Every survey you look at highlights succession as one of the top issues of almost
every firm. As firms begin retiring and buying out partners at a pace never seen
before many of us are looking at our partner agreements and firm valuations for
the first time in a long time. Have we structured the buy-out provisions in a way
that remains fair to all and affordable to the firm?

It is not just the value that we place on the practice but as important, how we cut up the pie and the terms under which that value is paid to a retiring partner. This article explores the three steps that you should be considering as you tackle this important issue in your firm.

Step One is determining the value of your firm. Remember we are describing an
internal structure, not an external sale or merger. Values are typically higher for
an outside deal and that discussion is beyond the scope of this article. Also, this
is a process/transaction that is between the firm and the retiring partner; not a
deal that is done outside the firm between individual partners.

Let's start with the typical structure. There are two pieces: capital and goodwill.
Capital is pretty simple. It is the firm's accrual basis capital adjusted for the fair
market value of real estate, valuation reserves for work-in-process and accounts
receivable. It is allocated to the retiring partner based on their ownership
percentage in the firm and paid out as cash or an interest-bearing note, over a
relatively short term.

The second piece is the goodwill of the practice and this is where most of the
conversation centers. Goodwill value is almost always expressed as a multiple of
revenue and the generally accepted value historically was one times revenue.
The value discussion here is for traditional accounting firm revenues. If you have
significant revenue in your firm from non-traditional businesses such as financial
services, insurance products, pension administration or IT services, then
these should be valued separately.

The surprise for many of us Baby Boomers may be that the overall average
goodwill value out there has been about 80 percent of revenue for several years. The
latest 2014 Rosenberg MAP survey of 364 firms puts the average at 81 percent. It is
also interesting that the size of the firm makes a difference. The largest firms in
the survey, those with over $20 million in revenue, are valuing themselves lower
on average at approximately 76 percent of revenue. Many of us have had a one times
revenue expectation for a long time but clearly, we need to re-think that.

So, once we get our heads around what is perhaps a lower value for our firms, Step Two is determining how we split up the firm's goodwill among the owners.

The choices here include allocating it based on ownership percentages or books
of business which you tend to see in smaller firms. In larger firms there is a
process called average annual volume or AAV which is still pretty popular. Last
but not least, and the direction that firms of all sizes are trending, is to allocate
the goodwill based on owner compensation.

Also called the Multiple of Compensation method, it uses relative owner
compensation to allocate the goodwill value of the firm. The presumption here,
and it is a critical one, is that the firm has a performance-based compensation
system in place and that the relative levels of compensation reflect the relative
contributions of partners to the firm. Normally, a firm will use an average of the
last three to five years of a retiring partner's total compensation (not including
fringes) as the starting point. The average comp is then multiplied by a factor to
arrive at the partner's share of the firm's goodwill number.

In a fairly typical example, if a firm is netting 33.3-percent profit before any partner
compensation and they are using a goodwill value for the firm of 80 percent of revenue, then the calculation of the goodwill value is 2.4 times total partner comp. If we assume that our retiring partner's average compensation was $300,000, then the
total retirement benefit for that partner using the 2.4 multiplier is $720,000. Note
that the multiplier and the methodology is normally the same for all partners in
the firm.

Step Three is the process you utilize to pay out the value to the retiring partner.
As we said above the capital is usually paid out in cash or over a short term with
interest. The vast majority of firms are paying out the goodwill in the form of
deferred compensation (ordinary deduction to the firm and ordinary income to the
partner). We see terms ranging from seven to ten years, with no interest. Ten
years has become the norm. All of the CPAs reading this are now thinking "but
with no interest, the value used for the firm is really less than 80 percent." Yes, that is
correct!

There are best practices and trends in several related areas that you should
make sure that you consider for your firm when you are updating your partner
retirement provisions. Those areas include the process you use for new partner
buy-ins, vesting schedules for age and years of service, death and disability
provisions, mandatory retirement ages, post retirement employment parameters,
client transition expectations with potential penalties and overall caps on payouts
to protect the firm.

It is probably time to pull those agreements out of the drawer, dust them off and
take a look!