Welcome to Succession Diagnostic

Succession Planning is one of the biggest issues facing the accounting profession.

This guide is designed to assist you in your practice succession planning. Whilst there is no substitute for specific advice, this guide will provide you with a quick assessment of your level of succession readiness, identification of your succession options and an indicator of practice value.

The Succession Diagnostic will help you to assess where you are up to in your succession planning. The ‘Are you Succession Ready’ test will only take a few minutes to complete. Once completed, it will provide you with a succession score and a report on identified succession issues. You can take the test as often as you like.

This is a step-by-step process to identify some of the key succession issues for you.

The Current Succession Environment

Succession is impacting the accounting profession in the same way it is affecting most other small medium business sectors. The impact of the baby boomer generation of practitioners is about to be felt. This wave of business owners is approaching a period where they are considering their retirement options. For the accounting profession this will have a significant impact.

You only have to look at some key statistics to appreciate the likely impact.

In recent public practice surveys respondents indicated that:

  • 25% had at least one partner who was planning to retire within 5 years
  • 19% indicated they planned to sell their practice in the next 5 years
  • 19% were looking to merge with another firm
  • 68% rated retirement or resignation of a partner as the highest risk position for the practice

Add to this the fact that just over 80% of the practice units in Australia today are represented by sole practitioners and two partner firms. This high level of fragmentation across the profession means that a lot of firms will be addressing this issue at a similar time, without a natural succession path in place.

Irrespective of what report on the accounting profession you look at in Australia you will see that succession is emerging as the issue for the current decade. And the risk is that most practitioners are so caught up in the day to day issues of caring for their clients that they sometimes overlook their own needs. The risk is that succession will ‘creep up’ on you and if you haven’t taken adequate time to plan for it then you may find yourself having to accept a second best alternative.

We are in the early stages of the succession ‘bubble’. Activity is on the increase, and planning is important to achieve the best result. There is a significant increase in merger activity and a continuation in the sale of small practices. In each of the last two years there have been more than 500 sales or mergers of practices. Much of this has been succession driven. The majority of these transactions are not presented to the market. They are caused through introductions or practitioners who know each other. This diagnostic provides you with some overview of the issues, identification of your most likely options, some analysis around your level of succession readiness and valuation considerations. It is a general guide only and is not meant to replace specific advice. It may assist you however in progressing your succession thinking and direction.

Are you succession ready?

Characteristics of Succession Ready Firms

  • strong profitability
  • good liquidity management over debtors and work in progress
  • fee rates at market levels
  • effective systems
  • growth history
  • good spread of client base
  • high proportion of clients with a history with the firm
  • low client attrition rate
  • well trained team
  • required partner hours not more than average 45-50 per week
  • clear operating procedures and documentation
  • quality control and efficient file records in place
  • good client compliance history
  • spread of services
  • evidence of practice maturity

What are your Succession Options?

Select from the following options:

sale of practice

Currently the most common succession option - in most areas there is an active market for good quality accounting firms. There is a significant number of mergers and acquisitions being completed at the moment as many existing firms are looking to bulk up through acquisition. In addition there are always practitioners seeking to enter public practice by way of acquisition of an existing firm.

It is likely that there will be an increasing number of firms coming on to the market over the coming years. This may lead to supply exceeding demand. If this is the case then buyers will have a greater number of firms to choose from and will become more selective.

If you are considering the sale of your practice then you should look at the following:

  1. A buyer is likely to review practice performance for the three years prior to purchase. If you have time, get your practice succession ready and look to maximise practice performance. This includes both financial and non financial indicators.
  2. Review your local market and identify any likely buyers.
  3. Develop your succession plan and review taxation, human resource, lease commitments and other exit considerations

You will need to decide on the timing of your sale. Accept that you may not be able to nominate your precise exit time. Rather you should work to an exit time window. This window may cross over one to two years. A range of factors including market conditions will determine the best exit opportunity time. It’s a good idea to have some flexibility here.

You will also need to decide on how you will sell your practice. Your options include negotiating the sale yourself or engaging a broker.

sale of fee parcel

This option will most likely occur in one of two different situations. You may be looking to sell off a part of your practice. Alternately you may be in a partnership arrangement where either the other partners do not wish to purchase your fees or by prior agreement it is anticipated that each partner is expected to deal with their fees in isolation.

The sale of a fee parcel normally does not involve the transfer of any assets other than the clients. As such it should be a simpler transaction. The size and quality of the fee parcel will determine the time required to complete the sale. A typical buyer will look for data base records that can stand up to due diligence and which provides clear details of the clients, client groupings, historical fee levels over the past three years and the range of services being provided. They may also want to examine your tax invoices to assess services being provided against fees charged. The better the quality of your records the easier the sale process is likely to be.

