1 Succession planning for practitioners, Part 1 By JEFF BUCKSTEIN, CGA This is the first of two articles by Mr. Buckstein on Succession planning for practitioners to be carried on PDNet. The initial stages of succession planning The succession process After the sale Although succession planning is one of the most important activities CGA practitioners will ever undertake, many have never put adequate thought into this process. A so-called exit strategy can, after all, be an extremely unpleasant subject to contemplate at any stage during one s accounting career. Many practitioners have worked 50 to 60 hour weeks for years to build up their practice and bring clients on board; thus, the emotional process involved in letting go of such a personal investment and transferring trust to somebody else can be a most daunting challenge. Most practitioners eventually retire, however, and end up selecting one of four major succession strategies. They will either: refer clients and walk away from their practice without receiving any value, merge the practice and develop a partnership, sell their practice, or promote an employee from within as their successor. The initial stages of succession planning Ideally, succession planning needs to be tackled when the practice is first set up and reviewed periodically on a regular basis thereafter. Once the practice is established and the practitioner gets busy with the daily pressures and demands that ensue, it becomes much more difficult to initiate the succession planning process. Being proactive when it comes to succession planning affords practitioners several potential advantages, allowing them to focus on building a portfolio of perhaps slightly higher quality accounts, as well as, to hire professionals with the personal characteristics and business savvy necessary to take over their practice in the future. With respect to the latter, practitioners will therefore need to assess more than technical ability when they evaluate how certain employees perform on the job. In addition to strong moral and personal ethics, the individual who eventually succeeds at the helm of their practice will require the right managerial personality. This includes strong communications skills to motivate other partners, employees, and clients. He or she will also require business vision and the confidence and ability to market ensuing plans. These skills could take years to mature, particularly in a younger employee. The chosen successor must also become knowledgeable about all aspects and details of the practice, including the Code of Ethical Principles and Rules of Conduct (CEPROC) specific to public practice, as well as other applicable legislation.
2 Although most partners who establish practices are approximately the same age, for succession planning purposes, it is usually best if the succeeding partner is younger, ideally by about 10 to 20 years, so that the succession is properly spaced out. Of the four succession strategies, promoting an employee from within to take over the practice offers the potential for smoothest transition, including the highest rate of client retention, and best ultimate sales value. It also demands a significant amount of effort from both parties to establish a trusting, nurturing atmosphere. Once a decision is made as to who the ultimate successor is going to be, the practitioner must take the time to properly train that person and provide him or her with full access to information about the practice. The successor must be encouraged to participate, and then take the lead, in all of the activities the founder usually handles, including meeting with bankers and existing clients, recruiting new clients, and hiring and managing staff. Good communications networks are crucial elements of a successful transition. It is especially important to let clients know that somebody has been handpicked who will provide them with the same level of care as the founder. Winning over the clients and employees trust will ultimately be a key component in determining whether the practice will continue to thrive or will even survive. Conversely, not undertaking succession planning early enough means it may be much more difficult, particularly in a remote geographic area, to attract the quality of employees needed to take over and continue the practice. Furthermore, the seller is less likely to get his or her asking price for the practice because prospective purchasers, aware there has been a lack of planning, would probably expect to lose a higher percentage of the existing client base than they otherwise would have. They discount this factor into what they are willing to pay. Practitioners should hedge their bets While an accounting practice is one of the most important assets a practitioner will ever invest in, it is important to remember that despite his or her best efforts to preserve its value, there are so many external factors beyond the practitioner s control that could quickly dissipate that value. Although it is an old cliché, an accounting practitioner should ensure they haven t put all their financial eggs in one basket by counting on the sale of that practice to provide their exclusive financial means for retirement. Like all other investors, practitioners need to make sure they are well diversified and must protect themselves through smart, common sense measures, such as, consistently contributing a certain percentage of their income into a personal RRSP. Insurance can also play a key role in protecting their accounting practice in the event of disability or death. The proceeds from a partnership or shareholder insurance policy, for instance, can be used to provide the surviving/remaining partners with a tax-efficient mechanism to purchase the previous partner s shares. In the event of a disability, insurance can provide income replacement when a family breadwinner is unable to make a living and its members lose the benefit of his or her income. According to the National Underwriter Company, an insurance publisher based in Erlanger, Kentucky, suffering a long-term disability at age 30 is statistically about four times more likely to occur than death during the prime earning years; that reduces to about three times more likely at age 40; and just over twice as likely at age 50. Life insurance proceeds provide several benefits from a taxation standpoint, including: a taxfree build up, tax-free withdrawals under certain circumstances, and death benefits that are also generally tax-free. It is best to consult an insurance professional, who is qualified to Succession planning for practitioners, Part 1 2
