Courtroom Drama: Departing Partner Sues Firm Over His Buyout – Part 2 of 2

In this two-part series, Darth, a 42-year-old partner sues his former firm, Force CPAs, for a larger buyout payment. The courtroom dialogue will share with you the facts, evidence, and arguments from each side as we explore industry trends related to payments for withdrawing partners. [Read Part 1 of the series here.]

We continue below with the defense’s case, closing arguments and the judge’s decision. 

Note: The legal issues in this case vary by state law. Be sure to check applicable state laws to apply the principles addressed in this case.

FORCE’S ATTORNEY: Your Honor, we call Obi-Wan to the witness stand.

FORCE’S ATTORNEY: Obi-Wan, please tell the court why you are qualified to be an expert witness in this case.

OBI-WAN: I am a CPA and have been consulting to accounting firms from coast to coast for 20 years. I have worked with over 1,000 clients, focusing on partner matters such as compensation and buyouts. I have written 16 books on CPA firm management. I have provided expert witness testimony in 12 cases. I have been named by Accounting Today as one of the Top 100 most influential people in the accounting profession for 18 consecutive years. I’m also a Cubs fan.

FORCE’S ATTORNEY: Thank you, Obi-Wan. You sound very qualified. How common is the method Force uses for valuing goodwill?

OBI-WAN: The method of valuing goodwill in a partner buyout plan based on a partner’s compensation is the most common method used by CPA firms. It is referred to as the “multiple of compensation” method. We have surveyed CPA firms in the industry on this for the past 23 years. In our most recent survey, 55% of all firms with between five and seven partners used the multiple of compensation method for their buyout plans. There are five other methods, none higher than 12%. Only 11% of firms with between five and seven partners use ownership percentage to determine a retiring partner’s buyout.

FORCE’S ATTORNEY: You say that only 11% of the firms in your survey use ownership percentage to determine partner buyout. This seems surprising. How can this possibly be so low?

OBI-WAN: The central theme in determining a partner’s share in the value of the firm is this: What contributions have each partner made to building up the value of the firm vs. the other partners’ contributions? Ownership percentage at most CPA firms is a convoluted figure and few partners understand its origin. As a practical matter, the main reason many partners have a high ownership percentage compared to others is simply because they are older than the others. At virtually all firms, there is virtually no correlation between a partner’s ownership percentage and their contributions to creating the firm’s value. So it is grossly unfair to use ownership percentage to calculate a partner’s buyout.

FORCE’S ATTORNEY: You reduce a retiree’s buyout with a vesting percentage. Why did Force do this?

OBI-WAN: Vesting is a standard feature of virtually all CPA firms’ buyout plans. Firms reason that their partners should not see their buyout as a “savings plan” to be cashed out whenever they want. Partners are extremely valuable to the firm and are hard to replace. Firms need their partners to remain with the firm for a long time. In Force’s case, this period is 20 years. Partners vest 5% per year as a partner. This is all extremely common.

FORCE’S ATTORNEY: Force reduced Darth’s buyout to reflect the fact that the firm lost 30% of his clients after he left the firm. In your expert opinion, was this appropriate?

OBI-WAN: There is one reason and one reason only for paying goodwill to a departed partner:  to retain the partner’s clients after they leave the firm. If firms knew for certain that all of a partner’s clients would leave upon their departure from the firm, they would never pay a buyout.

FORCE’S ATTORNEY: I have no more questions of Obi-Wan.

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DARTH’S ATTORNEY: Luke testified earlier that the system used to compute Darth’s buyout was 2.5 times compensation. As an expert in CPA firm buyout plans, can you please inform us how this 2.5 multiple equates to a percentage of Force’s revenue?

OBI-WAN: If we assume that all partners retire today, 2.5 times all partners’ compensation equates to 81% of revenue.

DARTH’S ATTORNEY: So the firm’s use of a 2.5 multiple is less than the industry’s long established practice of valuing goodwill at 100% of revenue?

OBI-WAN: You are correct that there has been a common practice—a “rule of thumb”—in the CPA industry to value goodwill at one times revenue. Many rules of thumb originate from actual fact and practices. But over time, things change. It’s easy for rules of thumb to become hearsay, and hearsay is often an invalid way to determine a best practice or a practice that is suitable for a specific firm.

Many decades ago, one times revenue was indeed the most commonly used method of valuing a firm, both internally and externally for acquisitions. But the one-times multiple changed about 20 years ago. For many years now, the average goodwill valuation for CPA firms has been about 80%. In fact, according to our survey, in 2017, the multiple fell below 80% for the first time, to 78%. In our most recent survey, the valuation is 76%. There are still practices that are valued at 100%, but this is no longer the norm.