You will need to decide on the timing of your sale. Accept that you may not be able to nominate your precise exit time. Rather you should work to an exit time window. This window may cross over one to two years. A range of factors including market conditions will determine the best exit opportunity time. It’s a good idea to have some flexibility here.

You will also need to decide on how you will sell your practice. Your options include negotiating the sale yourself or engaging a broker.

progressive sell down

This option seeks to achieve a full sale of the practice or the fee parcel on a progressive basis. This may be done in conjunction with the admission of a new partner or alternately a progressive sell down to existing partners.

This succession option has two key features. The first is the negotiation of the price for the sale. The second is the underlying agreement by which the sale will be completed over time. This agreement is quite critical because under this option there is not a single succession event but rather a progression to the completion of the sale. This extended time frame increases the risk with the sale. It is important to ensure that your agreement not only locks in the purchaser but also provides appropriate protection in the event of any default. Good legal advice is essential and the agreement should always be executed under an enforceable contract.

Your buyer will look at the practice and its performance over the past three years. Normal review and due diligence should be expected. There is also an additional element in this type of transaction. You and the buyer will be working with each other over the period of the progressive sell down. This may be a number of years. There needs to be a reasonable cultural fit. You both need to be able to get on and work together. This is an area you need to satisfy yourself on.

merger

There has been a significant increase in merger activity. Mergers as a route to managing succession will be popular particularly where practitioners are engaging in long term planning of their succession. Using this option is a two step approach. You will need to first manage the challenge of a merger, with your succession exit being the second stage.

It is essential that all partners in the merged firm have a clear and common understanding of the arrangements. Your partnership agreement has an increased importance under this option. It should clearly detail not only the relationship and arrangements between the partners, but it should also document how and when succession will be completed. Where possible, you should avoid the documentation of the succession arrangements being deferred. They should be included in the original merger and partnership agreement.

In most cases the valuation of your share, on ultimate exit, from the merged practice will be determined by the performance of the practice. This means that you need to be confident of the performance of the merged firm and your ability to work with the partners in the firm. In most cases a merger will take between six and eighteen months to settle in. During this time you should expect the practice to under perform. The extent of this under performance will vary based on the merger transition. You should allow sufficient time post merger for practice performance to be achieved that will produce a reasonable valuation return. Normally this would mean a gap of three to five years between merger and your succession exit.

Again ensure that there is a good cultural fit between the partners. You are going to be working with them for a number of years.

acquisition by existing partner

This option allows for arrangements between existing partners. It may include all remaining partners taking out the share of the retiring partner under pre-emptive rights, or by arrangement between individual partners within the firm. Arrangements of this type may be contemplated within the partnership agreement or alternately may be discussed and agreed within the partnership group over time.

Where you have expectations that the partnership or certain of the partners will take out your partnership interest it is a good idea to build into your partnership agreement the terms and conditions of the succession plan and also the valuation model that will be used. Where these terms can be agreed when no succession event is on hand, this normally allows the partners to reach an agreed position with no tensions around immediate interests.

It is also important to look at the age spread across the partnership. Unless you have a reasonable age spread with new partners coming on there will not be natural buyer group. The other key is to ensure that partnership performance is such that will encourage partners to take up greater equity in the firm.

Managing partner retirement should normally be planned three to five years out from the succession event.

internal succession

This succession option anticipates that senior staff will be ready to progress on to partnership and that partner retirement will be managed in part through the appointment of new partners. Internal succession can occur by chance or through a planned and developed practice succession program. Succession by chance provides no real certainty. There may be the best of intentions within the firm but without proper planning realisation will always be at risk.

Effective internal succession requires:

  • growth within the practice that facilitates progression to partnership
  • recruitment of staff who aspire to and are capable of being partners
  • a manager and partner development program
  • practice performance that makes the firm attractive for partnership aspirants
  • the expectations of partners in terms of hours worked to maintain profit return to be perceived as reasonable

In some firms there are capital funding arrangements that assist incoming partners to take up equity in the firm. This may include a partial contribution from profit entitlements.

Internal succession programs need to be well developed over time. Such programs are much more effective than those where it is dealt with as a one off event.

introduction of a new partner

Another way to manage succession is through the introduction of a replacement partner, externally sourced. Introducing external partners normally increases the risk to the firm. Not only is there a need to manage the transition of the exiting partner, but also the requirement to manage the induction of a new partner, who is perhaps not well known to the rest of the partner group. This option may be used as an alternative where internal succession is not possible and where the existing partner group do not want to acquire the retiring partner’s interest. An example of where this option could be used is where there is not a significant age separation between the partners and where the continuing partners do not want to take up the capital of the first partner to retire.

This option has a higher degree of success where the incoming partner is introduced into the firm twelve months in advance of the partner transition. This may be possible through appointment as a salaried partner for the first twelve months. Again documentation is critical here, both in terms of the partnership agreement and the exit agreement for the retiring partner.

