Internal Buyout vs. External Sale: Why Valuations Differ

Over the years, we have found that many firms confuse terms for internal partner buyout plans with those commonly seen in external firm sales. Both transactions are vehicles for transferring CPA firm ownership, but there the similarity ends. The biggest problem with lumping the two together is that in designing a buyout plan, firms mistakenly use provisions commonly associated with firm sales—almost always more liberal and rich than internal buyouts—with the result that some buyout plans are neither viable nor competitive. This blog reveals the differences.

Firm valuation. The national average for valuing goodwill (excluding capital) for an internal buyout at CPA firms is 75-80% of revenue. In contrast,  many firm sales hover around 100% of revenue. This sales price may be a bit higher in cases where the seller is unusually profitable or has desirable features, such as young talent or a specialty that the buyer covets. Internal valuations are lower than external ones for several reasons: (1) In an internal plan, there is only one buyer—the firm itself; in external sales, there are multiple buyers. The law of supply and demand drives up the sales price when there are multiple buyers. (2) The partners who remain after a partner retires are often anxious about the affordability of the buyout payments and the ability of the firm to survive the departure of retiring partners, especially if they are major profit generators. As a result, firms often like to be conservative in their internal valuation for buyout purposes. (3) Future partners are often taken aback by the prospect of having to pay their share of millions of dollars of buyout obligations. They are concerned about obligating themselves to large buyouts many years in the future, when nobody knows what the firm or the CPA profession will look like. They fear a Ponzi scheme scenario. They don’t want to be the last ones to turn out the lights. A conservative valuation helps allay these fears.

The lesson: Don’t let prices for external sales drive your internal valuation for buyout purposes.

Term of payout. When firms are sold, the payout term is usually 4-6 years. But this is way too short for internal buyout plans, which are usually at least 10 years, sometimes a bit longer. We have a saying about internal buyout plans: “The math must work.” The acid test of a well-conceived and affordable buyout plan is that when a partner retires, the remaining partners earn more money—or at least not less—than they did prior to the retirement. This is possible because the money “saved” by the firm by no longer compensating the retiring partner exceeds (a) the buyout payments, and (b) the compensation of labor to replace the productivity of the retiree. In almost all cases where we’ve seen buyout terms at 4-6 years, the math doesn’t work because the annual buyout payments are too high.

The lesson: Ease the burden of buyout obligations by providing for a longer payout period than is common at external firm sales.

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What payments are contingent on. In an internal buyout, the payments are normally fixed at the time of retirement. In a firm sale, payments are normally linked with collected revenue. So, in a buyout, as long as retiring partners provide the required notice and assist in client transition, and the math works, their buyout payments are not in jeopardy. But in a firm sale, sellers are vulnerable to clients leaving the buyer. At the same time, sellers benefit if revenue increases during the payout term. Roughly 80% of all CPA firm buyout plans do not reduce payments if clients leave after the partner retires (again, provided that proper notice and transition occur).

The lesson: Client transition is smoother and retention is higher in partner retirements than firm sales. As a result, buyout plans should provide for a stable stream of retirement payments compared to firm sales.

Capital. The value of a CPA firm is its balance sheet (tangible) capital plus its intangible value (goodwill). In both internal buyouts and external sales, the partners or sellers receive their capital. However, they receive it in different ways. In internal retirements, partners are paid both capital and goodwill. The retiring partner’s share of the firm’s capital depends on the method of determining the capital; for example, (a) the balance in the retiree’s capital account or (b) ownership percentage. In external sales, the seller does not sell the balance sheet (which is mostly cash, WIP and receivables); instead, it is retained by the seller and redeemed as the balance sheet is collected and liquidated.

Buyout scenarios are an important consideration for firms looking to transition to the next generation. Developing a plan that works for the firm, retiring partners and newer partners is key. And don’t wait too long—it’s not often something that can be put together in 30 days. You need time to think through the various options in a well-constructed buyout plan and make the right decisions.