M&A maven Robert Fligel says coronavirus is pushing deal-flow and trimming multiples.
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Featuring Robert Fligel
COVID-19 is putting new pressure on CPA firms to close merger deals, even if it means taking a haircut in the selling price, says Robert Fligel, the legendary New York-based CPA firm mergers-and-acquisitions dealmaker, in a new CPA Trendlines Flash Briefing.
In this replay of the live web event, a fast-paced 30-minute webinar update, Fligel covers:
- The Current State of the M&A Market,
- Best Practices for Sellers, and
- Pitfalls for Buyers and Sellers
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Included with the briefing, are five bonus downloads:
Three Excel spreadsheets:
And a White Paper (PDF):
Robert Fligel: Our topic today is a really important topic. I think every CPA firm, every business out there has to think about what’s going to happen next. We are obviously living in incredibly unprecedented times. COVID-19 has just changed the landscape of our lives completely, whether it’s your health, being a virtual workforce, and what that’s going to mean going forward. Business collections are not the same. Certain industries have obviously been hit very hard. There’s a lot of factors going on now that are affecting business in general, and that’s part of the reason why we’re having this call.
You add on top of that, what’s going on in the rest of the world, especially in this country, which we’re not going to get into, obviously, but there’s obviously a lot of discontent, a lot of divisiveness, a lot of unrest, and all that makes for a bit of an unsettling time. The good news from all that is that we’re surviving. We’re making it. I think we will get over it, but it does create issues.
The other good news is that in the CPA market, things are really not bad. All the firms I speak with locally; small, medium, and large are doing fine. Yes, it’s disruptive in certain ways, but CPAs are an essential service. If anything, they’re more needed now than ever before. What I’m seeing also is obviously a continuing need for dealing with succession.
I’m happy to see we have buyers and sellers online, and people that are sort of not sure because the time is now. If I had to say one watchword for this presentation, it would be a sense of urgency. Because if you’re a firm that you know you have succession issues, whether it’s age, health, quality of life, or whatever the reason, it’s going to happen, and we’re going to talk today about a lot of things that are going on that hopefully will help you.
The basics of accounting firm success have not changed. These ideas of growth, profitability, and specialization, but I will share with you because I plan to be as this blunt and honest as possible in this session. It’s all true, but I would say that it’s not really happening in the small to mid-size firms unless there’s a major effort put into it. I’ve gone to plenty of management of accounting practice sessions. There’s always a lot of talk about this, but small and mid-size firms don’t really have the luxury or the finances or whatever to afford a growth partner. Unless you have a champion, it’s very hard to deal with this stuff. I will spell out to you, I’d be happy to help any way I could and recommendations because there are a lot of people that are really great at all this stuff. My cell phone and email are below, so feel free to call or text anytime about anything we talked about today.
Getting into the M&A market, valuations have been trending downward for, I would say, probably 5 to 10 years. It wasn’t unusual, not that long ago, for firms to have multiples of 1.5 of collected revenues or higher. It’s been a slow downturn. It’s not precipitous. COVID-19 has fortunately not made that precipitous. If anything, it affects both sides of the transaction, the buyer and the seller. What’s more normal now is a one-point multiple or a little bit higher than that, or a blended rate. We’re going get into some of the nuts and bolts of the mergers in a couple of minutes here.
Selectivity continues to be an important factor during the merger craze in the ’90s and the 2000s. There was a lot of emphasis on top-line growth, not at the expense of specialization and geographic, all that kind of stuff, but more and more now, firms that are looking to acquire, and I know there are people online now looking to do that as well, are looking for specialization, getting it to a new geographic area, younger staff, younger partner, specializations, et cetera.
I don’t know if any of you have heard the expression “orphan” firms. I didn’t invent that myself, I must tell you. What it means is firms that have some significant issues. It would be generally a one-partner or two-partner firm that is not really totally up to speed with technology, remote work, adequate staffing. The age of the client base could be an issue.
