admitting partners valuing equity 10-23-14...• tangible pool of equity – accrual basis book...
TRANSCRIPT
Admitting Partners and
Valuing Equity for Internal Valuing Equity for Internal
Transfers of Ownership
Terrence Putney, CPA, CEO
Transition Advisors
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Transition Advisors
National Consulting Firm working exclusively with
accounting firms on issues related to ownership transition
Today’s Agenda
1. Valuing equity in your firm
2. Basic financial terms for
buying out partners
3. Backwards valuation
4. Other buyout terms to consider4. Other buyout terms to consider
5. Techniques for admitting new
partners
Polling Question
Does your firm have an owner agreement?
1) Yes, and it is signed by all owners
2) Yes, but not all owners have signed it
3) No, but we need one3) No, but we need one
4) No, and we aren’t sure we need one
Total Value
• Tangible pool of equity
– Accrual basis book value
– Receivables, WIP, other assets,
less liabilitiesless liabilities
• Intangible pool of equity
– Client list is the predominant
asset
– Also workforce, brand, etc.
Valuing Intangible Equity
Methods for Valuing
Intangible Equity
• Book of business
• Equity multiple• Equity multiple
• Compensation multiple
• Hybrids
Valuation Methods-Intangibles
Valuation methodology-for those
w agreement*
• 37% use a multiple of equity
• 16% use managed book of business• 16% use managed book of business
• 22% use a multiple of
compensation
• 25% use something else
*2012 PCPS Succession Survey
Valuation Benchmarks-Intangibles
Valuation methodology
for those using multiple of
equity or book• Less than 10% used more than 100% of • Less than 10% used more than 100% of
revenues
• Over 40% use 100% of revenues
• Almost 30% use between 75% and
100%
Valuation Benchmarks-Intangibles
Rosenberg Survey-intangible value to revenue
• <$2M firms 88.2%
• $2M to $10M 79.8%
• $10M to $20M 78.8%• $10M to $20M 78.8%
Valuation Benchmarks-Intangibles
Valuation methodology of those using
compensation
• Almost 40% use three times
• About 15% use two and one half times• About 15% use two and one half times
• Between 15% and 20% use two times
Total Valuation-Example
Revenues $3,000,000
Revenue multiplier 85%
Intangible value $2,550,000
Accrual basis book value $600,000Accrual basis book value $600,000
Total value $3,150,000
Equity % 30%
Owner’s value $945,000
Total Valuation-Example
Compensation* $300,000
Comp multiplier X2.5
Intangible value $750,000
Accrual book value-total $600,000Accrual book value-total $600,000
Equity % 30%
Tangible allocation $180,000
Total owner’s value $930,000
*often annual average of 3 highest of past 5 years
Polling Question
I believe our approach to valuing our owner’s interest
in the firm is
1) Fair and affordable
2) Fair, but I’m not sure we can afford the buyouts2) Fair, but I’m not sure we can afford the buyouts
3) Not fair, too rich
4) Not fair, too low
5) N/A, we don’t have an agreement
Valuation Assessment
• Use external benchmarks as a guide
– PCPS Survey
– IPA Benchmarking Report
– Rosenberg Survey – Rosenberg Survey
• Internal economics is the true goal
– Terms of the agreement
– Cash flow impact on the firm
Basic Financial Terms
• Term for payment of
– Intangible equity/retirement
– Tangible equity/capital
Most agreements pay intangible over 8 to 15 years and tangible over 5 to
same as intangible
• Tax treatment• Tax treatment
Most treat payments as deductible as paid
Longer payment terms and proper entity type can justify cap gain
treatment
• Interest often not paid on deferred payments
6% interest adds 33% to the total payments over 10 years
Right Financial Arrangement
Backwards Valuation Reward your retiring
partners fairly for their
years of sweat equity
BUTBUT
Don’t expect your
remaining partners to
borrow or take a step back
in compensation to do it.
Right Financial Arrangement
Available capital is the retired partner’s foregone
compensation.