3 provide detailed advice concerning issues, such as, whether to purchase term or whole life insurance, or whether other products, such as critical illness insurance, may also be a wise investment. Joining forces to create informal/formal alliances Today s CGA practitioners face unprecedented demands on many fronts, including having to conform to a larger volume of regulatory standards and professional requirements, as well as, dealing with client demands for more specialized services. In an increasingly complex and competitive business environment, it is impossible for a sole practitioner to keep abreast of every development affecting the accounting profession. Faced with these new realities, many have elected to join forces with fellow CGA practitioners, and sometimes, with other professionals as well. This practice is not new. Many smaller practitioners have, over the past 10 to 15 years, formed temporary, informal strategic alliances with professionals from other disciplines including law, insurance, financial planning, real estate, and the investment brokerage industry. They have done this to better serve complex client issues they did not have the resources to handle on their own. Such developments often have a significant impact on succession planning because, in addition to providing the firm with the critical mass necessary to compete on a more level playing field, they also provide employees, that are being groomed to take over the practice, a new slate of professional colleagues with which to work. Various synergies are created through these alliances. Members of the larger firm that results are, for example, better able to keep up with rapidly moving national and international events, including advances in information technology, new accounting regulations, and tax updates. CGA practitioners increase their competitiveness by specializing in areas, such as estate planning and tax work, auditing, and other areas essential to their practice. Aligning with other practitioners also helps CGA professionals to meet client demands for more specialized services, including succession planning, by offering in-house professional expertise in crucial areas like financial and estate planning. Creating a formal alliance with members of another CGA firm requires a lot of preparatory work. Both sides need to closely examine a number of factors, many of them intangible, to ensure they have the right fit. Potential financial gains, from increased business and/or reduced sundry administrative expenses, warrant prime consideration. Other important factors include the personal compatibility, business vision, and client-service philosophy of the would-be partners. If the goals and philosophies of the senior partners do not mesh, this could lead to legal difficulties in later trying to dissolve an unworkable partnership. The succession process A potential successor will need to conduct due diligence by personally reviewing the original practitioner s files, financial statements, information systems and technology, and other aspects of the firm s operations, before deciding whether to buy into a practice. Under those conditions, it is prudent to have anyone inspecting the files sign a confidentiality agreement to preserve the privacy of what they have seen. In addition to any private agreement signed between the prospective buyer and seller, both CGA parties must, of course, always adhere to the Association s confidentiality rules, as well as, to any applicable federal and/or provincial legislation concerning individual privacy and/or protection of information. Succession planning for practitioners, Part 1 3
4 Both sides must come up with an objective value for the practice in question, taking into account both quantitative and qualitative factors. There are several important quantitative values, including: net income, operating expenses, and annual billings or revenue that will, of course, bear close scrutiny. With respect to annual revenue, for instance, prospective purchasers will need to examine those revenues to determine whether they have been received on a one-time rather than on a consistent basis, and the relationship between hours billed and hours worked. The incoming practitioner is also going to want to know how the standard billing rates factor into annual revenue. For example, $50,000 worth of review engagements at an hourly rate of $100 is probably not going to be worth as much, on balance, as $50,000 worth of engagements with the hourly rate of $150. The breakdown between earned revenue from audit, review, compilation, tax, consulting, and other specialized work is also important. Practices with a healthy balance between personal and corporate tax, consulting, and other services tend to attract a better sale price than practices focused exclusively on personal work. The information systems and technology used to operate the practice, as well as the niche in which the practice is focused, are also important factors that will influence the final sale price. A qualitative assessment can be much harder to undertake but one component, goodwill, constitutes an integral part of a practice s true value. Because accounting is a highly personal business, a practice essentially consists