Over the last several years, private equity (PE)-backed companies have become increasingly active within the accounting field. Many CPA firm partners and leaders have received calls from interested PE buyers—or reached out themselves. What do firm managers need to consider when deciding whether to sell their practice to private equity?
Benefits
For a US public accounting firm, a transaction with a PE-backed company can provide many potential benefits including: continued employment after the sale, up-front cash purchase price, taxed at favorable capital gain tax rates, deferred cash payouts or earnouts, and “rollover equity” in the PE-backed management company. Normally, rollover equity is not subject to taxation until it is later sold and owning equity in the buyer provides sellers with a potential “second bite of the apple,” whereby sellers receive a payout when the PE-backed company is thereafter sold by the PE buyer.
Besides the potential economic benefits of a sale transaction, the transaction may provide an accounting practice with capital to fuel needed technology investment, talent acquisition, and strategic expansion. It may also free the selling accountants from the future administrative burden of running the firm, since the PE backed management company typically assumes the “back-office” administrative functions of the practice. A PE sale may be particularly appealing for an accounting practice that has some professionals approaching retirement (hence, creating a need for capital to fund a buy-out) and other professionals that are at earlier stages of their professional careers. The most attractive practices for a PE buyer are those that have achieved consistent and strong revenue growth, with solid profit margins, a stable client base, and professionals at varying stages of their careers.
Risks
Unsurprisingly, a sale to PE-backed company may also create challenges and risks. For example, many commentators, including regulators, have voiced concerns that PE ownership could jeopardize auditor independence, based upon fears the PE firm may seek to influence the practice’s attestation services. Because of regulations requiring attestation firms to be majority-owned by licensed CPAs, a transaction with PE utilizes an alternative practice model where the practice is split into two separate entities: one, owned solely by CPAs, provides attestation services and the other, owned by the PE firm and CPAs, provides non-attest services.
Another risk is that some PE buyers may be so focused on growth and increased profitability that they push those levers at the expense of the quality of the services provided. Similarly, a unilateral focus on growth could jeopardize the firm’s “culture”—the very culture that made the practice an attractive acquisition target in the first place. For a PE transaction to succeed, it is critical that the transaction structure appropriately incentivizes all the practice’s CPAs, including those that may join after the transaction. Practices are already struggling to add new talent and a change from the traditional model where a CPA strives for the rewards of “partnership” 10 to 15 years into their career could make talent acquisition that much more challenging. Most PE buyers understand this dynamic and create structures that provide incentives for all the practice’s current and future professionals.
PE buyers also bring a level of financial discipline and focus, one to which even practicing CPAs may not be accustomed. After a transaction, the PE buyer will often install detailed and rigorous financial reporting mechanisms and analysis that can be both illuminating and exhausting.
Many of these risks can be mitigated by choosing the right PE buyer, the buyer whose approach and vision matches those of the practice’s current leaders. Given that PE has been purchasing CPA firms for several years now and many of these PE buyers have also completed acquisitions in other industries where the “assets go home every night” (i.e., the assets are the individual professionals), such as physician practice roll-ups, there are many PE buyers that understand and are sensitive to the dynamics at play within CPA firms.
Preparing for a Possible Sale
Choose the best buyer.
The most crucial decision when deciding to sell an accounting practice is choosing the buyer most aligned with the firm’s objectives and vision. There are several different PE firms actively acquiring accounting practices. It is important to find the one that seems like the best fit for the practice and its professionals. PE firms aim to exit (i.e., sell) their portfolio companies within 3–5 years after acquiring them (although holding periods have increased in recent years), typically selling to another PE firm. During its ownership tenure, the PE buyer will seek to make additional accounting firm acquisitions and will work with each practice to grow revenue, profitability, and administrative professionalism. Performing due diligence to ensure a practice’s business values and priorities align with those of the buyer is critical. Firms should understand, for example, their buyer’s proposed vision and plans for growth, the expected time horizon before they are likely to exit and their plans for incentivizing firm professionals (especially those that are not currently owners and, thus, will not directly benefit from the sale). At the appropriate time, firm leaders should contact other professionals who have already undergone a sale to the proposed buyer.