What is your Practice Worth?

The answer to that question is one we would all like to know. The reality is that the only certain answer is in the market. The price of a practice will vary significantly depending on its quality, profitability and stability.

In purchasing a practice you are investing in the client base and the recurring revenue stream that flows from that client base. In worst case scenarios practices can be unsaleable. The market may form the view that either the revenue stream flowing from a client base is not sufficiently attractive or alternately that the client base will not ‘stick’ to the practice in a change situation. In these cases the position being taken is that the client base will fragment from the practice and look for another accountant. So why buy the asset when, if you are an established and competing practice, you may inherit many of the clients anyway? This position will only affect a minor number of firms. In most cases you have a saleable asset.

There are good indicators available as to the price range you can expect and the basis by which your practice will be valued. Increasingly different valuation methodologies apply based on the size of the firm or fee parcel being offered. The price range will be influenced by the degree to which the buyer is an ‘anxious buyer’, the underlying market, and the quality of the practice as reflected by its level of succession readiness as measured by the succession thermometer. The higher your score the better the price you should expect, subject to local market conditions.

For the majority of firms, the level of maintainable fees will be a factor in the valuation. Maintainable fees are those fees which can be maintained with reasonable certainty on a continuing basis. In the assessment of maintainable fees adjustments would typically be made where over the years being reviewed there have been factors in existence such as:

  • significant one off projects
  • loss of major clients, where significant fees attached
  • clients who are assessed as not likely to continue with the firm e.g sale of business or retirement
  • loss of partners or key staff

In looking at the pricing methodologies and characteristics that exist in the current market they can be segmented based on the size of the fees.

Fee level is:

less than $300K

Valuation methodology: in the majority of cases practices or fee parcels of this size will be negotiated on a cents in the dollar of maintainable revenues. Currently there is a reasonable demand for practices of this type. If the practice is a good quality one and exhibits reasonable levels of profitability it will command pricing at the upper end of the price range.

Price range: the majority of sales will be in the range of 75 – 100 cents in the dollar of maintainable fees. Pricing outside of this range is possible. Practices or fee parcels that exhibit strong profitability, an historic level of growth and a good quality client base could command a rate dollar for dollar or better of maintainable fees. Conversely practices or fee parcels that have low levels of profitability, and where there has been no growth or a contraction in business, or where the client base is considered to be of poor quality could cause a cents in the dollar rate of less than 65 cents. Currently a rate less than 50 cents in the dollar would be considered unusual and would reflect specific circumstances.

Typical buyer: the typical buyer for this type of practice will either be someone looking to commence practice or an existing practitioner who is looking for more than organic growth. In the majority of cases they will not be looking for you to continue working in the practice, other than a normal transition period.

Other considerations: it would be normal for the purchaser to require a non compete agreement. In addition to normal warranties and depending on the agreed price there may be claw back provisions required in the event that a specified level of fees is not achieved in the first year after sale. There may also be a request for payment to be made in tranches over the first year. Other than where substantial assets exist, normal plant and equipment will be included in the purchase price. Leased assets would be assessed and in many cases the leases will be transferred. Normally debtors and work in progress would be billed out by the vendor prior to settlement and be the responsibility of the vendor to collect.

$300K to $1M

Valuation methodology: in the majority of cases price will still be negotiated on a cents in the dollar of maintainable revenues. The closer the fees to the $1 million range the greater the focus will be on the profitability of the practice. Your buyer will be more concerned about the rate of profit after allowance for principal or partner salaries. In some cases at the upper end of this fee range you may find buyers who want to employ more traditional valuation methodologies to establish pricing such as a capitalisation of future maintainable earnings.

Price range: where negotiated on a cents in the dollar basis the normal range will be 75-100 cents. Fees near the upper end of this range are more likely to have some discount for the size of the fee parcel being negotiated. Pricing in the range of 80-90 cents would not be uncommon. Where the price is negotiated on a Capitalisation of Future Maintainable Revenues the multiple will most likely be in the range of a multiple of three to four times maintainable earnings.

Typical buyer: at the lower end of the fee range your most likely buyer will be a sole practitioner looking to bulk up their fee base or an accountant looking for a parcel of fees to commence practice with. As the fee levels move more to the upper end of the range, your buyer could also be an existing partnership that is pursuing merger activities again with an objective of increasing critical mass. The higher the level of fees the more likely that the purchaser will look for the vendor principal to continue with the firm for a period of time. In true merger situations the purchasers may look for the vendor principals to continue and play an active role with the new firm.

Other considerations: it would be normal for the purchaser to require a non compete agreement. In addition to normal warranties and depending on the agreed price there may be claw back provisions required in the event that a specified level of fees is not achieved in the first year after sale. There may also be a request for payment to be made in tranches over the first year. Other than where substantial assets exist, normal plant and equipment will be included in the purchase price. Leased assets would be assessed and in many cases the leases will be transferred. Normally debtors and work in progress would be billed out by the vendor prior to settlement and be the responsibility of the vendor to collect.