of a book of clients that the founder has built up and cultivated; hence, there is inherent goodwill. Ensuring the existing client base stays intact will likely result in protecting the future cash flow of an accounting practice. Thus, the prospective purchaser will need to closely examine several factors, including the quality of the existing files, and the age of the clientele. Ideally, it is best if most clients are about the same age as the incoming practitioner, because that usually increases both parties chances of building a personal relationship. If, in contrast, a large chunk of the client base is much older and perhaps close to retirement, that might raise concerns, unless they run a family-owned business that is engaged in its own succession-planning exercise. Other factors the prospective successor must consider are: the skill level, technical proficiency, age, and personal loyalties of the existing staff, as well as, their ability to attract and retain clients. It may be important to retain the firm s employees, as well as the original practitioner, for a period of time, in order to reassure clients that there will be continuity in the practice. Existing agreements between partners might also have a bearing on the sale price. Thus, it is incumbent upon the new practitioner to fully understand ahead of time what, if any, extra contractual arrangements may be involved when entering into an existing partnership. Demographics will also impact the final sales price. The supply and demand for accounting practices in a particular geographic area, as well as the size of the community in which the sale is taking place, are important factors. For example, a practice facing little competition in a smaller town may be able to get much more long-term business from a certain number of files than a practice located in a larger center with the equivalent, or an even slightly larger, number of files. Financing a sale Although the terms of each sale are unique to the parties involved and can vary widely, often the sale of an accounting practice will involve a down payment of approximately one quarter to one third of the total purchase price, with the rest of the payout extending another two or three years. Succession planning for practitioners, Part 1 4
5 A good rule of thumb is to arrange for the remaining payout, if there is any, to occur on a sliding scale, based on the retention of clients. The decreasing probability that, as time passes, the original client base will remain intact must be taken into account. During the first year following a succession, a client will likely remain loyal, based on the original practitioner s ties and influence. After that, however, the client is much more likely to judge the new practitioner on his or her own merits. It is, therefore, reasonable to assume that for a variety of potential reasons (i.e., lack of rapport with the new practitioner, retirement, being forced out of business), a certain number of clients will be lost during the payout period. This, of course, does not preclude the probability that, even as they lose existing clients, the new practitioner will also be bringing in his or her own new clients, and possibly building up an even stronger practice. In British Columbia, for example, what normally happens upon the sale of an accounting practice is that the new practitioner puts down one-third of the total purchase price. Discounted instalment payments are then made over the next two years. The middle third of the purchase price is payable after one year, discounted for the number of clients that leave. The final third, also discounted for lost clientele, is due at the end of the second year. Take, for example, a practice with 100 clients, sold for a total of $90,000, with a down payment of $30,000. Another $30,000 would be due at the end of the first year, discounted for the number of clients lost. If five clients left that year, the $30,000 payment would have to be discounted by five per cent, to $28,500. At the end of the second year, when 80 clients remain, the remaining $30,000 due would then be discounted by 20 per cent, to $24,000. Thus, the total purchase price of $90,000 would be discounted to $82,500. Another possibility is for vendors to establish a payout period, whereby the remaining instalment payments are heavily weighted at the front end. Assume again that a business is sold for $90,000, with a $30,000 down payment, except this time instalment payments cover a three-year period, instead of a two-year period. The incoming practitioner would, therefore, owe $60,000. The way this works is: they would pay, for example, 50 per cent of the amount owing ($30,000) at the end of the first year, proportionately discounted for the loss of any customers; 33 per cent following the second year ($20,000, proportionately discounted); and, 17 per cent ($10,000, proportionately discounted), following the third year. By paying more up front, the new practitioner is acknowledging that the existing client base is less likely to remain intact as time passes. He or she is acknowledging also that the goodwill of the exiting practitioner is vanishing while their own is forming. Taxation issues The goodwill emanating from an existing client base is the main taxation issue practitioners need to take into account when selling a practice. There are several related issues that need to be considered in conjunction with that goodwill, including: whether or not the practitioner has a balance in his or her cumulative eligible capital (CEC) account, in which case, the goodwill proceeds may be required to first offset that; and, whether an earn-out agreement might alter the timing of the income recognition and, therefore, the taxes due. Should the CGA practitioner reside in a jurisdiction that allows them to incorporate, he or she might want to take advantage of establishing a professional corporation and selling shares in order to qualify for, and take advantage of, the small business capital gains deduction. In British Columbia and Alberta, where provincial legislation has allowed incorporation to take place for several years, it is common for some practitioners to offer shares in their own practice. However, the degree to which that is allowed and practiced varies by province. To Succession planning for practitioners, Part 1 5