Prepare for a potential sale.
Before commencing any potential transaction, firm owners should perform due diligence on their own practice. They should discuss the possibility of a sale to ensure they are all aligned and fully understand the practice’s historical performance and financial statements. Because the price a buyer will pay for a practice is often a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization), firms should calculate their historical EBITDA over the current year and three prior years.
Any potential EBITDA “addbacks” in each of those periods, such as non-recurring expenses, extraordinary gains or losses, compensation and benefits in excess of market, expenses that perhaps are not ordinary and necessary business expenses (for example, the season tickets to the professional sports team that are used more for personal than business purposes), and beyond market rate payments to affiliates, should be identified and quantified. Identify and attempt to quantify any expected future revenue or profitability growth opportunities, such as the recent addition of a new, large client or the expansion into a new geographic location, industry, or practice area. The goal is to convince a potential buyer to value the positive future developments in the practice by agreeing to a high purchase price multiple of EBITDA and to base its price not on reported EBITDA but on an adjusted/normalized/increased EBITDA amount.
During the pre-negotiation/internal due diligence period, owners should examine the firm’s governing documents to understand the required vote to approve a sale transaction and any requirements regarding how the purchase price in such a transaction would be shared among the owners. For example, regarding related-party transactions, if a firm’s offices are leased from an entity owned by some of the partners, evaluate whether the lease is at market rates and terms and, if not, be prepared to amend those rates and terms and quantify how those changes affect EBITDA. Determine whether the firm’s professionals are subject to employment agreements or noncomplete agreements. If professionals are not yet subject to noncompete agreements, such agreements should not be initiated without first speaking with a qualified attorney, because depending upon a firm’s current tax structure, it may be more tax efficient for the owners to sell their “personal goodwill” to the buyer and, generally, they do not own any personal goodwill if they are bound by a noncompete agreement.
To summarize, before commencing sale negotiations, firm owners must fully understand the practice’s business, its historical financial performance, its prospects, and its challenges. A potential buyer should not raise something about the business that owners have not already considered and are able to explain and mitigate.
Firms should also prepare for a buyer’s due diligence. Have ready and organized access to all important firm contracts, employee records, tax records, insurance policies, insurance loss reports, and lists of top suppliers and customers. Be sure the firm’s records are organized and well maintained. A well-organized firm will be prepared for the sale process and will present itself as a professionally run organization to any proposed buyer, which certainly will help when purchase price is negotiated.
The Sale Process
First step—the confidentiality agreement.
Typically, the first step in a sale process is entering into a confidentiality, or nondisclosure, agreement (NDA) with the potential buyer. This is the stage when a firm’s mergers and acquisitions (M&A) attorney gets involved. The NDA prohibits a potential buyer from disclosing the practice’s confidential information to third parties. It should also prohibit the buyer from disclosing that discussions are even occurring. Obviously, a firm wants to avoid the public, the staff, clients, and suppliers from learning of the potential transaction because that can cause unnecessary disruption and distraction.
After an NDA is in place, a potential buyer will ask for historical financial statements and tax returns and various other high-level, material information. Buyers will not yet perform a deep dive into diligence; rather, they will seek to gain a solid understanding of the firm’s historical financial performance, prospects, and risks. They will seek enough information to decide whether to proceed to a nonbinding letter of intent.
Second step—the letter of intent.
Assuming continued interest by both parties, the next step after the NDA and initial buyer due diligence is typically the negotiation of a letter of intent (LOI). The LOI typically contains binding and nonbinding provisions. Typically, the only material binding provision is the “exclusivity provision,” also known as a “no-shop clause.” This provision prohibits the practice and its owners and representatives from negotiating any potential sale transaction with any party other than the proposed buyer for a specified period of time, often 60–120 days. A potential buyer does not want to spend the time and effort pursuing a potential transaction if the accounting firm is also negotiating with other potential buyers—hence the exclusivity provision.
