Growth and succession in small to mid-size accounting practices

By Max T. Krotman

The accounting profession is now experiencing a new phenomenon that is directly related to a precipitous decrease in the number of accounting professionals graduating from our academic institutions.

This change has had a major effect on the internal growth of existing firms, the succession planning within firms and the lengthening careers of senior accounting practitioners.

The talent pool differential

In the last 30 years, the pool of talented people who studied accounting has decreased sharply. During that period, many outstanding students who formerly would have gone into accounting chose careers in law and finance. As a result, there are fewer top professionals in our field than there were three decades ago.

Therefore, partners in accounting firms who are currently between the ages of 50-65 are faced with the problem of passing the torch to professionals who have lesser abilities than in previous years. This problem is particularly acute in small and medium-size firms.

Dealing with the shortfall

For the last 10 years, small and mid-size firms have responded to the shortfall in this age group with a variety of internal responses, such as the following:

Bidding up the price of available talent.
Intensely nurturing the talent available.
Utilizing technology to leverage the time of the partners and the staff.
Avoiding the provision of services that are less profitable or highly time-consuming, such as client payroll work, bookkeeping, etc.
Merging practices to increase efficient use of talent and incorporating organizational efficiencies, freeing partners from non-billable administrative time.
Retaining senior partners beyond expected retirement age.
Turning away new clients or shedding existing clients.
Shoddy work.

Some of these tactics inevitably lead to overwork and frustration.

The first choice to solve the shortage of staff is internal — to promote from within. If that process does not meet the firm’s needs, they go outside to hire the talent necessary to insure their survival, growth and ultimately their ability to pay out retiring partners. Because of market conditions, it is often necessary to use an executive search agency to find the right people.

There are positive aspects to each approach. Promoting from within provides hope and incentive to the next generation. They may be motivated to work harder because they see that good service is rewarded by advancement. It is also helpful to the firm because they are working with a “known quantity.” Among the advantages of importing outside talent are new skills and ideas. There is also the possibility of expansion that may bring new clients.

If neither of the methods is satisfactory, it is necessary to use external solutions.

Mergers and acquisitions

Partially because of the talent shortage but also because of the increasing realization of the benefits of mergers and acquisitions, the M&A route has become much more popular in recent years and figures to become still more popular in the future.

First: Acquisition or merger-in of partners from another firm

Usually, a firm seeks to acquire / merge-in a smaller firm. Ideally, the combined firm will have these characteristics:

The new equity partners will be a minority.
The collections brought in by the new equity partners will be less than half of those of the combined firm. Ideally, the revenues of the new partners would be closer to one third of the total.

For example, a $2 million, four-partner firm would seek to merge with a two-partner, $1 million firm. A $6 million, six-partner firm tries to find a firm with less than $2 million in collections and fewer than three equity partners. If these ratios hold, all partners can add significantly to their books of business because they will be able to take advantage of the larger firm’s administrative infrastructure.

By selecting a smaller firm, the larger firm seeks to maintain the pre-eminence of its partners. The goal is to acquire the staff and niches developed by the smaller firm and to use the expertise and billing rate of the larger firm to increase the income generated by the partners from the smaller firm.

Of course, the situation occasionally works in reverse: A very efficient, smaller firm successfully acquires a firm with more billings and more partners but is far less profitable per partner because each one manages a smaller book. However, when the larger firm is committed to following the model of the more efficient, more profitable company, the combined firm benefits from its instant addition of the partners it needs to expand.

Second: Acquisition of a smaller firm to obtain staff and future partners

A very successful option is for a larger firm to purchase / merge a firm in which the senior partners are approaching retirement age but have developed an excellent staff. These employees can be not only a working asset in the combined firm but also may ultimately supply one or more future partners. In this scenario, the senior partners may remain full or part time for a finite period.

