By Bill Reeb, CPA, CITP, CGMA
When we take our clients through succession planning, eventually the focus turns to implementing best practices for running a firm, but first we normally have to start with short-term retirement issues. Why? Because typically you won’t get any buy-in for change until the partners have looked at whether the current retirement system is paying at least roughly a fair market value to the near-term retiring partners.
Our rule of thumb is that the remaining partners in a firm will pay a retiring partner up to 120% of the fair market price and the partners selling their ownership will take as little as 80% of the fair market price to turn over their ownership. When either group goes even a fraction outside this boundary (and often even when they start coming close to it), then “principle” is invoked and bad things begin to happen. The conversation shifts from one of win-win – where both parties come out okay – to win-lose with each party out to hurt the other for being selfish and unfair.
Therefore, the first stake to put in the ground for building a succession plan is a fair retirement benefit. Generally that is made up of two components. The first is a return of capital and the second is the retirement benefit. For small firms (one- to two-partner firms), this equates to buying the retiring partner’s book. For larger firms, it is about paying a benefit for the contribution that the retiring partner has made to the firm.
This calculation often comes in the form of a multiple of salary or the partner’s share of equity ownership applied to the revenues of the firm.
Based on the results from the PCPS and Succession Institute 2012 Succession Planning Survey, here is how those results shook out:
On average, about a quarter of firms with up to 200 FTEs (full-time equivalent employees) use the ownership percentage times Net Annual Revenue (NAR) to calculate retirement benefits. Larger firms clearly favor the multiple-of-salary approach, while the smaller firms prefer to use the book of business method. Based on our experience, book of business is almost always the default model used to sell firms with one to two partners, although that statistic is not reflected in the survey results below.
Firm size does not affect whether the firm pays more or less than $1 for $1 of client book or firm revenue. For firms using ownership percentage times NAR, 46% pay less than $1 for $1 of revenue, while slightly less pay a full $1. Just 8% of firms pay more than $1 for $1, similar to the 2008 responses. Among firms using a multiple of salary to determine benefits, a little over half pay less than three times salary. A little more than a third of the firms pay three times salary. Only 13% pay more than three times salary, which is consistent with 2008 results.
Our general rule of thumb is that if you are going to sell your book, it will be done based on a retention agreement paid out over four or five years. So, while the agreed-to purchase price would probably default to a $1 for $1 of revenue, given normal retention the final payout to the selling partner over the payout period would likely be 60-70 cents on the dollar (because the selling partner only gets paid for clients retained each year).
But for firms where a partner is being bought out by his/her remaining partners, capital is typically returned over three to five years (three years if the number is low, but five years if that number is several hundred thousand dollars or more) at the firm’s borrowing rate of interest.
If you are using salary as your retirement benefit calculator, the most common multiplier we run across is three times total compensation, based on the average of your three highest years’ salary in the last five years. Some firms throw out the high and low figures while others have moved to 2.5 times compensation because of the high compensation paid to senior partners.
The Ohio Society of CPAs has established a collaborative effort with the Succession Institute to provide small firms with the tools they need to manage their practices and seamlessly transition to new leadership. OSCPA members can purchase a small firm subscription at a deep discount.
Look for part two in the July/August issue. Bill Reeb, CPA, CITP, CGMA, is the CEO of The Succession Institute, LLC.