DARTH’S ATTORNEY: What explains this decline from 100% to 80% of revenue?

OBI-WAN: There are several reasons for this. I’ll discuss three: (1) Questions have arisen regarding the affordability of substantial buyout obligations; (2) younger partners fear that the firm cannot survive the retirement of highly productive senior partners; and (3) the lower multiple is consistent with CPAs’ conservative personalities.

So, in electing a multiple of 2.5, Force is merely adopting a best practice in the CPA industry.

DARTH’S ATTORNEY: Let’s talk about Force’s reduction of Darth’s buyout due to client loss. It stands to reason that if these clients left after Darth’s departure, it must be due to the ineffectiveness of Force’s personnel to provide good service to the clients, right?

OBI-WAN: Not necessarily. A best practice at firms is to require two things of a departing partner: first, proper notice of the departure—usually 12-24 months; and second, proper transition of the client relationships to other firm personnel during the notice period. This is designed to maximize the likelihood that clients will stay with the firm. As I said earlier, the only reason firms pay buyouts is to keep the partner’s clients. It is much more difficult to retain the clients when a partner leaves without proper notice and transition assistance. In my opinion, Darth’s failure to give the proper notice and transition is the main reason 30% of his clients left after he quit.

DARTH’S ATTORNEY: I have no further questions, Your Honor.

Closing Argument By Darth’s Attorney

Darth was a productive employee and partner of the Force who should have been highly valued. But instead, Force exaggerated a few perceived deficiencies and made life miserable for Darth. CPA firm partners rarely earn a grade of A on their performance; Darth will be the first to admit he wasn’t perfect. But the excessive, incessant harassment of Darth by the firm over perceived performance failings made it impossible for him to continue working at the firm. His resignation was carefully and artfully engineered by the firm. In substance, this was a termination, not a resignation. It was impossible for Darth to give notice and assistance in transition, and thus unfair to penalize Darth for client loss.

We heard testimony from Obi-Wan that the average buyout multiple was about 80% of revenue. But he also said that many firms continue to use the rule of thumb of 100%. We therefore argue that 100% is a reasonable factor to use, especially due to the deceitful way that the firm forced Darth to leave.

Force has no written partner agreement, which means that there was no provision for partner buyouts. In the absence of such an agreement, it is quite reasonable for courts to resort to ownership percentage in determining the fair value of a departed owner’s interest in a company.

This is a simple open-and-shut case. We ask that the court rule in favor of Darth and award him $1.44M.

Closing Argument By Force’s Attorney

Darth’s attorney is correct. This is an open-and-shut case.

Darth is correct that Force did not have a written buyout plan in place, and they are apologetic about this lapse. However, three partners retired from the firm in recent years, and all were paid buyouts based on the exact same method that the firm used to calculate Darth’s buyout. This consistency of prior practices is compelling evidence for the court to disregard the absence of a written buyout agreement and rule in favor of using the method consistently used for prior retirements.

As for Darth’s claim that the firm forced him to resign, this is sheer folly. All one has to do is review the evidence (as presented in Exhibits I, II and III) in Darth’s personnel file to substantiate (1) his significant performance deficiencies, (2) the fact that the firm gave Darth multiple opportunities to resolve the performance problems, and ultimately, (3) his inability or unwillingness to correct these deficiencies.

In computing Darth’s buyout, the firm:

• used a buyout method consistently used in every previous retirement
• used a vesting convention that is very common among CPA firms
• reduced the buyout to reflect the client loss that occurred due to Darth’s failure to provide notice and client transition to the firm.

Force’s offer of $415,000 is a fair and proper amount. We ask the court to rule in favor of this position.

Ruling of the Judge

Darth failed to produce any compelling evidence that he was treated unfairly. The fact that Force paid buyouts to three previously retired partners on the same basis as was used to compute Darth’s buyout is convincing and compelling.

I am particularly troubled by Darth’s assertion that the firm forced his resignation. Force produced clear evidence of Darth’s failure to perform, and it validates the actions they took to address the problems. A reading of Darth’s personnel file shows a sympathetic and patient effort by the firm to resolve these performance deficiencies that, quite frankly, many firms would be unwilling to make. Darth was lucky he wasn’t terminated months before he finally resigned.

I dismiss the lawsuit of Darth against Force. Furthermore, due to the sheer audacity of challenging the method used by Force to compute Darth’s buyout and the frivolousness of Darth’s assertion that the firm forced his departure, I find that Darth should pay the legal expenses of Force for wasting the time of this court and the time of Force.

Case dismissed!