Getting Sick and Tired of Ownership Percentage Driving Your Partner Decisions?
Marc Rosenberg, CPA / May 21, 2019
I sure am.
Why? Imagine you entered into an ownership position in a CPA firm in your mid-30s. Over the next 30 years or so, you’ll be paid your share of millions of dollars. Do you want your share to be based on judgments that are rational and logical, or unfair and lacking in common sense?
There are five major partner issues that need to be addressed in CPA firm agreements:
- Allocation of partner income.
- Calculation of partner buyout.
- New partner buy-in.
- Allocate proceeds of a firm sale.
Each of these issues can be dealt with through various methods, including one I see with disturbing frequency that drives me crazy: governing by means of partner ownership. This approach is guaranteed to cause tremendous acrimony among current and future partners. Firms get twisted up in the illogic of using ownership percentage and find themselves trying to solve an insolvable problem using old school methods. They need outside-the-box thinking and that’s what this post will provide.
Many clients of CPA firms use ownership percentage to drive shareholder compensation, voting and distribution of the proceeds of a company sale. But there are major differences between operating an industrial company and a CPA firm. Whereas companies’ products, plant, equipment and patented technology drive their profits and goodwill value, CPA firms’ primary financial asset is the partners’ ability to bring in and retain annuity clients. Partners’ ownership percentages are heavily based on the capital they initially contributed, but this has little or nothing to do with the ongoing profitability of the firm and building its goodwill value.
Over time, ownership percentage is almost never a fair measurement of a partner’s contributions to the firm’s profitability and success. Here is an illustration:
|Partner A||Partner B|
Can there be any possible justification for Partner A’s compensation and buyout being twice as high as Partner B’s?
Per the 2018 Rosenberg MAP Survey, the following data is irrefutable evidence that ownership percentage is not a popular choice among CPA firms:
Partner compensation systems:
- Compensation committee-30% of firms
- Ownership percentage – 6%
Partner buyout systems (5 or more partners):
- Multiple of compensation – 53%
- Ownership percentage – 14%
LET’S DEFINE PEFORMANCE-BASED PARTNER COMPENSATION
The firm’s income allocation to partners is based on their relative performance. Partners making the greatest contributions to the firm’s profit and overall success are paid more. Performance-based systems motivate partners to perform at high levels and reward them for their efforts and success. Without these incentives, firms often stagnate and perform at lower levels.
I often begin consulting projects by asking a simple question: Is your partner compensation system performance-based? They often answer with pride “yes.” Then I look at the details of their system and find that 80% of the income is allocated based on ownership percentage and 20% is a performance bonus. The math doesn’t work. If 80% is not allocated based on performance, then the system is not performance-based.
In my 20 years of consulting, the number of times I have seen partner ownership percentages with absolutely no correlation to relative partner performance, is astounding. I often ask partners why they are a 20.7% partner or a 14.8% partner, etc. They haven’t a clue. It’s a meaningless figure.
CPA Firm Partner Agreement Essentials was written because 75% of firms’ agreements are out of date or missing critically important passages. Even more concerning, 20-30% of firms don’t even have a written agreement. We incorporate hundreds of best practices learned over 20 years of helping firms with their agreements: book addresses ► voting ► ownership percentage and capital ►non-solicitation covenants ►partner duties and prohibitions ►mandatory retirement ►non-equity partners ►death and disability ►managing partner authorities ► executive committees ►clawback ► new partner buy-in ►ownership percentage and other issues
THE PROPER WAY TO LOOK AT PARTNER BUYOUTS
CPA firms have a well-defined street value to buyers:commonly 60% to 120% of the firm’s annual revenue. The percentage varies based on many factors, primarily the quality of the firm, its revenue size and the location of its market. Many partners receive a buyout upon retirement (often referred to as deferred compensation – DC) that can exceed $1M at big firms.
One way to look at DC is that, just like partner compensation, it is performance-based. It’s a portion of a partner’s overall compensation that is deferred rather than paid out currently. The DC value increases as the partners perform at high levels; the impact of this performance is cumulative. When the partners bring in new clients, retain and expand services to existing clients, effectively manage the firm, develop a great staff and deliver world-class service to clients, this increases the revenue, profitability and overall success of the firm, all of which builds the goodwill or street value of the firm. Ownership percentage has nothing to do with the tremendous increase in DC value that occurs over the years.
Just as compensation should be performance-based, so should deferred compensation. Ownership percentage should have little or no place in determining the buyout of a retiring partner.
NEW PARTNER BUY-IN
Boy, do firms mess up on determining the buy-in for new partners. The old school method is to decide the ownership percentage of the new partner (virtually no science in this!), multiply it by the value of the firm (capital plus goodwill) and voila, the result is the buy-in, which in most cases, is many hundreds of thousands of dollars. For many years now, firms have gotten away from this method because new partners are unable and unwilling to pay this humongous buy-in. Less than 5% of all firms over $3M determine their buy-ins using this antiquated method.
The new method for determining new partner buy-ins is to determine the buy-in amount on a discretionary basis – usually $100-150,000, lower for smaller firms – and to disassociate the buy-in from ownership percentage. This is the gold standard. If the importance of ownership percentage is unimportant or meaningless, then who cares what the ownership percentage is of a new partner? Some firms opt to make all partners equal owners.
Of all the five partner issues potentially affected by ownership percentage, voting is the trickiest.
The ultimate goal should be to get to the point where voting is one-person, one-vote, with certain critical issues (mergers, making a new partner, etc.) voted on by super-majority.
But smaller firms (usually 5 or fewer partners) that have at least one dominant partner – usually a founder and/or the firm’s major producer – usually like to structure voting so that a minority of lower performing partners cannot throw out the dominant partner and control the firm. So, protective measures are often needed in this situation. Using ownership percentages is one way to provide this protection.
ALLOCATION OF THE PROCEEDS OF THE FIRM’S SALE
Real simple. This should be determined with the same method used for calculating partner buyouts.
CONCLUSION: IF OWNERSHIP PERCENTAGE IS PUT TO PASTURE, WHAT SYSTEMS SHOULD BE USED?
Partner compensation: – performance-based systems such as compensation committee, managing partner decides or a formula.
New partner buy-in: – the firm decides on a discretionary buy-in amount that is disassociated from ownership percentage.
Partner buyout – performance-based systems such as multiple of compensation or AAV.
Voting- strive for one-person, one-vote, but at some firms, it’s important to prevent a dominant partner from being outvoted. Ownership percentage is one way to address this.
Allocating the proceeds of a firm sale – same as partner buyout.
So please, embrace the new school thinking and minimize the role of ownership percentage at your firm!
Every firm needs to ask: Is our partner agreement current? Does it protect the firm? Do we even have one? This book covers every major section of a properly written agreement: partner buyout, new partner buy-in, ownership percentage, voting, non-solicitation covenants, partner duties, mandatory retirement and non-equity partners.Learn More