Succession Fundamentals – Part 4

Written on Aug 06, 2015

By Bill Reeb, CPA, CITP, CGMA

Now, for the final column on Succession Fundamentals. In our last column, after discussing issues to consider regarding retiring partners, we started down the road of identifying the various sections that should be included in any succession plan. The point of this last section is not to present you with a sample succession plan, but even better, to describe topic areas you should address in your plan.

Throughout this succession series, we have been covering various best practices to consider as you put your plan together. For any succession plan to work, you have to start with consideration of the business model you use:

Section 1: Identify and describe your business model

Your choice of business model, with the two most common being Eat What You Kill (EWYK) and the One-Firm (or Building a Village – BAV - concept), will drive many of the choices you will have make to create and effectively implement your succession plan.

For example, if you are an EWYK firm, then when it comes time to sell, you see if anyone wants to buy your clients, with the partners of the firm having a first right of refusal, based on client retention paid out over four to five years without interest. Under an EWYK model, you get to enjoy the spoils of your success while working. When it is time to leave, you sell your relationships for what you can get and hope whoever buys your book of business will keep most of your clients.

Our experience is that if you sell your practice for a $1 for a $1 in client book, if the departing partner makes an effort to motivate the clients to stay with the new firm or transitioned partner, the retiring partner will likely receive about 65 to 70 cents on the dollar. If the retiring partner does not make an effort in transition, or the buying partner or firm doesn’t work hard to keep them, then this number will go down fast. Since the purchase is based on retention, the buyer’s motivation and integrity is critical to getting paid as the buyer could just cherry-pick a few clients, pay a $1 or even $1.5 for each dollar of revenue and still leave the retiring partner with little to show for their hard work over the years.

Under this model, everything is a negotiation, from what clients are sold, to what the retiring owner might be allowed to do work-wise going forward, to any other term that either side is interested in discussing. This is because under the EWYK model, the succession plan is simply to sell your book of business and hope you have someone willing to buy it at a reasonable price and work hard to maintain those client relationships.

Succession planning under the BAV (One-Firm) model is quite different from that under the EWYK model. As discussed earlier in this series, there are a number of ways to value the firm and a big advantage of this model over the EWYK model is that the partner can expect to be bought out at the time of retirement with some specificity as to the terms of the buyout. Because the remaining partners are obligated to buy the retiring owner out (based on whatever valuation method they choose – we discussed several common ones in part two of this series), that obligation comes with a number of expectations or conditions. They are that the firm will be ready:

  • With someone who can build and cement relationships with the retiring partner’s clients in order to retain them
  • To replace the retiring partner with sufficient physical capacity to get the work done
  • To replace the retiring partner’s technical skills so that someone can actually do the work that the retiring partner was doing.
Once you consider the business model, it then makes sense why the second point of consideration is the retirement benefit:

Section 2: Outline the retirement benefit

The Vesting requirements need to be outlined in order for the retirement benefit to be fully determinable. So, sections addressing the following points need to be laid out in detail to close the loop on the retirement issue:

  • Vesting
  • Penalties for leaving with adequate notice
  • Penalties for early retirement with notice and
  • Mandatory sale of ownership (MSO)
Take a look at part two of this series for coverage of MSO and part six of this series for some vesting ideas.

The next section to write up in your succession plan is that of governance and all that it entails:

Section 3: Describe governance, roles and responsibilities

Take a look at part six of this series for some of the standard positions in governance for which you should consider developing powers, limitations, roles and responsibilities. As well, take a look at part four of this series which introduces two common partner roles you might consider formalizing. Finally, take a look at the four-part series of columns called “Partner Roles and Responsibilities” for more ideas to help you.

In addition, it is critical to manage the voting and ownership processes. This means that the firm needs to outline how it will deal with equity distribution and voting rights and processes. This is one area that can’t be over-emphasized as to its importance. How you determine who gets what say and how that say plays into decisions can make the difference between long-term success and failure.

Section 4: Explain voting rights, decision making and equity distribution or redistribution

In part six of this series we provided more insight into these topics. As well, refer back to the three-part “Equity Allocation and Reallocation” series of columns to see how we suggest you address ownership.  

