Accounting firms often need to merge when their business climate changes or partners reach retirement age. Some firms have talent gaps that a merger can fill, while others want to expand their reach into new geographic areas.
Whatever their motivation, CPA firms need to use extreme care when acquiring or becoming acquired. Coming together requires a solid combination of financial stability and cultural compatibility to help both sides overcome common pitfalls that can doom a CPA merger.
These are six risk factors that can undermine CPA firm mergers:
1. Getting the timing wrong
Let’s say the partners in a local CPA firm have decided to sell to a larger regional firm because they plan to retire. Picking the best time to put their firm on the market can have a substantial impact on the deal’s success. In a 2017 webinar on CPA firm merger and acquisition risks, Joseph Tarasco, CEO and senior consultant with Accountants Advisory Group, urged firms to strike when the market’s hot rather than delay and get stuck selling in a market with narrower choices.
“Timing the sale in relation to favorable market conditions, rather than a retirement date, will allow the seller to maximize the selling price,” Tarasco said. “The worst time to sell the firm is when you absolutely have to.”
2. Too many delays
It’s crucial to get as much accomplished as possible in the first two or three meetings between the merging firms.
“Time kills all deals,” Tarasco cautioned. To avoid endless meetings that keep dragging things out, both sides should agree to the most important financial data and crucial business details in those early meetings. “Having a sense of urgency getting to the letter of intent/memo of understanding phase ASAP will cut down on time to negotiate.”
Factors to settle early, Tarasco said, include:
- Partner compensation
- Equity calculation and allocation to the seller
- Voting rights
- Retirement buyout payments
- Firm name and location of offices
- Lease termination issues
- Non-equity partner arrangements
Tarasco advises creating a calendar with firm deadlines to finish due diligence, convene meet-and-greets and sign formal letters of intent/memos of understanding.
3. Mismatched valuation expectations
Buyers are always looking for bargains, while sellers want the maximum price. Partners in CPA firms they have owned for decades may have unrealistic expectations of how much their business can sell for. By the same token, acquirers may not understand the full value they are buying into.
“The valuation expectations between the seller and buyer can differ significantly and be a major deal-breaker,” Tarasco said. “Once initial financial information is exchanged, valuations should be discussed and agreed upon quickly, as they tend to drag on and create enough friction between parties to terminate the transaction.”
3. Culture and ego clashes
Early meetings should give both sides in a merger a good look at the people they will be working with. Leaders should keep a keen eye for potential cultural issues and personality conflicts that could trip up a merger.
“The most important factor is that the merging firms be culturally compatible,” M&A attorney Russell Shapiro said in an interview with AccountingWEB. “Just like a marriage, it won’t work if nothing is the same. Why? The partners have to be able to work things out, to be able to talk together on things. You have to see if the practice fits.”
Shapiro, who has structured some of the biggest U.S. CPA firm mergers in recent years, cautions against assuming anything about your partner in the transaction. If you have questions, ask them.
“Don’t make the mistake that a lot of smaller practices do — thinking that the larger firm has a better grasp on how to do things, so you don’t ask the important questions,” Shapiro said. “Don’t be dazzled.”
4. Lack of capacity after the merger
Larger firms may acquire smaller practices with the idea of taking on more work that leads to more revenue and profits. But, that can create unanticipated challenges.
“CPA firm owners often sell because they want to stop practicing,” CPA Brannon Poe wrote in an article for the Journal of Accountancy. “This raises the obvious question: Who is going to do the owners’ work after the sale? If you are acquiring a firm, you need to have significant capacity or your client-service will suffer. You will experience a dip in results, which can lead not only to client losses but also to critical staff losses. Head count is absolutely key.”
Poe urges acquiring firms to beef up their management systems to make them more efficient, hire the talent they need, or even acquire a whole practice to bring in new skills and experience.
5. Inadequate due diligence
Both sides need to be sure they know what they are getting into. “One of the most important considerations is the professional liability risk that can arise from combining with another firm,” CPA Amy Waldron said in an article in the Journal of Accountancy. Waldron said proper due diligence is key to discovering these liabilities. She advises close scrutiny of:
- Personnel: Examine the certifications, licenses, training, and work experience of all partners plus their top managers.
- Clientele: Make sure you know the kinds of accounts you will be bringing together — this includes when contracts start and end.
- Financials: Get a clear picture of both companies’ revenues, profitability, debts, leases, insurance policies, and likely financial risks.
- Quality control: Make sure there’s a process for ensuring high-quality client service during and after the transaction.
6. Insurance oversights
Insurance policies raise a host of concerns when firms buy and sell. John Raspante, a CPA and expert on liabilities arising from CPA firm mergers, co-hosted the webinar with Joseph Tarasco. He noted several key insurance issues:
- Engagement letters: Agreements with clients need to have special “successors and assigns” language to ensure they remain legally binding after the merger.
- Confidentiality: Client data must be protected to avert expensive privacy litigation. Mergers and acquisitions are special cases, however, because they require due diligence that could expose private data to a third party.
- Conflicts of interests: Merger deals need to eliminate conflicts of interest that could lead to litigation. This is a major concern, Raspante said, because mergers might include ex-wives, former business partners, and competing companies as clients.
- Software: Mergers may create software incompatibilities that affect service delivery, creating potential for litigation.
- Tail coverage: This is a specific kind of insurance that covers gaps in standard liability coverage that might occur in a merger. If you’re merging, make sure your insurance carrier explains to you how tail coverage works and why it is so important.
If you have questions about the risks inherent to CPA mergers, contact us at McGowan today.