These are firms that definitely have some issues. They really are a lot out there. They do very well. They don’t do badly because they have a good revenue base, and they may have high margins because of little overhead. If you happen to be one of those firms, or you know people like that, it’s just something to be aware of and to be cognizant of.
At the same time, deal structures have also not changed as Rick mentioned. My prism is the New York metropolitan market, and I will say here that almost all of the CPA merges and acquisitions are based on earn-outs or retention. I’m glad to have a national audience, and if things are done differently, I know in some parts of the country, bank financing is not unusual. It’s not something that I see much, or really see hardly at all in the New York area but certainly chime in with a question, or chat, or contact me afterward. I’d be always interested to learn more about how other parts of the country operate.
There are essentially three types of deals that happen. There is the merger to the acquisition, which most of you are probably familiar with, which is typically a smaller firm merging into a larger firm obviously. The principles are the founding principal, and the ongoing partners are going to work two or three years, and then entering into a deferred compensation arrangement.
The other one would be a merge of equals. That’s also something that is more of the medium to larger firms than big to smaller firms. We have a half-million-dollar firm or a million-dollar firm. The idea of merging with an equal doesn’t always create enough of a critical mass to make a difference. In fact, generally, one thing that I’m always concerned about is when firms that are too small consider merging are the compounding divisions. If they have staffing issues before, this may not go away. If they have business development issues, the same thing.
The third type of deal structure that is not on this slide, which I realized last night when I was looking at it, is the internal succession. It’s a joy to see and be involved with. I happen to have two of those going on at the moment. A specific example is a million and a half firm and a $5 million-dollar firm here in the New York metropolitan area. They both have partners that are much, much younger. They are about to embark on a transaction for the founding partner to cash in a certain percentage of the equity and enter into a plan for a full exit over the next two to five years.
The interesting thing that’s come up from the internal succession and talking to the other partners is they are actually very concerned about all the institutional knowledge and relationships even though they’re working on all the clients. The founding partner, probably 30 or 40 years in the business, has a tremendous amount of knowledge, and that transition has to be handled very carefully, and obviously, the continuing business development.
The components of the transactions are what we’re looking at next year. The big topic is always evaluation and the multiple. There are many different factors that go into that, from the type of clients they have, the realizations of the client’s profitability. One thing I am seeing in that equation now is the concept of recurring revenue. Up until this year, recurring revenue was pretty easy to figure out. It was the last fiscal year, calendar year, most recent 12 months, and it was essentially what was collected perhaps backing out any one-time special projects that are really not the norm.
Now with COVID, what we’re seeing is some concern in some higher client collapses in certain industries, and we’ve had a couple of recent experiences where it’s been agreed upon by all parties. Fair cut, whether it was 15% or 20% of the annual collections is not going to be continuing for the foreseeable future. All sides were agreeable to that, and obviously, my business is involved in that as well in terms of sharing in the pain, if you will.
The other thing that can be done with valuation and multiples, and I see it more frequently, is what I will call a blended rate where a firm might put a higher value on certain parts of the business and a lower value on others, come up with a rate that melds them all together. The big factors that need to be dealt with as quickly as possible in these discussions, and I think what’s mentioned there, the compensation, equity, deferred compensation, and on top of that, the name of the firm. We’ll talk about it a little more later. The sooner those things are ironed out, the better because it’s an obviously a very labor-intensive type of process.
The last thing here is probably one of the more controversial, and certainly, curious about chatter, otherwise what the audience feels about this. Obviously, a demerger clause is something that almost every seller would like to have. Sure, it would be nice to be able to get out, and no harm, no foul, and I would say that most acquirers were bad enough.
My feeling is I am not really in favor of those. I think that both sides should have as many meetings as necessary, as much due diligence, as much background checking, as much everything, and go into it with full force, it’s going to work. The first year may be really, really difficult.
If for some reason, something unforeseen happens and it doesn’t work out, work it out amicably as people. Nobody really wants to spend all that kind of money on litigation when it’s just sometimes things don’t work. Fortunately, I can tell you, it’s a rarity.
