CPA Firm Purchase Agreement: The 5 Essentials
If you are buying or selling a CPA Firm, your purchase agreement should cover these five essential deal terms accurately, completely and simply.
Often, contracts can get lengthy and repetitive. This can be extremely problematic when it causes the parties to lose sight of what’s really important. A successful purchase agreement is one that is written so that everyone understands the terms of the contract and can move forward with ease and assurance in a timely manner. If you missed our recent podcast with Chris Sloan on contracts, that is an excellent resource to check out. Chris has a very rare and refreshing approach to creating contracts.
A filter to use for each of the 5 essential terms below:
Before you wade into too much of the legalese, be sure to ask yourself, what am I comfortable with? Do I have any hesitations or concerns? Is the risk/benefit fair? Am I lacking any information? Is it reasonable? Perhaps most importantly, is what I’m intending written clearly in the agreement?
CPA practice Valuations vary a good bit. Ultimately, price depends on what a buyer is willing to pay, how a buyer is willing to pay, and what a seller will accept. Therefore, the valuation of every CPA firm is subjective. Stating the price in a contract is relatively straightforward unless there are retention contingencies.
From our experience, the lion’s share of practices sell in the range of .9 to 1.3 times gross fees. Bear in mind that most of Poe Group Advisors’ accounting practices sell for fixed prices at closing. We’ll dedicate a section to terms below, but unfortunately for deals with contingent terms, a lot of the practice value can be lost due to poor transitions, and poor service after closing.
To help you understand the marketplace better, keep in mind these:
SIX PRIMARY FACTORS THAT IMPACT ACCOUNTING FIRM VALUES:
1. Location – In general, there are more buyers in large metropolitan areas than in rural ones. The number of potential buyers for a practice is a key concept that must be top-of-mind when considering market value.
2. Size – There is a “sweet spot” for firms. In general, there are more buyers for accounting firms that can be bought and operated by a single owner. Practices under $ 1,500,000 generally fit into this category.
3. Marketing – Professionally marketed practices tend to sell for higher multiples with cleaner terms. Having an experienced intermediary maximizes the number of qualified buyers interested; and allows owners to stay focused on the practice while it is being marketed. Also, growth trends are important to maintain and the time and energy needs of selling a firm should be minimized. A good intermediary also adds value for the buyer by sharing best transition practices.
4. Profitability – As you’d imagine, the more profitable the firm, the higher the value. Fee quality and owner hours are also major considerations when evaluating profitability.
5. Terms – Seller/Vendor financing and contingent pricing will impact the price. Cleaner terms are much more desirable for the seller and therefore generally go with a lower price.
6. Curb Appeal – Having an office in a desirable location, with good systems in place, and a neat office all increase value.
Obviously, there are situations where other factors impact value. Quality of staff, employee competitive threats, partner non-compete issues, nonrecurring revenues, very strong growth, declining revenue trends, and very large clients are some of the more common factors encountered.
At Poe Group Advisors, we prefer the simplicity of a cash deal whenever possible. Approximately half of our transactions are sold with 100% cash at closing, while approximately 90% of our transactions have fixed-price structures, leaving only about 10% with any contingencies. We believe a small discount for the seller is well worth having clean terms. Furthermore, we believe fixed pricing helps both parties in the deal because it generally results in better transitions.
The biggest benefit of clean terms is that they allow the seller to move on to his or her next endeavor without worrying about the practice for years after the sale. They also allow the buyer to fully control how to operate the practice. Fixed-price structures are very easy to document in a contract.
Conversely, contingent pricing arrangements are often far more challenging to document in an agreement-especially as they relate to how and when the final price is calculated. Everything should be spelled out thoroughly. For example, how is work-in-process handled? What about new clients that are brought in by the buyer?
Clean terms are not only easier to document, terms impact the deal after closing in interesting ways. According to SRS/Acquiom, in general business sales, 2/3 of retention based deals give rise to conflicts with escrowed funds.
Earnouts are popular deal structures for CPA firms that are sold privately, but they have major drawbacks. In an earnout, a buyer pays the seller by using the future earnings that are actually experienced by the buyer. In a pure earnout arrangement, the buyer takes zero risk in the purchase and pays no interest, while the seller essentially assumes all of the risk. This misplaced risk often keeps the seller involved in the practice for a long time after a sale. Having too many “cooks in the kitchen” can be very problematic in the management of the firm after closing.
Some of the issues firms frequently run into with earnouts directly relate to misunderstood roles of the seller and buyer after closing. These misunderstandings often negatively impact the seller’s exit and the buyer’s ability to prosper.