The other main provisions of an LOI, which are typically nonbinding, are the material economic terms of the proposed transaction. These include the proposed transaction structure (e.g., asset purchase, equity purchase, merger), the proposed purchase price (or how the price will be determined), the proposed payment terms, both the consideration to be paid (e.g., cash, equity, earnouts) and how and when it will be paid, including the amount and duration of any required escrows. The LOI also typically includes the proposed terms for any post-closing employment agreements for the practice’s owners, noncomplete agreements, changes to affiliated-party leases and, sometimes, provisions regarding proposed indemnification terms that will be included in the definitive agreement. Often the LOI will also outline the more material expected closing conditions.
Although most of the LOI is non-binding, it is important to negotiate the terms. Renegotiation of non-binding provisions is legally permissible, but it is often greatly resisted by buyers, can lead to upset parties, and jeopardize negotiations. Of course, if circumstances change after the LOI, renegotiation may be warranted, but it often comes at a cost. Accordingly, sellers should utilize experienced M&A counsel when considering and negotiating the LOI.
The most painful step–buyer due diligence.
Once the parties sign an LOI, the proposed buyer and its representatives engage in an exhaustive due diligence investigation of the practice. This, and the sale process, become like second full-time jobs for the practice’s lead negotiator and their supporting assistants. The buyer and its internal and external professionals will send the practice a detailed due diligence request list. These lists cover all areas of the business, including organizational documents, legal items, insurance, financial and tax information, employee and employee benefit materials, client information, supplier information, real property matters, contracts, debt, litigation history, and workers compensation history. The proposed buyer will also engage an outside accounting firm to conduct a quality of earnings (QOE) evaluation of the practice. Once the seller provides the information, there will often be follow-up questions and information requests. This due diligence process is very extensive, invasive, detailed, and time consuming.
It is critical to maintain a record of all items supplied under each requested item or topic, any follow-up requests or questions and the responses thereto. Typically, much of the diligence communication and responses are done through a secure, online data site and attorneys are heavily involved. Often, the lead negotiator for the practice will be the practice’s managing partner. To ensure the process is efficient, the managing partner will need the assistance of a trusted employee who can locate and assemble all the requested items.
Deal Documentation
Provided no immediate “deal killers” are identified in the preliminary stages, often the negotiation of the deal documents will occur simultaneously with the due diligence process. The buyer’s attorneys will draft and share with the practice and its attorneys drafts of the documents for the proposed transaction. As a result, the practice and the buyer and their respective professionals are simultaneously involved in multiple work streams. Diligence and QOE are ongoing while the parties negotiate the transaction documents.
The following is a list of the typical material transaction documents:
Principal acquisition agreement.
This is the main transaction document. It effectuates the proposed transaction. It specifies what the buyer is and is not purchasing, the purchase price and amounts and forms of consideration, the payment terms, the conditions to closing, and the other required closing documents. Its largest section is the representations and warranties section, pursuant to which the practice’s owners make page after page of representations and warranties to the buyer regarding the practice, including that the specified historical financial statements are accurate and fairly present the practice’s financial condition and results of operations and that there are no liabilities other than those listed on the specified balance sheet. There is also an indemnification section which specifies to what extent the owners will be liable for damages the buyer suffers after the acquisition from breaches of the representations, warranties, covenants, and unassumed liabilities. This indemnification section, since it presents liability risk to the practice’s owners, is heavily negotiated by the parties.
The purchase agreement will also contain a net working capital (NWC) adjustment mechanism. Typically, the practice is required to deliver at closing a specified (target) amount of NWC. After closing, the actual amount of NWC delivered is calculated and if it is less than the target, the purchase price is reduced by the difference and if it is more, the purchase price is increased by the excess. It is critical that the final NWC is calculated using the same accounting principles and assumptions that were used to determine that target NWC. Accordingly, the parties also heavily negotiate this provision.
Noncompete agreements.