One of the other new things going on in the market which, again, curious about other people’s thoughts, I have not seen anything about COVID clauses that were specifically mentioned in either a letter of intent or a deal document. I’ve spoken to a couple of attorneys in this area, and at this point, that is not considered, and if I pronounced it right, a force de majeure. That would be one of these one-time earthquakes, terrorism, a one-time event that negates the contract. Most of you may have seen that term in a document of some sort.
I don’t have to go into all the details, but there are four factors that affect whether an act is qualifying for that. The bottom line is, something is not really a force de majeure unless it totally prohibits the other party from functioning, inability to function. In the accounting firm world, even as bad as this pandemic is, it’s not stopping firms from doing their business. At this point, I don’t see that being a major factor in the CPA merger market.
Moving on, if you’re a seller, I can’t emphasize enough starting this process early. As I mentioned before, you’re based on here, your age, and everything else. You’re going to do something. It’s going to be by far the biggest financial transaction you make in your life. It’s just so much better to be prepared and start early. That’s why I suggest a year or two, and get the information that you need. It is a very involved process, and it’s just so wise to talk to people you know that have gone through the mergers themselves. Whether it’s friends of yours or people you can seek out, attorneys that are involved in these types of transactions, and even people like me so that you go into it with your eyes wide open and don’t spend a lot of time and not have things end up the way you want them to.
I think one of the best sources is your state society. If you’re not involved, it’s just a great way to meet firms and build new relationships, and as I know here, the vast majority of these types of transactions happen without somebody like me involved.
Preparing your firm is really important. Not many people do that. The one thing that I would suggest either to try to do it yourself or consider getting an outside marketing person to help with it, is to create almost a one-pager, something that extols the virtue of your firm. A little bit of background, selling points, industry specializations, partner bios, that’s the one thing you can do to distinguish yourself in the market. Because of the trends in the market, there will be more and more people selling, and it’s going to be harder and harder to distinguish yourself and get as much value as you possibly can.
When you’re in the process, it’s very easy to establish the relationship if you’re having meetings with prospective buyers or acquirers. During the first meeting, it’s going to be obvious how the chemistry is, how the report is, meet all these people who you could possibly work with. You may be very surprised but before you know it, the economics of the deal are going to be at the forefront.
These five items that I mentioned here, I would recommend highly, having them ready probably even before you start the process of talking to other firms, because if the chemistry is almost always going to be good, and if the finances and economics don’t work, then nothing much is going to change from there. I know it’s hard sometimes to get the information together. It may be hard or uncomfortable sharing all this personal financial information, but you do it under an NDA, and in all my years of doing this, I can tell you quite honestly, no one’s ever had a problem with the information getting in the wrong hands or anything bad happening.
I would also suggest, even if there’s not somebody like me involved, to consider some outside representation. Yes, you will have an attorney. Hopefully, an attorney that has been involved in these types of deals before. There are people in my business that– I do it myself, of course, but on an advisory basis not on a full merger and acquisition assistance basis; reviewing documents, talking about deal structures, reviewing letters, being your independent advisor, and it is something that can pay off in the long run for sure.
You can’t answer the question to me directly, but I would ask, how many of you have been involved in deal discussions to acquire practices, or even merge your own practice that went on for a very long time, multiple meetings, and then didn’t work out? Besides me because that’s the issue in my business sometimes. The point being here, going into it with realistic expectations can make a world of difference in the success of the ultimate conversation. The things that I mentioned here if you go into it knowing what is realistic, works out much, much better.
Philosophical and ethical considerations. What I mean by that specifically is each firm has its own threshold of how comfortable they are with clients that want to take very aggressive acquisitions or very aggressive financial recording positions. That’s worthy of conversation because if it’s a major gap, it is going to be a problem.
Another example that comes up in that context is in the nature of non-business expenses. Most firms have some things that are not tactical business expenses. I ran across some major exceptions where firms just take that a little bit too far. In one case in particular, many years ago, there was a reason why a deal didn’t work out because they just couldn’t come to grips with that.
