By Bill Reeb, CPA, CITP, CGMA
In the first part of this article published in our May/June issue, we discussed the importance of having a fair retirement benefit that acknowledges the contributions a retiring partner has made to the firm.
Our general rule of thumb is if you are going to sell your book of business, it will be done based on a retention agreement paid out to the retiring partners over four or five years. 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.
As for ownership interest times net revenue, the most common discount we see is 15 cents on the dollar, resulting in a net benefit of 85 cents on the dollar. The Net Annual Revenue (NAR) is usually an average of the last two years to reflect consistency of revenues, as well as to ensure games are not played inflating revenues in the final year before retirement. However, you also have to subtract any outstanding debt owed to retired partners for their benefits (not outstanding loans to operate the business, just those amounts still due to owners who have sold their interest in the firm). So, if you were a $5 million firm, with $1 million owed to a recently retired partner, and if the current retiring partner owned 20% of the firm, the calculation would be as follows:
Average Net Annualized Revenues $5,000,000
Outstanding debt to retiring partners 1,000,000
Average NAR less retirement obligations $4,000,000
Revenue Discount 85 cents on the dollar
Equity interest of the Retiring Owner 20%
Retirement benefit ($4M X .85 X 20%) $680,000
In this example, the 20% owner would be entitled to $680,000, usually paid out over 10 years, at no interest. While we see some firms pay out the benefit over seven years, the most common we find now is 10 years.
In addition to the retirement benefit, an owner will receive a repayment of his or her capital. If the firm is a partnership, then the capital account is tracked and that is the money the selling owner is returned. In a corporate structure, the owner will receive his or her percentage of ownership multiplied times the accrued net book value of tangible assets. Thus, it normally includes cash, marketable securities, estimated collectible receivables and estimated billable and collectible work in progress, with
fixed assets adjusted to a reasonable market value (this is a number the firm and the retiring partner agree to, not a number that appraisers are hired to ascertain, as we are just trying to use a fair number since most firms depreciated their assets to zero as fast as possible for tax purposes) – minus all liabilities – except those representing deferred compensation obligations owed to retired owners.
Obviously, if we are talking about a sole proprietor selling his or her book of business, the sole proprietor keeps whatever cash is available after the dissolution of the company and its assets, in addition to whatever is earned through the sale of the book.
Although these might be viewed as common starting places for retirement benefit calculations, there are variations. For example, interest or guarantees, or shorter payouts modifying the retirement benefit discussed above would likely end up with the retiring partners being paid a premium. Or, if the benefits are set at something less than described above, like 60 cents on the dollar (without a logical and real reason for the extra discount) or a three-year average of revenues, the odds are high that the retiring partner is getting less than market. Your numbers can vary significantly from what I have described above and still be fair, depending on the perks.
For example, if the partner wants to continue working for the firm after his or her sale of ownership, how good or bad the terms of post-sale employment are will determine whether the entire retirement benefit is in line. Or, if a partner poorly transitions clients and the retirement benefit is not reduced for that infraction, then that can make a good deal bad to the buyer or a bad deal good to the seller.
In the end, the information above assumes predominantly recurring revenue, strong infrastructure (trained people) and governance that will allow the firm to continue. There should be a system to hold remaining partners accountable to the firm’s strategy and direction. The assumption within the pricing of any deal other than “selling a book of business on retention” is that there is an organized firm with talent ready to profitably sustain it. So, anything short of a sustainable, profitable firm means the best practice fair pricing discussed here should be in question and with some downward adjustment under consideration.
Probably 80% of senior partners in firms would suggest that their firm, without them, is dysfunctional. It could be interpreted that I have just given a free pass to every senior owner to sell the firm out from under its remaining partners. I haven’t. If you are one of the senior partners getting ready to retire and you haven’t built anything sustainable, then shame on you. And know that you are one of the people who needs to be taking a discount in retirement benefits for lack of what you have built. So, if dysfunctional is how you would describe your firm without you, then fix it before you leave. That will not only be your legacy, but it will also justify you getting full benefits (not premium benefits, but full benefits). Bill Reeb, CPA, CITP, CGMA, is the CEO of The Succession Institute, LLC. 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. To learn more, visit www.ohiocpa.com/succession-institute.