Sounds counter-intuitive, doesn’t it? How can assuming a significant debt obligation be a great investment? Bear with me.
For years, CPA firm partner retirement/buyout plans have been controversial. Buyout plans have been around for decades, with trillions of dollars paid to retirees during that time. It’s a practice that works. So why is there controversy?
Would-be and young partners often question these plans because they seem a bit like Ponzi schemes – paying into something and not getting anything back. Some question the multiple of revenue valuation (an average of 80% of revenue) of a CPA firm because the realization of that value depends totally on retaining the clients served long and well by retiring partners. And it’s understandable why a new partner would be anxious about signing onto a substantial obligation, payable decades into the future, given the uncertainties in tomorrow’s world.
So why is signing on to a partner buyout agreement such a great investment? Let me illustrate, using data for an average firm in the latest Rosenberg Survey:
- Revenue $10.7M
- Income per equity partner $424,000
- # of partners 7.4
- New partner buy-in $160,000
Let’s further assume that the new partner enjoys a 30 year tenure as an equity partner. The return a new partner will experience over those 30 years consists of three main parts: earning an elite income level, experiencing a tripling of one’s initial capital investment and receiving a hefty buyout paid at retirement. Let’s look at each.
Let’s assume the new partner’s last salary as a manager was $150,000. If we assume average partner compensation will be $424,000, that’s an average increase in annual compensation of $274,000. For 30 years, that amounts to $8.2M.
Increase in accrual basis capital account
Let’s keep this simple. Over a period of 30 years, it’s common that a beginning capital balance of $160,000 will triple. Let’s call it $500,000.
A very common buyout method is the Multiple of Compensation method. A common multiple is 3.0. If the partner’s average annual compensation is $424,000, it’s reasonable to assume that compensation in the year before retirement will be $500,000. So, 3 x $500,000 = $1.5M.
The total return
Adding up all three pieces, the total is $10.2M. By any measure, that’s a pretty good return on a paltry $160,000 investment.
Ah, my ears are ringing. I can hear the naysayers and skeptics. They are saying that anyone can play with an Excel spreadsheet and create fake news – or in this case, manipulate statistics to reach a desired conclusion. Clearly, the big assumption, faulty at best say the skeptics, is that the profitability and value of the firm will be preserved in a world where no one knows what the future will look like five years from now, let alone 30 years ahead. To preserve their value, CPA firms must survive the exodus of talented rainmakers, aging clients, the impact of technology, threats from tax simplification, the economy, unstable world conflict and probably most importantly, outside factors that have yet to surface. That’s a big leap of faith for the naysayers to make.
CPA Firm Partner Retirement / Buyout Plans is a must-read for firms that either need to revise and update their existing plans or need to write a new agreement. The book addresses ►what CPA firms are worth, ►what partners must do to get their buyout ►how to value a firm’s goodwill ►the acid test of a well-conceived retirement plan ►6 methods of determining an individual partner’s buyout ►vesting ►notice and client transition requirements ►mandatory retirement ►non-compete and non-solicitation covenants ►how to prevent your plan from becoming a Ponzi scheme
Financial opportunities are good investments only if properly conceived. But if the buyout plan seems like a Ponzi scheme, it probably is. Firms should have these features to make sure their new partners see the buyout plans as great investments:
- Mandatory retirement. The whole basis for a buyout plan being a good deal for new partners is the retention of the retirees’ clients. It would be nice if at least part of the buyout is a “thank you” for decades of being a great partner – partners at CPA firms are nice, but they’re not Santa Claus! So, for the firm – and the new partners – to “get” the retirees’ clients, they actually have to retire. That’s why firms have mandatory retirement policies.
- Notice and client transition. Retaining the clients of a retiring partner is strongly linked to the effectiveness of the retirees’ efforts at transitioning clients to other firm members. Firms are getting tougher on enforcing this, essentially adopting the adage: “No transition > no buyout.”
- The goodwill valuation must be fair. Too many firms overvalue the buyout payments because they see firms sold for 100% to as much as 140% of revenue. Valuations for external sales are completely different than those for internal buyout plans. The average goodwill valuations for internal buyout plans average 80% of revenue; one reason for this is that the firm’s partners wish to be conservative.
- Buyout plans are not intended to be savings plans, to be withdrawn at full value whenever a partner wishes. Firms need their partners to stick around for the long haul (close to normal retirement age). That’s why vesting provisions are critical.
- Buyouts to retiring partners should be performance-based, just like compensation. Poorly conceived buyout plans often pay buyouts to retiring partners that are significantly in excess of what they deserve, which makes the remaining partners – especially new partners – very uncomfortable with the plan.
- Keep the burden of the annual buyout payment affordable. One way to do this is to have a reasonable payout period. The vast majority of well-conceived plans provide for at least a ten year payout. Anything less could make the buyout payments a cash flow burden to the firm.
- The math must work. In 90% of the cases I have seen where a partner retires, the remaining partners earn more than they did prior to the retirement. Why? Because the firm no longer has to compensate the retired partner and the firm uses this money to fund the buyout payments