What if a Firm Loses Clients During a Retiree’s Buyout Period?

Here’s a fairly common situation facing firms with partners nearing retirement – how would your firm approach it?

A client firm writes:  We are putting the finishing touches on our firm’s new partner retirement/buyout plan.  A 50 year-old partner has a $1M client base that includes a single $400,000 client. The loss of this client would obviously have a significant negative financial impact on the firm’s profitability.  Should our plan provide for a reduction of his buyout payments if this sizable client leaves after he retires?

We respond:  The first question that needs to be asked is whether your plan stipulates a reduction in goodwill benefits if clients of a retired partner leave after he retires.  If it DOES, then obviously, this is how you deal with the loss of the large client.  If your plan DOES NOT address this possibility, consider this:

1. When firms value goodwill at 100% of fees (which only about 20% of all firms do), they usually provide for reduction of benefits if clients leave.   But over the years, firms have been valuing goodwill below 100% of fees, with 80% being the national average.  At 80% of fees, only about 20% provide for reduction if clients leave.
2. Regardless of the goodwill valuation, firms that DO provide for reduction of benefits tend to have these characteristics: (a) They tend to be smaller rather than larger firms and (b) the partners operate largely as sole practitioners – the partners don’t “know” each other’s clients very well.
3. When a retiring partner has a substantial client, like the firm raising the question, here are some common alternatives to deal with the possible loss of the large client:

• Payments for the large client are based on collections throughout the entire payout period.
• Payments for the large client during the first two years of the partner’s retirement are proportionately reduced if the client leaves.  The thinking is that, if the client stays at least two years, then thereafter, it’s the firm’s responsibility to retain the client, not the retiree’s.
• If a large client leaves during the retirement payout period, payments to the retiree may be reduced as follows:
  Each year, the firm compares its overall revenues to the revenues for the last year prior to the partner’s retirement. If the firm’s revenues after the loss of the big client never increase, then the retired partner would have his goodwill payments reduced dollar for dollar. However, if the firm brings in new business after it loses the large client, this increase offsets the fees lost from the new client, thus moderating the reduction of the retiree’s payments. If the firm’s new business totally offsets or exceeds the fees lost from the large client, then the goodwill payments to the retired partner would not be reduced.

Example:  Assume that in 2013, revenues of a firm are $3,000,000 and their buyout plan values each partner’s client base at one times fees.  Partner Smith retires in 2013 and his total goodwill benefits are $800,000, to be paid at $80,000 a year for 10 years, beginning in 2014.  Smith had a large client with annual fees of $400,000.  The client leaves early in 2014.  The impact is illustrated below in four possible scenarios:

• If revenues in 2014, after the loss of the big client, are $2.6M, the retiree’s benefits are reduced to $400,000 or $40,000 a year.
• If revenues in 2014 are $2.7M, then benefits are $500,000 (only a $300,000 net revenue reduction for the firm) or $50,000 a year.
• If revenues in 2015 are $2.9M, the firm’s revenues have declined only $100,000 since the partner retired, despite the loss of the $400,000 client.  Therefore, Smith’s annual payment would be reduced by 1/8 of $800,000 and his annual payment would be $70,000.
• If revenues return to the $3M level in 2018, then Smith’s annual payments going forward are restored to the original $80,000 a year.