June 1999 Issue



By Dan L. Goldwasser

Editor's Note: This is the second in a two-part series discussing the practical concerns of buying and selling a CPA practice. Part 2 delves into the details of the negotiation process. Part 1, which ran in May, provided an overview of the practice environment and topics to consider before deciding whether to buy or sell a practice.

Once a firm has profiled its strengths and weaknesses and made the decision that partnering with another entity will offer a competitive advantage, it must get down to the nitty-gritty of finding that perfect partner and getting together. There are many ways of locating the right merger partner, the most common of which is to let the firm's intentions be known to other accounting firms. At meetings of state and national accounting societies, partners can inform their friends and acquaintances of their firm's desire to engage in merger discussions. The accounting profession is a relatively tight-knit community, and such news generally travels fast. In addition, CPA firms tend to work closely with a number of law firms, which also come in contact with other accounting firms; these associations are another good way to make the firm's intentions known. Also, many accounting firms seek their merger candidates through advertisements in professional journals as well as through finders the specialize in putting accounting firms together.

While all of these approaches work, each has its advantages and disadvantages. Obviously, advertisements and business finders entail a certain cost that would not otherwise be incurred through word-of-mouth solicitations. By using a business finder, a firm can spare itself the trouble of dealing with those that might not make suitable merger partners and can avoid the image of being "shopped around."

Perhaps the best approach is for the firm to seriously consider the qualities it desires in a merger partner and do its own research to determine which candidates best fit this profile. The considerations detailed in Part 1 of this article can serve as a starting point for this process. The firm can then establish direct contacts to ascertain whether the selected candidates are receptive to merger discussions. While some firms might find this process awkward, in the long run it will be the least expensive and the most efficient means of achieving a desired merger.

The Negotiations

Before beginning discussions with merger candidates, the firm should determine what issues are not negotiable. By considering these issues in advance, the firm will be in a position to make quick decisions as to whether and to what extent it wishes to pursue further discussions with each potential merger candidate. For example, a firm that wishes to have all of its partners join the merged firm would be in a position to make a fast determination as to whether it wished to continue discussions with a firm that was only willing to take most, but not all, of its partners. Similarly, a firm that decides it needs a substantial cash payment should not waste time with a potential acquirer that simply is looking to merge the two firms.

It must be appreciated, however, that merger talks can be extremely destructive to any professional firm because it is difficult to keep such talks secret. Employees are likely to have strong feelings about working for a new employer, and some may wish to have a say in the merger or to look at other employers themselves. Thus, if negotiations are to be undertaken, they should be done quickly and broken off once it appears that a deal is not likely.

Just as employees may bolt from a firm engaged in merger discussions, so too may the firm's clients. For example, a client that has had a bad experience with the proposed merger partner may look upon the proposed transaction not merely adversely, but as an affront to its own sensitivities. Thus, the firm could end up losing such a client even if the transaction is never consummated.

Confidentiality. The firm should take every effort to maintain the confidentiality of merger discussions. Management, having received approval from the firm's partners to seek a merger, should not publicly discuss its talks with any particular candidate until those talks appear to be proceeding toward a possible transaction. More importantly, each member of the firm who is informed of the merger discussions must be warned of the importance of maintaining secrecy and explicitly instructed not to discuss the plans with other employees.

The negotiators should start with the basic terms of the proposed transaction, and only after agreement is reached on those matters should specific issues be addressed. The firms should first try to reach an understanding regarding the basic structure of the transaction and the compatibility of the two firms' economics, clientele, and operating philosophies. If there is no understanding reached on these items, questions of partner compensation and firm governance need never be addressed.

Sine Qua Nons. It is also important for the firm's negotiators to find out whether either party feels that there is a sine qua non to its participation in the transaction. For example, the acquirer may only be interested in a candidate if it can deliver all of its principal clients. In such a case, some effort should be made to ascertain how the necessary clients would view the proposed transaction. Many firms seeking to be acquired may be reluctant to share with any of their clients (and, particularly, their major clients) their desire to be acquired. This is a subject of enormous sensitivity. In some cases, such an issue may be resolved only by agreeing that if one or more of the necessary clients cease to utilize the firm within a specified period of time, the parties will agree to demerge. It is not uncommon for merger agreements to provide for a honeymoon period during which either party may rescind the merger on a status quo ante basis. Most consolidators will not agree to the inclusion of a demerger clause, even though they may be open to discussing demerger later if the transaction proves to be a mistake.

Frequently among sine qua non issues is the question of which partners of the acquired firm will become partners of the merged firm. The management committee of the merged firm will likely retain the authority to terminate any partner. It is important to review the provisions of the acquirer's partnership agreement (or bylaws or shareholders agreement in the case of a professional corporation) to ascertain under what circumstances and terms a partner may be expelled.

Another common sine qua non is the extent to which the partners of the acquired firm will be given "years of service" for purposes of the retirement benefits provided for in the acquiring firm's partnership agreement. While such considerations are rarely among the first issues to be considered in merger negotiations, they are frequently deal breakers--even though in most cases such issues can be resolved to the satisfaction of both parties. Regardless, they may be very important to the senior members of the acquired firm, which may possess veto power over any merger.

Management Style. In mid-sized and large accounting firms, managing partners are frequently given the power to manage the firm's practice, and a personality conflict with any such managing partner may be a precursor to a short-lived relationship. Thus, the partners of the acquired firm should carefully consider whether they would feel comfortable practicing in a firm that is managed on a day-to-day basis by the acquirer's managing partner. Unfortunately, personality conflicts are not always apparent at the outset of negotiations. Nevertheless, reasonably good insight into the personality of a managing partner can usually be obtained simply by speaking with former partners of the prospective acquirer.

