The AAV System for Partner Buyout Is Alive and Well!

The first question many of you may ask is: What in the world is AAV? I’ll try to keep it simple. It’s one of six methods that CPA firms use to compute the goodwill-based buyout for a retiring partner at a multi-partner firm. About 64% of multi-partner firms use either the Multiple of Compensation Method or the AAV method.

The Multiple of Comp method is by far the most common of the two – roughly 47% of all firms use it. A retiree’s buyout is simply the result of multiplying a predetermined multiple (usually between 2 and 3) times the partner’s compensation.

AAV is the second most common at 17%. It suffers mightily from a horrendous name – a set of initials (it actually stands for Average Annual Value) that means nothing to most people (just like CPA firms who use a set of unfamiliar initials to name themselves). But its methodology makes a lot of sense for certain types of firms. And in our practice, use of the AAV system is surging. But before I explain why, permit me to explain how the AAV system works.

Two Fundamental Principles of the AAV System

1. New partners only share in the increase in the value of the firm from the day they become partner.
2. New partners do not share in any of the firm’s goodwill value built up prior to becoming a partner unless they pay for it, an unlikely scenario in view of current practices which provide for nominal buy-ins, which these days range between $50,000 and $150,000 for most firms

Illustration

The AAV system is best explained with an example.

Assumptions:

1. The firm has annual revenue of $3.5M on 12/31/20.
2. There are 3 partners prior to the admission of a 4^th.
3. The firm grows to $4M at 12/31/21.

Here are the calculations (in thousands). Note how the basis for the calculations is a roll-forward spreadsheet.

(1) Income allocated by the partners in a method of their choosing (e.g. formula, comp committee).
(2) Beginning balances have been rolled forward from prior years. This column represents the allocation of revenue to each partner’s AAV balance, not the partner’s book of business.
(3) The revenue increase each year is again allocated based on relative compensation.
(4) If Partner A retires at 12/31/21, his buyout is $1.7M times the firm’s valuation percentage. In this example, if the firm’s valuation percentage was 80%, Partner A’s buyout would be $1.36M.

Our book, 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 money ►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 and other issues.

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How a Partner’s AAV Balance Grows

Two main ways:

1. Sharing in the increased valuation of the firm.
2. When partners retire and buyout payments are made, their AAV balances are reduced by the payments and reallocated to the remaining partners.

The Kind of Firms That the AAV System Appeals to the Most

The common theme in all of the scenarios below is that there is a sizeable gap between the highest and lowest contributing partners in terms of contributions, both in the past and currently, to revenue growth and profitability.

1. Small firms – solos and 2-3 partner firms – who are bringing in a new partner after having not done so for many years.
2. Firms adopting their first-ever buyout plan. The AAV system gives the senior partners comfort that they aren’t “giving away” the significant value of a firm they built up prior to admitting junior partners.
3. Firms making a major change in their buyout method.

Why the AAV System is Flourishing

For the past ten years, Baby Boomers have been retiring like home runs off Babe Ruth’s bat. About 60-80% of firms in this situation have chosen to merge into larger firms as their exit strategy. But the 20-40% who choose to remain independent need a system to bring in new partners and provide for the buyout of existing partners. Firms either adopting their first-ever plan or changing existing plans are fueling the heightened interest and usage of the AAV system.

If your firm fits one of the scenarios above, you should look into the AAV system for your buyout.