6 After the sale date, most CGA practitioners have not incorporated; although, the phenomenon of incorporating is expected to grow because of recent amendments to professional corporations legislation in several provinces outside of British Columbia and Alberta. The issuance of corporate shares could potentially form a key cornerstone of the original practitioner s succession policy. Gradually issuing shares in the firm could, for instance, be used as a strategy to bring a younger practitioner in as partner. Even after a practice has been sold, there may still be significant challenges ahead. Unlike a company that is selling a product, where personalities often do not matter a great deal, the accounting practitioner/client relationship is usually very personal. Therefore, it is often a smart strategy to have the original practitioner stay on for a reasonable period of time after the sale has taken place. The terms of this arrangement will, of course, vary depending on the type of agreement, if any, that the incoming and outgoing principals find practical to negotiate. In practice, when having an original practitioner stay on can be successfully negotiated, the time period involved often works out to about one or two years; although, two full years is preferable to ease the successor into a comfortable relationship with the firm s clients. If the successor is a former employee, this could lead to a complete role reversal, but many practitioners have found that there are advantages to being a temporary employee, subcontractor or consultant in their old practice. This way, they have the best of both worlds; they can slowly ease out of their firm while still enjoying an important, active role in its operations. This is important particularly when the practice has been purchased by somebody who is from outside the firm, rather than by an employee groomed from within. In this case, the selling practitioner should anticipate that clients might initially feel uncomfortable with a successor with whom they had not had the opportunity to work and the original practitioner should do his or her best to ameliorate these concerns. Thus, even when the practitioner chooses to simply sell their practice, it might still be beneficial for the predecessor to stay for a reasonable transition period of perhaps 18 to 24 months to help the newcomer deal with clients and to establish that all important trust. Much more than the loyalty of a firm s clients and the harmony of its employees could be jeopardized if this part of the succession is not adequately planned. Since a significant portion of a firm s sale price is often based upon the percentage of clients retained, it is also in the seller s financial interest to do all he or she can to help maximize a practice s income stream during the transition period. As a rule of thumb, however, it is usually best for the original owner to stay on with the firm only if they are emotionally willing to let their successor take over. That means they should not be doing anything to undermine that person, such as meeting with, or taking phone calls from, clients about key issues without the successor present, unless he or she has previously agreed to that arrangement. Ideally, during this transition, the original practitioner will be able to strike a reasonable balance between being available to assist the successor and allowing him or her freedom to run the practice as they see fit. It is important that the exiting practitioner is not overly critical of business decisions undertaken by their successor. Succession planning for practitioners, Part 1 6
7 Non-competition restrictions Non-competition agreements between the original owner and his or her successor are often drawn up to protect the personal relationship the incoming CGA has with their new client. Understandably, the agreement is to ensure as much as it is possible to do so, that the original owner will not leave and take the practice s best clients with them. Such contracts must be drawn up carefully to ensure that they would be judged reasonable by a court of law if the legal system was required to rule upon such factors as the length of time, or geographic distance, to which the agreement pertains. A word of caution, however, given that it is human nature for clients to form close personal contact with practitioners, it may be difficult to enforce such a contract if the client insists on maintaining a professional relationship with the predecessor. Regardless, the transition techniques described above may significantly reduce the risk of losing clients to the departing practitioner. Disclaimer While great care was taken to ensure the accuracy and contemporary nature of the information contained in this report, it is presented to CGA-practitioners as a succession planning guideline only. CGA Canada and the author do not assume liability for financial decisions and other succession planning strategies based in whole or in part on this report. Readers are advised to analyze all relevant facts and scenarios in arriving at all financial decisions and in making succession planning strategies for themselves and for their clients. Jeff Buckstein, CGA, is a freelance business writer in Ottawa, Ontario. Coming next month: the last article in this two-part series on Succession planning for practitioners. Appendices Appendix 1 Published succession planning materials Appendix 2 CGA practitioners with succession planning expertise (partial list) Succession planning for practitioners, Part 1 7