A version of this article first appeared in The Journal of Accountancy’s CPA Insider™ By Brannon Poe, CPA
How does an earnout affect the buyer and seller?
Earnouts are popular deal structures used by buyers and sellers of accounting practices, but they have drawbacks. In an earnout, a buyer pays for a practice using the earnings that are generated from that practice, plus an initial down payment in some cases. In a pure earnout structure, the buyer takes on little to no risk in the deal, while the seller carries most or all of the risk.
One reason earnouts became popular is that many sellers (and many buyers) have difficulty imagining that clients will transfer easily to a buyer. They believe it takes months or years for clients to become comfortable with a new owner. As earnouts place a high level of risk on a seller, they keep him or her involved in the practice for a long time after a sale in hopes of maintaining client retention. This is a false belief. When ownership changes hands, the risk of ownership should transfer as well. Client and staff retention after closing is largely driven by the buyer’s management, service quality, and pricing decisions, not by how long the seller lingers. When a seller selects a buyer who is the right fit for the practice, smoothly transferring those relationships is an achievable and likely outcome when the transition of an accounting practice is done with reasonable care and common sense.
How should you structure a CPA acquisition?
For this reason, Poe Group Advisors prefers to structure deals with a strong majority of cash at close. Our goal as an intermediary is to structure deals that accurately assign risk to the party that controls the results. When 100% cash at close isn’t the right fit, we advise buyers and sellers to structure a deal that is a hybrid of an earnout and a cash-only deal. A number of variables can be tweaked to 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.
Today’s market increasingly values accounting firms on a multiple of EBITDA rather than a flat multiple of revenue, especially among private equity backed consolidators. Smaller, more owner-dependent practices tend to trade at the lower end of that range (roughly 5 to 10x EBITDA), while larger, more scalable firms with less owner dependency can command 7 to 12x EBITDA or more. Because price and terms are negotiated together, both are shaped by how many qualified buyers a firm attracts. For smaller transactions (generally under $5 million), bank financing is widely available and often gives buyers longer payout terms than sellers would get with seller financing, which helps buyers pay a larger share in cash at close. Our goal is to leverage offers so sellers achieve anywhere from 70% to 100% cash at close.
For larger transactions (over $5 million), it’s more common to see some seller financing, contingent payments, and equity bonus arrangements or rollover equity, particularly in private equity deals. PE offers often start with lower cash percentages at close than an all-cash deal, so having multiple offers on the table gives sellers the leverage to negotiate those percentages upward. Some sellers do choose to reinvest a portion of their proceeds into the new entity as rollover equity, and PE firms often encourage this. There are real risks and rewards to weigh in that arrangement, and it tends to work best when the seller is genuinely motivated to stay on and help build the firm before their eventual exit, not just going along with it as a condition of the deal.
In our opinion, pure earnouts place the risk on the wrong party, which is why sales with earnout structures lend themselves to problems. Here are some of the issues firms frequently run into when making deals that include earnouts:
1. Loss of Clients
Earnout structures can lead buyers to “cherry-pick” only the clients they deem worthy of keeping. If buyers don’t lose money when clients leave, they have no financial incentive to hang on to those they don’t want to serve. This can be especially problematic when the buyer and seller have big differences in how they value their clients, deliver and price services, or when the buyer doesn’t have enough staff to give clients the level of service they’ve become accustomed to. Clients may become dissatisfied with the changes and leave the firm, costing the seller money.
Our experience, selling accounting practices since 2003, has shown us that buyers who pay cash for practices approach transition and client service with much greater enthusiasm. In the instances we’ve seen where buyers have had earnout clauses in their contracts, those buyers typically lost a higher percentage of clients than did cash buyers.
One caveat: in some instances, earnouts are necessary to protect the buyer. Most commonly, we’ve seen this occur when a practice has a concentration of especially large clients or when a past or present partner or employee may pose a competitive threat to the practice.