Frequently, the partners in the acquired firm who are planning retirement feel insecure about their original firm’s ability to pay them out. They are often willing to sell to obtain security. In the current market, this works well for the selling firm. They have not had to share their profits with junior partners and have not diverted their energies nurturing talent.

These merger / buyouts work best when the staffs of the two firms are complementary or when the overpriced long-term staff of the acquired firm can be retired, saving payroll expense. Usually, some or all of the partners in the acquired firm want to work for one to five more years after the merger, but their primary goal is to ensure their retirement. On the other hand, the acquiring firm may value a high-quality staff more than the clients purchased.

Third: Merger of a smaller firm into a larger firm to secure succession

If a firm cannot develop younger partners, it can merge with a smaller, more youthful firm whose partners will become the future successors. The larger firm commences this program when a senior partner intends to retire within the next one to three years, even though retirement may be five to 10 years away for most of the partners

In the short run, the merged partners of the smaller firm give up their pre-eminence to the senior partners of the larger firm. The larger the firm, the larger the constraints.

However, these mergers are most successful when the smaller firm’s partners are mature enough to appreciate the increased earnings, security and future opportunities they will enjoy with the bigger firm.

Fourth: Merger of a firm or a partner into a very large firm

The Big 4 and a host of accounting firms with more than $20 million in revenues offer another option to many firms and partners. These firms can easily absorb a partner and his clients. The partner is not “bought out.” He or she joins the firm and receives his or her standard or “tweaked” retirement payout.

That arrangement is extremely satisfactory to those who are satisfied with being a respected, well-remunerated professional. Others grimace at the change in role to “cog,” from “master of his or her domain.”

The April 2005 issue of Accounting Today lists, for the first time, 100 firms with more than $20 million in stated annual revenues. These firms can absorb a partner or firm and assure a payout, at least on paper.

No firm is totally secure. The disintegration of Arthur Andersen and the demise of other leading firms in the past 30 years proves the rule that size alone is no guarantee of safety. There is a good argument to be made that a smaller, solid firm is a better source of security than a very large firm whose financial health defies accurate analysis. However, the smaller firm must constantly be alert to keep enough high-quality staff to maintain its status.

Summarizing imperatives of mergers among small to medium-size firms

In all successful mergers, the increased financial rewards resulting from the economies of operating through one organization help to smooth egos. Some of the economies result from 1) shared technology expertise and expense; 2) the affordability and availability of higher-level talent (for example, a larger firm can economically employ a tax partner or litigation support specialist who can bill a higher hourly rate in his or her specialty than the generalist who provides some of the same services); and 3) the ability to cross-sell clients through the additional support that a larger firm can offer its partners.

Staff synergies are the next key to successful sales or mergers of practices. Advantages are 1) complementary staffs — good juniors from one firm and good seniors from another; 2) the ability to excess overpaid people; 3) the addition of staff with expertise in areas useful to the firm; and 4) complementary staff time, such as the merger of a firm specializing in tax services with another that has underutilized time during tax season. These same factors apply to the skill sets and expertise of the partners, both professionally and administratively.

Technological differentials are more of a plus than a minus. Even if one firm is light years ahead of another, it will take less than a year to bring the weaker firm up to snuff. The flip side is that the incremental cost to equip and train the new people is dwarfed by the additional time and efficiency recovered.

Finally, the personalities of the firms must work or the merger will not be successful. There must be basic agreement on moral issues in addition to personalities that are not abrasive with each other.

Fortunately, these issues emerge very quickly in the preliminary meetings between firms. They come out in the first meeting, the negotiation process, the due diligence and the documentation. If there are problems, they can usually be settled if all parties are alert, but not paranoid.

There are so many firms with $20 million or more in annual revenues because an increasing number of practitioners see the value in merging. At lower levels of revenue, there are proportionate benefits. The right sale, merger or acquisition is truly a win-win proposition.

Max T. Krotman, JD, is vice president and general counsel at Globalforce International Inc., in Melville, NY. He can be reached at mkrotman@globalforceintl.com.

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