I should have underlined the word any discomfort because when you go through this process if there’s something that’s troubling you when everybody is on their best behavior, it’s not going to go away. I would go as far as saying, if you have any discomfort, just simply do not make the deal. Sometimes it takes some time to figure it out, but my personal experience is most of the time, the discomfort comes with in terms of personalities where you just don’t feel that comfortable with somebody whether it’s too big of an ego, or whatever the case might be.
Anybody who’s been involved in these deals knows that the first year is incredibly hard with all the different transitions but that’s something you have to go into fully expecting it. I don’t know that many firms do this, but I do highly recommend doing background checks both sides, on each other, the partner group. They’re fairly inexpensive and worthwhile, because if something comes up that you couldn’t find doing internet searching or another background check, better to know. What I’m talking about specifically is a credit check, criminal check, driver’s license check, and others. It’s probably, I’m guessing, $150 per person to do it and you get a lot of information that can only make you feel good, or have avoided a problem.
Due diligence. Talking to a group of CPA you’d say, “Why would I bring up due diligence? That’s something you can do in your sleep.” I’m sure you can do that in your sleep. What I have seen though, in my experience, is that it’s not always done as aggressively or as fully as it should be. There’s a trust factor involved. Sometimes there’s a lot of excitement about making the deal, and it’s not attacked as much as I would like to see. Specifically, I’m talking about making sure the cash receipts are there over the last couple of years. Making sure there’s not a problem with litigation, or excess receivables, which might indicate some management issues. There are a lot of things that could be dealt with.
One of the handouts in this session is a due diligence checklist that I’ve put together a couple of years ago, and I would certainly recommend it because it’s extremely extensive and can certainly save you some time.
In the transition plan, I put that almost in the same category as due diligence. A lot of times, it’s done a little bit too casually. I recommend a very detailed plan, 10-20 steps in transition, what’s the timeline for getting it done, and who’s going to be responsible for it. I realize all these things take a lot of time but obviously, nobody wants to make a mistake.
I would minimize the change in your life if you are a founding partner or senior partner at the firm, and you’re looking to merge, need to merge, and you do find the right people to become new partners with. All of a sudden, you’re not the one sitting at the corner office. You’re not paying the bills. You’re not deciding all the hiring and firing. It can be a difficult transition. I think with the right new partner group, it becomes less painful, and the firms that are really good at this recognize that. I may be mentioning this out of order, but I also say for those of you that are acquirers, the firms that do the best at acquiring other firms do a fantastic job at figuratively putting their arms around the other founding partner, the other senior partners, making them welcome, and also not counting the days until they transition out.
The firms that I know that do a lot of these types of deals very successfully, even after the buyouts, are totally happy with those partners staying around. They bring in clients, they get involved in other activities, and they can get paid for it as well, even after their buyout is complete. Continuation is a good thing.
One other thing that I didn’t mention– I’m just going to make sure there’s nothing else here, no- is one of the other trends that’s going on is mergers and acquisitions among a little bit of an older group. I hope I’m not saying anything out of turn here, but there’s a lot to be said. I’ve seen some of these deals happening, of firms where their partners are not – They’re retirement minded. It’s not mergers of equals. These are firms where the main active partners are in their mid to late 50s. They have another 10 or 15 years to go, depending on health. They can be a very viable merge-end prospect for those firms looking to acquire the “younger” CPA firms made up of CPAs in their 30s and 40s.
As you probably all know, there’s not a lot of them out there. Let’s be realistic. They want to be like you. They want to be their own boss. They want to grow their own firm. Consider the firms that are a little bit more mature in terms of merging in. I think that is it on my end.
I’ll just end by saying it is a fantastic profession. I am honored to have been part of it for 35 plus years. It’s still one of the most trusted out there. Everybody should be very proud of what they do for themselves and their clients. Continue all that good work.