In previous blogs, I discussed the need to assess the level of need you have for replacing retiring partners, how to assess your firm’s potential for partner level talent, and developing that talent into viable successors. The next step in this five step process is to make sure your owner agreement is financially feasible for all of your firm’s owners.
Keep in mind this simple principle. Buyers don’t make acquisitions to lose money. If you are retiring, your partners are your buyers. You should not expect them to borrow money or take a step back in compensation in order to fund your buyout. At the same time, you should be paid fairly for your years of sweat equity building up the value of your firm. So, how do you accomplish both objectives?
We call this technique a “backwards valuation”. The capital the firm has available to fund the buyout of a retiring owner is their compensation before they retire. You need to do three things with that capital: 1) Replace the owner, 2) Pay for their buyout, and 3) Leave some profit to create upside for the remaining partners that will be taking on the responsibilities that owner left behind.
Normally you can arrive at a cost for replacing a retiring owner by assessing the cost of replacing their billable dollars (or if they have other responsibilities what you would pay someone off the street to do those things). If they produce $300,000 annually in billable time, the replacement cost might be $120,000.
Usually the problem with paying for a buyout and leaving enough behind is not the gross amount due assuming the multiple doesn’t exceed one times revenue (for book of business or equity based plans) or three times for compensation based plans. The problem normally occurs due to a payment period that is too short. Plans with five years or less for the retirement payments and one year or less for the capital are usually hard to fund without creating negative cash flow. Consider a plan that pays the retirement (also known as the “intangible value”) over 8 to 12 years and the capital over 3 to 5 years. The retiring owner isn’t really giving up much by receiving the payments over a longer period and the firm benefits greatly by avoiding negative cash flow.
If your owner agreement holds to the principle that owner buyouts should be self-funding, the retiring owners should not feel like they were shorted in the value of their buyout and the owners that are taking on the obligation should have no fear the plan will create an unreasonable financial burden.
About the Author
Terrence Putney, CPA (firstname.lastname@example.org) is CEO of Transition Advisors, LLC, www.transitionadvisors.com, which exclusively consults on succession and growth strategies for accounting practices nationally and ownership transition. He can be reached at email@example.com or 866-279-8550.