$1M to $2M

Valuation methodology: as the size of your practice moves above annual fees of $1 million it is far more likely that the practice will be valued for pricing purposes using a traditional valuation methodology. The most common valuation method currently employed is a Capitalisation of Future Maintainable Earnings. This requires establishing a maintainable earnings level for the firm. The earnings will normally be adjusted for any abnormal items and in particular salaries for principals and partners will be adjusted to market levels. The earnings level being established is after reasonable principals and partners remuneration. This methodology has a very strong focus around the levels of profit being generated by the firm. Once the maintainable earnings level has been established it is then necessary to determine an appropriate capitalisation rate for the firm. Where the firm has quite different types of revenue streams such as business services, financial planning and insolvency then the firm will not be valued on a single revenue stream basis. Different revenue streams characteristics will be valued separately.

Price range: where a firm is valued using a capitalisation of future maintainable earnings the most common earnings multiples will be in the range of 3.4 to 4.2 times the maintainable earnings. This multiple is a reflection of the ‘risk rating’ of the revenue stream. The better the quality of the revenue stream and the greater the level of annuity characteristic the higher the multiple can be. It would be unlikely to see a multiple greater than five or less than one point five.

Typical buyer: the typical buyer for this type of practice will either be another firm of similar or larger size seeking to bulk up or a very large firm that is making the acquisition as a ‘tuck in’ to the existing practice. On current estimates there are no more than 1400 firms across Australia with fees in excess of $1 million. On this basis your market of buyers is starting to narrow down. Continuity of the vendor principal or partners is normally a negotiable matter.

Other considerations: it would be normal for the purchaser to require a non compete agreement. In addition to normal warranties and depending on the agreed price there may be claw back provisions required in the event that a specified level of fees is not achieved in the first year after sale. Other than where substantial assets exist, normal plant and equipment will be included in the purchase price. Leased assets would be assessed and in many cases the leases will be transferred. Normally debtors and work in progress would be billed out by the vendor prior to settlement and be the responsibility of the vendor to collect. Where debtors or work in progress is transferred to the purchaser, this amount will be in addition to the value assessed. An assessment, together with an appropriate adjustment, would normally be made for bad debts or write off adjustments.

$2M or more

Valuation methodology: practices of this size will almost certainly be valued for pricing purposes using a traditional valuation methodology. The most common valuation method currently employed is a Capitalisation of Future Maintainable Earnings. This requires establishing a maintainable earnings level for the firm. The earnings will normally be adjusted for any abnormal items and in particular salaries for principals and partners will be adjusted to market levels. The earnings level being established is after reasonable principals and partners remuneration. This methodology has a very strong focus around the levels of profit being generated by the firm. Once the maintainable earnings level has been established it is then necessary to determine an appropriate capitalisation rate for the firm. Where the firm has quite different types of revenue streams such as business services, financial planning and insolvency then the firm will not be valued on a single revenue stream basis. Different revenue streams characteristics will be valued separately. It should be noted that some large firms do not recognise goodwill as this is seen as an impediment to the progression of younger partners where a large goodwill payment may be difficult. Firms of this type require incoming partners to make a contribution toward working capital and when they leave their payout is only for working capital. Sales to such firms could lead to different views in relation to goodwill recognition. Such cases would be in the minority.

Price range: where a firm is valued using a capitalisation of future maintainable earnings the most common earnings multiples will be in the range of 3.4 to 4.2 times the maintainable earnings. This multiple is a reflection of the ‘risk rating’ of the revenue stream. The better the quality of the revenue stream and the greater the level of annuity characteristic the higher the multiple can be. It would be unlikely to see a multiple greater than five or less than one point five.

Typical buyer: the typical buyer for this type of practice will either be another firm of similar or larger size seeking to bulk up or a very large firm that is making the acquisition as a ‘tuck in’ to the existing practice. On current estimates there are no more than 250 firms across Australia with fees in excess of $2 million. On this basis your market of buyers is quite small. Continuity of the vendor principal or partners is normally a negotiable matter.

Other considerations: it would be normal for the purchaser to require a non compete agreement. In addition to normal warranties and depending on the agreed price there may be claw back provisions required in the event that a specified level of fees is not achieved in the first year after sale. Other than where substantial assets exist, normal plant and equipment will be included in the purchase price. Leased assets would be assessed and in many cases the leases will be transferred. Normally debtors and work in progress would be billed out by the vendor prior to settlement and be the responsibility of the vendor to collect. Where debtors or work in progress is transferred to the purchaser, this amount will be in addition to the value assessed. An assessment, together with an appropriate adjustment, would normally be made for bad debts or write off adjustments.