Our experience has overwhelmingly shown that keeping the seller involved for a long transition isn’t the best way to maximize client retention rates. When, for whatever reason this isn’t possible, we advise buyers and sellers to structure a deal that is a hybrid of the two methods. A number of variables can be tweaked to fairly shift risk from one party to the other, such as the duration of the contingency period, the size of the down payment, and the percentage of price adjustment for each dollar of lost revenue. The possibilities for how to structure these deals are endless. Each of these variables can be communicated in a contract-but may take time to create language that can be understood with ease and simplicity.
If there is one section of the agreement to be extra clear about up front it’s this one. Hopefully the seller’s intentions are disclosed and transparent before getting to the offer stage. For buyers, this section tends to be quite sensitive if changes are proposed by the seller. It helps to also know what bank requirements are for the noncompete section. We have seen separate non-compete agreements, but for an accounting practice sale, the noncompete agreement can be quite succinct as long as the below 4 primary points are well documented:
1. The main thing to accomplish with the noncompete agreement is to prevent the seller from serving the clients of the practice being sold. The noncompete agreement should reference a complete list of all of the clients being sold as well as all clients being kept by the seller (if any.) The seller should not be able to serve or solicit clients of the firm regardless of distance.
2. Noncompete agreements should contain a provision for distance. If the seller operates in a different market area, that will not be confusing to clients and is typically a very low threat to the buyer. From a legal perspective, an excessive distance is not enforceable. (It will be interesting to see how laws change over time as more accounting can be done remotely for clients.)
3. Buyers should ensure that their noncompete agreement is enforceable under local laws. Most jurisdictions will not enforce noncompete agreements that cover too much geography or too long a period of time.
4. What specifically is the seller allowed to do after closing? If the seller wants to keep a component of the practice or keep certain clients, make sure the noncompete agreement is specific and clear. If the seller wants to do other types of work that could be considered “public accounting” then that needs to also be specific and clear.
Also keep in mind that noncompete agreements have tax consequences. A portion of the purchase price should be allocated accordingly.
After price and payment terms, the transition is usually the most important item in the offer. Too often buyers just throw out a number of hours for the transition time without thinking what is really required. By thinking through the steps and asking the right questions, the buyer can make a calculated offer that both seller and buyer can be comfortable with.
Keep in mind these 5 concepts for a successful transition:
1. Buyers often think long transitions are necessary. This is rarely the case unless there is a significant amount of audit or advisory work.
2. Create an overall vision for transition prior to making an offer. Then, remember to create a more detailed transition plan before closing. This allows everyone to plan without the pressure of ownership after closing. Develop a plan for nurturing staff relationships, client relationships, as well as logistical components.
3. Open and transparent communication about the transition with clients and staff is essential. When the parties attempt to “mask” the sale as a merger or new partnership when it is not that – tends to leave a very bad impression on everyone involved.
4. Team members can be quite nervous about a change in ownership. There needs to be a plan for the first year on treating the staff well to make them comfortable with their new situation.
The key to a successful transition is to have the right purchaser for the practice being sold; otherwise the previous 4 concepts won’t really matter. Make sure that professional experiences, management styles and client service philosophies match up fairly well.
Due diligence when buying a CPA firm tends to happen fairly quickly after a deal is struck. The contract should clearly define the due diligence period and the process for withdrawing from the agreement.
When approaching the due diligence process, always begin with a focus on only the high-level information. Don’t get buried in too many details. We’ve seen buyers want to jump right into the details and end up losing sight of the big picture items that really help them determine their opportunities and obstacles. Most of the high-level information is gathered through inquiry.
KEY AREAS MOST BUYERS FOCUS ON DURING DUE DILIGENCE:
1. Understanding compatibility between buyer and seller.
2. Understanding staff and future hiring needs.
3. Understanding some of the nature of the practice’s clients which includes industries, longevity, and complexity of the work.
4. Knowing how work is priced, and how money is collected.
5. Understanding work quality and ease of following past documentation.
6. Verifying historical revenue and receipts.
7. Determining that there are no hidden threats to the business like competitive threats from past staff or partners, large clients leaving the firm, or planned key-staff departures.
Other common closing conditions that must be documented in the purchase agreement include bank financing and lease assignments. Seller financing is generally documented in summary in the price or terms section and is accompanied by a separate promissory note.
This is our miscellaneous and sundry section. Most of these items can be easily documented with some care and common sense. Here is a brief list of the most common other items:
- Closing Date.
- Handling of Work-in-Process and A/R.
- “Reps and warranties” (Typically where council can assist the most.)
- Handling of Prepaids.
- Arbitration Clauses if desired.
- Allocation of Sales Price.
- Description of Assets being Sold.
- Description of Assets being Kept by the Seller.
The key to the successfully navigating a deal through the contract negotiation process is to avoid spending too much time on “everything else.” Unfortunately, legalese can contribute to an obfuscation of the 5 essentials.
If you are contemplating an exit from your company in the near future and you’d like to learn more about how Poe Group Advisors simplifies the purchase and sale of a CPA practice, please check out our informative 25-minute video.