Merger Epidemic: Seller’s High Comp Demands

Sellers of small CPA firms should always ask themselves:  Taking into account both financial and non-financial aspects of the deal, are we better off selling now or continuing to work until we no longer can?

If all sellers care about are the financial terms, in many cases they will maximize their cash flow by not selling the firm and continuing to work, primarily due to prolonging their income stream.  But if non-financial aspects are also important, which is often the case, the sellers may be better off selling sooner than later.

Non-financial aspects include (1) sellers tired of working, burnt out by the tax season or want to work part-time, (2) sellers want their clients and staff “taken care of,” (3) better access to quality staff and (4) getting away from the admin burden of operating a firm.

This post is written from the perspective of a “2-stage deal.”  Stage One starts when the sale is closed, with the sellers working a few more years full time (usually no more than five) while continuing to control their clients.  The duration of Stage One is usually agreed upon during negotiations.  Stage Two is the start of the buyout, terms of which are agreed upon prior to the sale.  The start of the all-important client transition process is also provided in the sales agreement.  During Stage Two, sellers commonly work part-time and/or retire completely.

In a 2-stage deal, there are two huge financial terms:  the purchase price of the firm and the compensation to be paid to the sellers while they work.

An illustration

Assume a 62 year-old sole practitioner has $1.2M of revenue and her annual compensation is $600,000.  Further assume that the sales terms are 1.2 times revenue plus compensation to the buyer of $450,000 a year for five years, after which the seller totally retires.  We’ll talk later about why the seller’s comp is reduced.  Client transition starts in earnest 1.5 years before Stage Two kicks in.

The financial package to the seller would include:

• Price of the firm: $1.2M revenue x 1.2 valuation multiple = $1.44M.
• Compensation to the seller: $450K/year for 5 years = $2.25M
• Total = $3.69M

What if the seller rejects the above proposal because she won’t accept the $150K reduction in compensation?  If she chooses not to sell, her proceeds over, say, 8 years, when at age 70 she no longer is able to work, would look like this:

• Assume her revenues deteriorate to $800K in 8 years. Further assume that due to the age of her clients, the seller can only fetch 1 x revenues.  Total price of the firm:  $800,000.
• Assume her comp for the first 5 years would be $600K and $400K for the last 3 years, for an 8 year total of $4.2M.
• Total = $5M.

So, by continuing to work until 70, her cash flow would be 36% higher than if she’d done a 2-stage deal at age 62.  If the seller only cares about financial terms to the exclusion of non-financial issue, then she clearly is better off not selling at 62.

Our book, CPA Firm Mergers: Your Complete Guide, was written because every year, scores of mergers – up, down and sideways – are taking place. But relatively few buyers and sellers have much experience in negotiating what will be one of the most important transactions of their lives.  Among the topics addressed are: ►Keys to successful mergers, ►21 steps in the merger process, ►Assessing cultural fit ►One times fees is a steal ►Negotiating a merger ►Letters of intent-points to address ►Due diligence

Why the buyer won’t maintain the seller’s $600K compensation

In recent years, we have come across a number of small firms that earn incredibly high levels of income – $750K to over $1M.  These high earnings levels result from two things:  (1) Expertise and client retention skills of the owner(s) which regularly translates into premium revenue and profits and (2) The small firm operates on a much smaller scale than larger firms.  Specifically, larger firms invest heavily in management (COO, marketing, HR and IT directors, etc.), technology, marketing, training, recruiting and staff compensation that smaller firms wouldn’t dream of doing.

In the example of the $1.2M sole practitioner, the buyer could never earn $600,000 on the seller’s revenue because the buyer has a higher cost structure due to the substantial operating investments the firm regularly makes.  Larger firms wisely invest some of their current profits back into the firm to assure long term success.  Small firms rarely do this.

This is why many buyers are unwilling or unable to maintain the compensation of high-earning sellers.

The epidemic

In the past couple of years, we have seen an increasing number of deals hit a snag over the compensation to be paid to sellers when they work at the larger firm.  We have seen sellers become insulted, disappointed or greedy when buyers aren’t willing to match their past compensation.

This is most unfortunate, especially where non-financial aspects of the sale are critically important to the seller. The initial compensation cut is frequently offset by tapping into the resources of the buyer such as better management, cross-selling abilities, marketing know-how and better trained staff.