Sharing of Data. Sharing data is particularly important to the firm to be acquired. Such data will normally include several years of financial statements, a list of clients, the revenues derived from major clients over the past few years, aggregate data about the types of services provided by the firm, and the volume of revenues derived from each type of service. The firms should also share payroll and billing rate data so that the compensation scales and billing rates of the two firms' professionals can be compared.

Naturally, no professional firm wishes to make such data known to others without confidentiality protections. The parties should, therefore, enter into a confidentiality agreement providing that, unless otherwise waived by the supplying party, all materials supplied in the course of merger discussions will be kept confidential and will be returned if and when merger negotiations are discontinued.

As a practical matter, merger negotiations must be conducted by a limited number of individuals on each side in order to maintain confidentiality and efficiency. Once the basic terms of the transaction have been determined, it may be possible for the remaining partners of the firm to be acquired to meet with the negotiators (and possibly other partners) of the acquirer. Such meetings, however, should not be held until substantive merger discussions are approaching their conclusion. In this way, not only is confidentiality protected, but also the time of the non-negotiating partners can be concentrated on servicing the firm's clients.

Negotiations with a consolidator generally tend to be far more complex, both because the deals tend to be more complex and because of the additional regulatory considerations. Rather than simply merging practices, a sale to a consolidator is likely to involve cash payments. Thus, the amount, timing, and conditions of these payments must be agreed upon. In addition, some acquisitions by consolidators provide for payments in the form of the consolidator's securities. In these transactions, there must be some basis for determining the value of the stock, a series of covenants designed to protect the value of those securities, as well as restrictions on the resale of those securities.

Because consolidators may not provide attest services, it will also be necessary to separate the firm's attest and nonattest services. This is usually done through a "separate practice" agreement, under which the acquired firm's partners receive a license to continue to perform attest services, and a "service" agreement, under which the consolidator agrees to lease back facilities, services, and employees to permit the partners of the acquired firm to conduct their "separate practice." As a result, these transactions tend to be far more complicated than mergers of two CPA firms.

Equally significant are the remaining regulatory concerns. There are still a great many states that have not taken a position on whether the "separate practice" format complies with existing state regulations. This means that, in such a state, there is a lingering possibility that the performance of accounting-related services through a non-CPA-owned firm violates the law. Similarly, there is a possibility that the state might conclude that the separate practice is, in fact, owned and controlled by the consolidator, thereby precluding the acquired firm from continuing to offer attest services. While these possibilities are relatively remote, they further complicate the negotiations.

The Acquisition Agreements

The parties will undoubtedly wish to negotiate a merger/acquisition agreement spelling out the terms by which the firms are to be combined. It is important for the parties to agree upon the terms of the combined firm's partnership agreement, as that agreement will govern the future operations of the firm and the terms under which the firm's partners will be compensated and the firm will be managed. Consolidators may also wish to enter into an employment agreement with each individual partner of an acquired firm.

One of the issues that the negotiators must resolve is how detailed the agreements need to be. CPAs must bear in mind that agreements are only pieces of paper with writing on them, and only evidence legal rights if the parties are willing to go to court to enforce those rights. Therefore, there is little to be gained by negotiating minute details of the transaction. It is usually far more important to develop a sense of trust and goodwill among the parties so that issues may be resolved quickly and smoothly if, and only if, they actually arise.

Acquisition agreements should record the major terms of the transaction, such as which partners and employees of the acquired firm are to become partners and employees of the merged firm, their compensation, and the amounts to be credited to the capital accounts of the acquired firm's partners. In many cases, compensation will be defined only in terms of partnership points or units, and a significant portion of a partner's annual compensation may be based upon bonuses awarded for specific contributions. There is likely to be no fixed amount of compensation attributable to any specific partner.

Many of the more important terms are likely to be found in the acquiring firm's existing partnership agreement. The partnership agreement is also likely to include a list of covenants pertaining to each partner as well as restrictions on serving firm clients following withdrawal from the firm. Such provisions frequently prompt many firms to negotiate a demerger clause that permits the acquired firm to demerge within a specified time frame under terms not governed by the acquiring firm's partnership agreement. Demerger clauses thus enable the firms to proceed quickly without ironing out all issues on the understanding that they will be addressed during the honeymoon period. If they are not addressed to the satisfaction of the acquired firm, it retains the right to rescind the merger.

The parties should reach an understanding on how they will handle claims that arise out of acts taken prior to the merger and what coverage the parties will use to cover such claims. This is frequently a sensitive issue, and its resolution may depend upon the state of the insurance market at the time of the transaction.

Similarly, agreement must be reached regarding who will take responsibility for leasehold and banking obligations of the acquired firm as well as continuing obligations to the former partners of the acquired firm. While these would normally become the obligations of the acquiring firm, in some cases they remain the obligations of the partners of the acquired firm. This usually happens when a substantial number of partners of the acquired firm do not participate in the transaction.

To be sure, the firms' lawyers will add numerous other provisions, including representations and warranties and conditions to closing. These provisions, while commonly thought of as being standard or "boilerplate" clauses, are an important part of the due diligence process, helping the parties to focus on important information regarding the practices of each firm. Because a violation of these provisions could give rise to a serious claim for damages or cause the merger to fail, they must be given careful attention.

The Odds Are Good

At some point during the next three years almost every CPA firm is likely to give serious consideration to merging its practice with another firm. The important thing is to focus clearly on the objectives to be achieved through a merger. If those objectives cannot be met, the merger should be aborted. *

Dan L. Goldwasser, Esq., is a partner at Vedder, Price, Kaufman & Kammholz in New York City.

James L. Craig, Jr. CPA
The CPA Journal

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