next generation of partners as being able to sustain the firm. This impacts their retirement benefits, lateral recruiting and the legacy of the firm. In one instance, there was a younger partner who said he could not do it alone given the dearth of people like him at the firm. Sometimes the firm has clients that need the services of a larger firm or the partners feel that too much work is being referred out or left on the table. More and more firms are identifying technological requirements as being a factor. Another factor I have heard is difficulty in recruiting at smaller firms.
Partnership Agreement Issues
Q: How is the capital buy-in determined for new partners? Is it different than for lateral partners or merged practices?
A: Most firms will require a set payment for a new partner who has risen through the ranks. It could be $50,000 or $100,000. It is often payable over time. Some firms will require a buy-in based on the value of the firm or link it to compensation. In merger situations, the capital needs of the merged-in business will need to be met. This will typically be done by requiring capital similar to what the old business needed or what the larger firm requires.
Q: What about mandatory retirement? Are you flexible for merged-in partners? How about for income partners?
A: Most firms have mandatory retirement and it is generally around 65. Bigger firms have younger ages. Merged in partners will generally be given more flexibly especially if their firm had an older age. You have to be very careful about applying mandatory retirement to income partners. They are typically viewed under employment laws as employees and not owners, which means they are subject to age discrimination laws. The laws on age discrimination provide an exception for owners.
Q: Are there post-retirement adjustments for loss of business?
A: There used to be a trend against this. Lately, I have been seeing more firms wanting the right to give a retired partner a haircut if a significant amount of their business is lost soon after retirement. This is not the majority view. In merger deals, you will often see this haircut as it applies to retirement benefits.
Q: Are there defined liquidated damages if a partner violates a restrictive covenant? If so, what are they?
A: Most firms have a liquidated damages provision. That way you don’t have to prove the damages amount and you have something to work off of when negotiating a deal. If a client doesn’t want to stay with the firm, then they should be able to be purchased. You have to keep it real. I have seen firm use 200 percent, but this is hard to enforce and could invalid the whole clause. We try to stay in the 125 percent range which is more likely to be enforced. We also like arbitration to keep these things out of court. We have been seeing accounting firms acquire other types of businesses, like software and cloud based platforms. In those cases, we may actually ask for non-compete agreements.
Q: What is the notice requirement for leaving before full retirement age? What is the penalty if that notice is not given?
A: I usually see one year notice for this. On the penalty side, the trend I have seen is to give the executive committee authority to reduce the payout by up to 25 percent if there is insufficient notice or a failure of the retiring partner to follow a transition plan. This would typically be in lieu of a provision that reduced benefits if business is lost.