As part of this same definitional section of the document, you also need to identify a Golden Parachute for the managing partner:

Section 5: Draft your managing partner considerations

The purpose of this provision is to make sure that the person filling the managing partner position is protected if he or she is removed from that role. In order to do the job properly under the BAV model, the managing partner needs to be in a position to consider the firm as his/her largest and most important client. This usually requires a reduction in managed book size so that the firm can become the managing partner’s key priority, together with an expected compensation package for filling that role. Therefore, when a partner is removed from the role of managing partner, they need to be assured that the firm is committed to putting them back into a line-partner position that is consistent with where they would have been had they not taken the managing partner position.

Next, the firm should outline the strategy as to how it will continually build the necessary capacity to replace the retiring partners and create more leverage for the remaining partners to make the financial aspects of the BAV model work. This area of the succession plan has multiple components:

Section 6:  Sharing your strategy for building capacity for long-term sustainability

  • Developing Real “People-Management” Skills
  • Learning How to Develop People More Quickly
  • Closing Competency Gaps
Review part four of this series for some ideas on these topics. As well, consider looking at the six part series of columns called “Management and Leadership in a CPA Firm.”

Now that we know what model we are going to use to operate our firm; when people will retire and under what terms and conditions; the governance that will hold the partners and firm personal accountable; and the strategy for creating capacity and closing competency gaps through the efficient and effective development of people, it is time to move onto the next section, which is defining transition:

Section 7: Define the process for transitioning client and referral relationships; penalties for improper transitioning and the fact that when a partner enters the transition phase, he/she will be under a special compensation framework

This section review how the firm is going to hold partners accountable for transitioning their clients and how they will be paid during that slow-down period. This process actually has quite a bit of trickle down effect to it because typically once a transition plan is created for a retiring partner, a similar plan has to be generated for multiple positions below the departing partner in order for each level to free up capacity to take on the work being handed down. Part three of this series provides some good insight into this area as well as the two part “Client Transition” columns.

Next, we need to talk about how to bring in a partner. So we need a section on admission to ownership:

Section 8: Describe the admission to ownership process

We are big fans of bringing in partners at accrual basis book value buy-in, and then buying them out when their sweat equity has earned them retirement benefits. This in turn requires vesting, which usually doesn’t even result in partial vesting until around age 60. Way too many firms have partners buy in at market. The problem with that model is that if someone buys in at market, you don’t have a good argument as to why someone can’t leave at any time they wish and be bought out at market (i.e., why would I pay market and get anything less than market when I decide to leave?).

A major reason organizations bring in younger partners is to create a succession strategy. They need people who will be ready to take over and run the firm when it is time for the senior partners to go. Therefore, we don’t want partners leaving anytime they want to go, but in an orderly fashion once they have worked for us long enough as a partner and reached a retirement age. We can tell you from experience that, if the younger partners can sell out at any time at full value, many of them will decide to cash out right before the senior partners retire. When this occurs, the question so often asked at that point is, “What happened. Didn’t we make it clear that our younger partners are supposed to buy us out, not the other way around?” And if this isn’t enough, here is another important reason not to require the buy-in to be at full market value – you are going to give them the money to buy you out in the first place.

Regardless of the price charged to buy in, the firm ends up adjusting the new partner’s income so that he/she can effectively buy-in without a reduction of income—so the more he or she is paying to buy in, the greater the upwards adjustment in pay required. Anyway, regardless of your choices in this matter, you need to include a section identifying the buy-in process and pricing model for admission.

Logically, if we are going to talk about people buying-in, we also need to talk about people leaving. Since we discussed departure for retirement earlier, we now need to address the other departures, including voluntary or involuntary withdrawal from the firm. When you outline this section in your agreements, you need to address a number of areas associated with people leaving and competing with your firm:

Section 9: Address People Leaving and Competing 

  • Benefits Available when Leaving and Competing or Not Competing with the Firm
  • Penalties for Leaving and Taking Staff and/or Clients
  • Vote Required to Terminate a Partner
As we’ve discussed in previous parts of this series, your firm should not be in the business of creating spin-off competitors, so you need to think through how you will address partners who leave and take clients and/or staff to compete with your firm. This usually involves a reduction in what they receive in retirement benefits and liquidated damages owed to your firm for clients and staff taken—and the damages need to be high in our opinion, in the range of 200% of client fees and staff salaries. 