Three uses for that capital:
• Pay the retiring partner off• Pay the retiring partner off
• Cost of replacing that partner’s labor
• Some upside for the remaining partners for
assuming the obligation and the extra work
Replacement Labor
Example• Retiring partner billable hours 1,200
• Hourly billing rate $250
• Production $300,000• Production $300,000
• Cost of replacement
labor (40%) $120,000
Right Financial Arrangement
Example:
Retiring partner comp and benefits $300k
Replacement resources $120k
Remaining capital $180kRemaining capital $180k
You need to decide how much can be used for
buyout and how much should be left behind.
Example
Firm volume $1.9 million
Retiring partner equity % 45%
Intangible value at 100% multiplier $855,000
Retiring partner comp & ben $275,000
Capital account $175,000Capital account $175,000
Total obligation $1,030,000
Pay capital in first year $175,000
Pay retirement over 5 years $171,000 per year
Cost of replacement resources $125,000
Example
• Year 1 net cash flow:
$275,000 less $125,000 equals $150,000
of available capital
$150,000 less $175,000 (cap acct) less$150,000 less $175,000 (cap acct) less
$171,000 (retirement) equals
$146,000 of negative cash flow
• Years 2 thru 5 net cash flow:
$150,000 less $171,000 equals $21,000 of negative cash flow
Example
Alternative plan:
• Pay capital over 5 years
• Pay retirement over 10 years
Example
• Years 1 thru 5 net cash flow:
$275,000 less $125,000 equals $150,000
of available capital
$150,000 less $35,000 (cap acct) less$150,000 less $35,000 (cap acct) less
$85,500 (retirement) equals
29,500 of positive cash flow
• Years 6 thru 10 net cash flow:
$150,000 less $85,500 equals $64,500 of positive cash flow
Other Buyout Terms to Consider
• Caps on total partner retirement payments
• Restrictive covenants
• Notice period required
• Mandatory retirement age• Mandatory retirement age
• Special situations presenting extraordinary
risk
Polling Question
Does your firm have adequate talent on the bench to
replace retiring partners?
1) Yes, and we are confident our approach works
2) I think so, but we don’t know how to admit them2) I think so, but we don’t know how to admit them
3) No, we don’t have the talent we need
4) We don’t plan to pursue internal succession
Techniques for New Partner Admission
Traditional approach-handle like you
are selling a portion of the firm
• Value the firm as a whole
• Select a portion to sell to the new • Select a portion to sell to the new
partner
• Allow new partner to pay over time
often with compensation adjustments
Example
Firm volume $3,000,000
Valuation multiple 100%
Total capital $600,000
Total value $3,600,000Total value $3,600,000
10% interest $360,000
Five year compensation
adjustment $72,000
Techniques for New Partner Admission
Potential issues• Cost to new partner
• What is the right amount of compensation to allocate to
justify-
– What the new partner invested?
– What the existing partners were paid?
• How and when do you deal with acquiring more equity?
• When you do sell more equity to them, how do you consider
the value they have helped create?
Benchmarks-New Partner Buy-ins
IPA Benchmarking Report
<$3M firms $112,120
$3M to $10M $89,960
Rosenberg Survey
<$2M firms $161,154
$2M to $10M $130,018$3M to $10M $89,960
$10M to $30M $104,581
$2M to $10M $130,018
$10M to $20M $146,269
Techniques for New Partner Admission
Two alternative approaches-
• Unit system
– Separate the intangible value from the tangible
value in your agreement value in your agreement
– Sell/invest the tangible portion only
• Long term vesting for new partners
– 10 to 20 years typically
Unit System
Intangible value is expressed in units tied to firm
volume
• New partners not required to buy units up-front
• Sometimes awarded small allocation in recognition of • Sometimes awarded small allocation in recognition of
prior efforts
• New partners earn unit allocations through
– Participating in the firm’s growth
– Participating in buying out retired partners
• Upfront investment limited to tangible value
Vesting Programs
Refers to long term vesting in retirement
benefits for new partners
• Works especially well with compensation based systems
• Effectively delays accumulation of value until
– Senior partners are retired
– Value has been earned through tenure with firm
• Promotes retention of succession team
• Allows for more flexibility on initial buy-in; no worry
giving away accumulated value
For More Information
Please visit our website for resources including
FREE reports, whitepapers and case studies.
Terry PutneyTerry Putney
1-866-279-8550
www.TransitionAdvisors.com