Selling owners are often required to agree to three different but similar noncompete agreements. There is a deal noncompete agreement that prohibits the accounting firm and its owners and their affiliates from competing with the buyer/acquired practice entities for a specified period of time after the closing date, often five years. In addition, the accounting firm owners often enter into an employment agreement with the practice that prohibits them from competing with the practice during their employment and for one to two years afterwards. Finally, if the practice or its owners receive rollover equity in the buyer, they are prohibited from competing with the buyer during the period they own such equity and for one to two years after their ownership, or the buyer’s right to repurchase their ownership, ceases.
Employment agreements.
The accounting firm’s owners often enter into employment agreements with the practice that specify compensation and terms of employment. As indicated above, they also include a noncompete agreement and other restrictive covenants. Because the buyer is purchasing a portion of the practice’s future revenue, the compensation payable to owners after the closing is typically materially less than before.
Rollover equity agreements.
If the practice or its owners receive rollover equity, there will be agreements that effectuate the issuance and governance of that rollover equity, including buy-sell restrictions. It is important to understand that the recipients are essentially “along for the ride” with the PE firm, with no right to influence the management of the PE firm or the timing of any potential PE sale of the entity. Accordingly, there is typically only a limited number of items, if any, that a buyer will be willing to negotiate in these documents.
Ancillary documents.
There are also various ancillary documents involved, depending on the transaction and its structure. For example, in an asset sale there will be a bill of sale and assignment and assumption agreement. There are also a set of employee on-boarding documents for those that will be employed by the acquired practice after the closing. There are often closing officer certificates, escrow agreements, and other deal-specific documents.
The Closing and Thereafter
On the date of the closing, the parties exchange signature pages to all the transaction documents, they make any required governmental filings to effectuate the closing, and the buyer pays the seller the closing date purchase price. The employees of the practice will be informed of the transaction, if they have not been informed previously, and any employee on-boarding documents will be completed.
A number of transaction-related actions will occur after closing. It is typical or representatives of the parties to notify or meet with key clients and suppliers; sometimes they will issue a press release announcing the transaction. Those professionals who do not retire as of the closing (and typically none do), will show up to the same building, sit at the same desk, and perform the same accounting services the day after the closing as they did the day before. They will simply now be employees working for a new entity or different owners. To them and the outside world, little will seem different. Later on, certain items will occur at specified periods after the closing, such as the finalization of the closing NWC and any resulting purchase price adjustment.
Private Equity Sale Checklist
- ✓ Determine whether a practice is a good fit for a PE transaction. Do owners desire a transaction; would a transaction advance the practice’s vision; what are owners’ main objectives for a transaction?
- ✓ Prepare for a potential transaction. Examine a practice’s governing documents to understand the vote required to approve a transaction; examine historical and projected financial performance and be prepared to address any areas of concern; review material contracts to identify any potential approval, debt prepayment penalties or other issues; review any related party contracts to determine whether they are on arm’s length terms; identify any off balance sheet liabilities; attempt to quantify any anticipated new business or expanded service offerings.
- ✓ Engage an experienced transaction team. Hire a law firm and lead attorney experienced with CPA/PE transactions; consider hiring an investment banker to help locate the best PE buyers and achieve the best price and terms.
- ✓ Identify and empower the internal lead negotiator and support team. The lead should be one of the practice owners, preferably with experience in M&A and the bandwidth to provide the required time and effort. Assistants should be trusted employees who can rapidly and discreetly find the information requested by potential buyers.
- ✓ Be flexible and available. Any sale transaction is labor intensive and rapidly evolving. It is imperative that those involved remain fully engaged and calm as they work through issues and due diligence requests. A potential buyer is evaluating the practice and its people at every step, so everyone must remain professional and courteous at all times.
- ✓ Do not be afraid to the pull the plug. Just as the buyer is evaluating the practice and its people throughout the sale process, so too should the practice be evaluating the PE buyer. Parties can walk away at any point before they are contractually bound to sell. Do not be afraid to pull the plug. It is better to walk away from some unrecoverable funds than to complete a transaction that is not a good fit.