The voting percentage required to terminate a partner is critical to succession management. If you are going to operate under the BAV business model, you have to be able to hold partners accountable to following systems, processes and procedures. When a partner will not comply, you need to first be able to motivate them to comply by penalizing them financially. If that doesn’t work, you need to be able to penalize them even more financially. And if that doesn’t motivate them to change, then you need to be able to let them go. One of the biggest weaknesses we see is firms adopting such a high voting threshold to fire someone that it is almost impossible to let someone go. If this is the case, then your odds of being able to effectively run your firm under the BAV model are minimal since you don’t have a way to cut partners from the herd who have made it clear that they will not comply with operational policy.

Next, you need to establish the rules of conduct and operational processes for those ex-partners who retire and still want to continue working in some capacity for the firm. Obviously, this means they will be working differently than they did before. And even more important, they won’t be working for the firm at all if the firm doesn’t specifically invite them to continue working (and we believe the maximum length of that invitation should be one year at a time). Therefore, you need to define how you will deal with this prospect:

Section 10: Outline the processes and procedures for retired partners still working for the firm

We spend time in both parts five and six of this series outlining the “do’s and don’ts” of this issue.

To ensure that the firm can pay those who have retired or left without putting the firm’s sustainability in jeopardy, a policy has to be developed to puts a cap on the maximum amount of money that can be paid out to departed partners. So you need a section addressing the maximum amount of payout in any year:

Section 11: Describe the maximum payout process

In order to protect the firm in the event that it has a poor year, usually a cap is set on how much of the firm’s net profits before partner compensation will be paid out to retired partners. If the amount due to the retired partners exceeds the amount under the cap, the excess owed to them gets tacked on to the payouts and paid out over a longer time period, usually with any deferred amounts carrying interest until caught up.  

At this point, it is time to layout the compensation framework:

Section 12: Discuss the partner compensation framework

The framework needs to be flexible enough to dramatically change every time the firm’s strategies or priorities change. The job of the partner compensation system is to motivate partners to achieve their part of the firm’s strategic plan. Compensation is the incredibly effective tool an organization can use to reward those people who are contributing to the firm’s success and make it clear to those who are not that they need to change their behaviors. The partner compensation framework needs to be supported by firm policy in such a way that it enables the managing partner to hold the partners accountable to achieving whatever goals are assigned to them. But at the same time, it has to be set up with enough balance that the managing partner doesn’t gain so much control through the compensation process that he or she is in a position to usurp powers that are reserved for the board. For an in-depth discussion on this topic, refer back to the “Accountability for Performance Management” series of columns.

Finally, your succession plan has to address how death, partial or full disability are handled when they occur. Therefore you need a section that addresses death and disability:

Section 13: Review how death and disability will be managed and compensated

We suggest that provisions addressing buyouts for death and disability take into account the fact that someone’s departure under these conditions can place the firm in some serious financial risk, if only due to the inability to properly transition client and referral relationships and develop the capacity for someone to take over for the departed partner. As well, special attention needs to be paid to situations where a partner comes and goes—in and out of disability—over time and how that will be addressed by the firm. These critical areas need to be addressed in a way that is fair and equitable to both the departing partner and to the firm and they normally are covered separately under death, partial disability and total disability provisions.

In conclusion

Our stance, in everything we do working with firms, in what we write in our books and what we talk about when we speak, is that succession is the natural and seamless evolution of managing a well-run firm. But if your firm is not following best practices, then succession will turn a spotlight on every weakness the firm has. We believe that if you take the time to think through and address each of the topics above, you will be more than ready for succession. As well, you will be one of the few firms on the planet with a truly robust succession plan to form, guide and direct your upcoming change in leadership.  

Good succession management is about ensuring that when key people leave, the firm doesn’t redefine everything it is doing, but continues to operate on sound foundational principles with the only real difference being a change in “who” is filling key leadership roles and responsibilities.  

We wish you the best of luck drafting your succession management plan. 

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. The Succession Institute is lead by its owners Bill Reeb, CPA, CITP, CGMA and Dom Cingoranelli, CPA, CGMA, CMC®, who have each been working with CPA firms and family businesses to help them improve their performance for over 30 years. Visit their page now to learn how you can save on the solutions right for you.

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