2. More Transition Issues
Many CPAs believe that, after a practice changes hands, it’s good for the seller to stay in the office for several months or even years to help ease clients’ transition. In our experience, that is not true in most cases. The earnout structure often incentivizes sellers to stay in the practice far longer than is necessary for a successful hand-off, and when that happens, control battles often ensue.
Moreover, buyers often bond with clients faster if the seller is not around. If the seller is in the office when the client calls or comes by, the client will want to talk to the seller, not the buyer, and the buyer-client relationship is not nurtured. Plus, the buyer often loses money by paying the seller a substantial salary to stay on for a while. Often, the buyer could afford to lose a lot of clients for what he or she is paying the seller for extended transition assistance.
There are, of course, exceptions to this. In private equity acquisitions, it can be optimal for the seller to stay on for a while as the PE firm provides structure and back-office support, since the goal is often further acquisitions and growing a larger platform. A private equity buyer will value and need the continued support of a seller who is usually still invested through rollover equity. You can read more about this in our whitepaper, “Private Equity M&A in the Accounting Industry.”
Another exception to speedy transitions can occur when there are multiple partners. When timelines are misaligned on retirement with partnerships, it can be ideal to keep some partners on board. As firms get larger, oftentimes client relationships are not solely owned by the seller. In these instances, it can be great to keep company culture and maintain client points of contact by employing partners not ready for retirement. Transition planning in these cases must be carefully done before closing to ensure a healthy start to a new relationship. Finding a buyer for these types of transitions can also take longer, because fit becomes even more crucial when a partner plans to work with the new owner for an extended period.
3. More Disputes
When a seller doesn’t end up receiving what he or she had hoped for from the earnout structure, disputes often arise. According to data from SRS/Acquiom, in general business sales, about two-thirds of earnout deals give rise to conflicts regarding escrowed funds. In our experience, the most frequent cause for dispute is that a buyer either didn’t calculate the revenue as agreed or was negligent in developing client relationships and providing reasonably good client service.
4. Why to Choose a Cash-Heavy Deal Instead
Cash-heavy deals happen much more frequently than many realize. At Poe Group Advisors, we consistently work to leverage competing offers so sellers land in the 70% to 100% cash at close range, with the rest of the market’s own data backing up why that’s worth pursuing. A small sacrifice in headline price is often well worth getting the right terms, and fixed pricing generally helps both parties in the deal because it facilitates smoother transitions.
5. Contingent Earnouts Leave Uncertainty for the Future
The biggest benefit of a cash-dominant deal is that it allows the seller to move on to retirement or their next endeavor without thinking about the practice for years after the sale. The seller can experience a clean break. After all, the new owner of the business should be the one fully focused on it. Cash-heavy deals also benefit the buyer because they allow him or her to make the decisions about how to best run the business. It’s the buyer’s to grow or change as he or she sees fit from day one. One of the best ways for a seller to get that peace of mind is to maximize cash at closing and treat any contingent payments as a bonus, not as money they’re counting on.
About the Author
Brannon Poe, CPA is the founder of Poe Group Advisors, one of North America’s leading M&A advisory firms specializing exclusively in CPA and accounting firm transactions. Since 2003, he has advised hundreds of accounting firm owners on succession planning, valuation, and practice sales throughout the United States and Canada.
Before founding Poe Group Advisors, Brannon worked as a CPA with Ernst & Young. Today, he leads a team of CPAs, transaction advisors, and former investment banking professionals who help accounting firm owners navigate one of the most important decisions of their careers.
Brannon is a frequent speaker and published author on accounting firm succession and has been featured by organizations including the AICPA, CPA Canada, and Accounting Today. He also hosts the Accountants’ Flight Plan podcast, where he interviews leaders and innovators from across the accounting profession.
After more than two decades advising accounting firm owners, Brannon believes that the best transactions aren’t defined solely by price—they’re measured by the long-term success of the firm’s clients, employees, and legacy.
