By R. Peter Fontaine, Managing Partner, NewGate Law
Given the enormous disruptive effect of the COVID-19 crisis, it is surprising that mergers and acquisitions are still very much near the top of accounting firm agendas. In a word, sellers want to sell – and – buyers want to buy. Let us look at the reasons we have seen that contribute to the continued strength of acquisitions, as well as the changes and challenges confronting buyers and sellers in a COVID world.
CPA Succession Planning — Sellers Want to Sell
Many accounting firms have lost client revenues as a result of the Coronavirus. Accounting firm clients cannot afford to pay or are slow to pay fees, putting pressure on cash flow. Some firm clients have gone out of business altogether. The hardest hit industries are hospitality, travel, retail, personal services, and dealerships. Even with the help of the Paycheck Protection Program loans and other federal and state financial assistance and tax relief programs, accounting firms may struggle to meet their current and future expenses – most notably real estate leases. Firms with significant retired partner payment obligations are particularly vulnerable to financial struggles. CP
While firms may survive in the short run, the prospects for the future might be dim. In order to compete effectively for new clients and staff, firms will need to make significant investments in new service offerings, technology, expertise, staff and risk management practices. Finally, partners who saw retirement on their horizon may be forced to work longer (and harder) than anticipated.
CPA Growth Planning - Buyers Want to Buy
Just like sellers, many buyers have lost clients and staff. In order to replace revenue and its workforce, larger firms are in the market to acquire the right sellers. Growing organically may not be a viable option; the competition for clients and talent may be too intense to restore clients and staff in any meaningful timeframe.
More than ever, buyers are exploring new services lines, particularly consulting services where margins are higher (e.g. technology consulting, benefits administration, transaction advisory, healthcare consulting, investment advisory/financial planning). It is far easier to acquire these practices than to build them. Perhaps most importantly, there are a lot of great — albeit distressed — firms available for sale, usually at an exceptionally good price. Opportunities abound.
CPA Firm M&A Dealmaking Trends
Here are some of the trends that we are seeing in the COVID-19 merger and acquisition world.
- There are many factors that make firms attractive (or unattractive) to buyers. Client base, location, revenue, margin, realization, and the like still are on the top of the list. That said, criteria previously given less attention include:
- The seller’s management quality, technology infrastructure, risk management practices, staff recruitment and retention programs, billing and collection, policies are becoming more important to buyers. Why? Deficiencies in these factors may strain integration and require a significant investment by the buyer (i.e. money and time) to bring them up to the buyer’s standards.
- Stable practices, particularly those in higher demand specialties or desirable geographies will see their purchase price going up. Even though a seller maybe distressed, buyers are willing to pay a premium for attractive practices in order to nudge out the competition.
Buyers are reconsidering how to value firms. The traditional way of setting accounting firm purchase prices has been a multiple of revenue. Buyers are now focusing greater attention on earnings as a more accurate measure of value. In addition, purchase prices are nearly always based on collections over a period of years, with minimal if any guarantees.
While a significant down payment has never been the norm, it is now a rarity. Buyers are already strapped for cash flow, and they are not inclined to further exacerbate the situation with a downstroke. Further, the amount of revenue that will be transitioned to a buyer is more unpredictable than it had been in the pre-COVID environment.
The ownership of accounts receivable and work-in-process is often subject to negotiation between buyers and sellers during normal times. Today, buyers are more insistent on acquiring or borrowing against the seller’s AP and WIP. The obvious reason is preserving or increasing cash flow.
Buyers are reluctant to assume the entire amount of large payment obligations to retired partners. Buyers may assume a part of the payment, leaving the sellers with the balance to either pay or renegotiate. The retired partners may have no other choice than to accept an amount less than full amount due; otherwise they risk receiving nothing.
The future of the firm office is uncertain, although it is pretty clear that more employees will be working from home (if COVID-19 has taught us anything, it is that accountants do not need to be in the office to be effective.) Accordingly, buyers may balk at assuming a real estate lease because of the uncertainty of space utilization as well as cash flow concerns.
Other CPA M&A Logistics & Legalities
The COVID-19 era has certainly changed the logistics and legalities of the acquisition. Here is a short list of those areas, which have come to the surface.
- The timing of transactions is accelerating. The situation facing sellers can devolve quickly, and they are anxious to close and avoid the challenges of continuing their practice. Decisions need to be made rapidly. Some larger firms are authorizing a small group of owners to negotiate and shepherd a transaction.
- The usual acquisition process includes multiple face-to-face meetings between the principals of the buyer and seller. In addition, buyers will typically meet with staff and possibly some clients to assess the prospects of a successful integration. COVID-19 has truncated in-person meetings. Masked communications in a social distancing bubble and Zoom meetings are less than optimal, but are becoming the norm, which can add to the uncertainty surrounding a transaction.
- A lot of the due diligence process involves the exchange of documents — something that can be done using technology. Nonetheless, the limited availability of personnel and information because of COVID-19 protection practices can affect the completeness and depth of information. In addition, the pressure to close quickly compresses the amount of due diligence that can be performed.
- The transfer of employees from seller to buyer can be a “wild card.” Some of the seller’s employees may have been furloughed or terminated. Whether they will come back to work for the buyer may be uncertain. Staff may have found another job or decided to abandon public accounting altogether. Some of the seller’s employees may have adopted the work-at-home lifestyle and elect not to work for a buyer that insists on a return to pre-Coronavirus officing. Additionally, buyers may opt for utilizing “fractional employees” — benefiting the cash flow stresses.
- Given that the actual unemployment rate is hovering around 20%, the successful enforcement of restrictive covenants against persons terminated because of COVID-19 is in question. These are unprecedented times, and fully enforcing the terms of restrictive covenants may be viewed as an unreasonable restraint on an employee’s ability to earn a living. As a result, employees may be able to take clients away from the firm with impunity.
- The requirements for successfully integrating an acquired firm into the buyer’s organization are always underestimated. This challenge is likely to be even more pronounced in the COVID-19 environment. The restrictions on in-person meetings and access to offices and personnel, limitations on technology and other infrastructure, the questions surrounding personnel already mentioned, and the availability of clients are just a few tests that may face buyers and sellers.
- Acquisition agreements may not be as comprehensive as usual. Because of the accelerated closing deadline, traditional representations and warranties may be omitted. This can lead to expanded seller indemnities. The conditions that can trigger termination or even reversal of an acquisition agreement are becoming more prominent and need to be clearly spelled out — most importantly, a significant loss of clients or personnel. Finally, discussions may be rushed, and some of the terms not fully negotiated, with the existing ambiguity only to emerge later around key provisions.
Needless to say, the COVID-19 crisis has changed just about everything in the world. Accounting firm mergers and acquisitions are no exception. However, with the right frame of mind, this adversity can create new opportunities and be a source of innovation.
Successfully executing these mergers will require vision, creativity, flexibility, and patience. We see firms forging new transaction structures aimed at reducing the risks surrounding the uncertainties of the future — both for buyers and sellers. These include trial mergers, delayed closing, employee sharing, administrative services arrangements, co-branding, strategic alliances, and minimum client retention thresholds. The accounting profession will find the right answers to questions yet to be asked. What lives inside of us is much stronger than what lies in front of us.
NewGate Law® provides a broad range of legal and risk management services exclusively to the accounting industry. Learn more about NewGate Law by visiting their website at newgate.law or by contacting R. Peter Fontaine, founder and managing partner, at firstname.lastname@example.org or (312) 626-2791.
You may also be interesting in our blog post about Employment Liability Risk Management for CPA firms after COVID-19.