Think “Bacon & Eggs”
By Paul Latham
All good things come in 3’s ….. and for any type of business there are only 3 types of exit strategy – unless you are planning on ‘going bust’ or giving the business away one day.
Those 3 types of business exits are:
- Going Public – possible but highly unlikely for a CPA
- 3rd Party sale – easy to plan for and to maximize value
- Business Succession – our focus today
From the 3 types of business exit – a succession is easily the most “idiosyncratic” and hardest to plan for. That is partly because there are (very broadly), once again 3 different types of business succession you may need to plan for:
– Family Business Succession
– Mix of Family & Management Business Succession
– Professional Business – CPA “Partnership Type” – Succession
Today, we are going to concentrate on the latter – the
CPA “Partnership Type” Succession
This is more “standardized” in terms of best practice (compared to the other succession types) – as it can be structured just like a series of “mini internal sales” – and therefore (just like any 3rd party sale) becomes relatively logical and easy to plan for.
At HaydenRock Solutions we usually call this type of business succession a “Rolling CPA Partnership Succession Plan”
“Big Picture” Thinking Like a Business Owner
This “big picture” thinking really should start – quite literally, several years in advance of the ultimate succession. However we would normally begin by taking the partners through a thought process, and asking them some key questions – like:
- “Have the (senior) partners ever given any thought to their ultimate destination (and do all Partners agree)?”
- “What is the Partners current and ultimate target business value (and is everybody in agreement)?”
- “What is their target timeline (or will it be different timing for different Partners)?”
More often than not, these questions will not have previously been discussed openly within the partnership. Then we ask some further key questions like:
- “How are the Partners rewarded financially today?”
- Usual answer is typically a Profit Sharing Ratio arrangement
- “Alternatively – are you run like a ‘proper business’?”
- Usual answer is – “what does that mean?
- “Do you separate different elements of remuneration to incentivize Partners to achieve business success?”
- Salary – Bonus – Equity Dividend – Interest – Rent rather than just a profit share?
When professional partnerships only work with “profit shares” – then we will draw the analogy that “maybe they enjoy playing golf with only 1 club in the bag too” because that’s not how their business owner clients work.
Next Steps – Working in Collaboration
Having worked through the above questions, the next step is often a conceptually difficult one for “Older Partners” to come to terms with.
Typically those partners need to change their perspective from “what’s-in-it for me” and begin to move towards how we might work together to make this a “win-win” scenario for all parties. Those parties being:
– “Older Partners” (today)
– “Younger Partners” (today) – and even perhaps
– “Future Partners” (in prospect today)
The parties need to work in collaboration to make a “Rolling Partner Succession Plan” sustainable and a win-win for all concerned.
“Balancing the Scales” – Certainty v Opportunity
A particular problem with partnerships generally is that they are usually only seen by the Partners as an “income-producing asset” rather than having a potential “capital-value”.
Consequently, it’s often in the best interest of the “Older Partner” to keep hanging on for “one more year” of income – and to focus (short term) on saving costs and maximizing revenue so that there’s a larger profit share next year.
Similarly, it is typically in the best interest of the “Older Partner” to ignore any plans to build the business for the longer-term because they will not be around to potentially benefit from those longer-term gains.
As a general rule, the “Older Partner” will prefer to focus on CERTAINTY. They will want to be certain that they will realize the financial value that they have built up (and have currently invested) in their CPA business.
By contrast, the “Younger Partner” will prefer to focus on OPPORTUNITY. They want the opportunity to help shape the business and create future business value.
To create a successful “Rolling Succession Plan”, all parties should be willing to balance, as near as possible, between the contrasting needs for certainty and opportunity (or the succession plan will most likely fail).
“Drawing a Line in the Sand” – “Creating a Bridge to the Future”
Often the best starting point is for the Partners (“Old” and “New”) to agree to “draw a line in the sand” between past CPA business performance and the future CPA business performance. This allows us to create a “bridge” to the future succession plan.
It’s important to separate past (or existing) profit performance owned primarily by the “Older Partners” from future growth that can be shared more widely.
This concept allows “Younger Partners” (and maybe potential future partners) the opportunity to participate in any future growth (beyond the “line in the sand”) but not share in the past (or existing) business profits (other than via their existing financial arrangements).
Under a typical “Rolling Succession Plan”, the “Older Partners” understand that future profit growth will most likely not happen to any significant extent if they don’t allow “Younger Partners” the opportunity to participate in that growth and help push the business forward.
Basically, in principle, the “Older Partner” is willing to sacrifice some future profit potential opportunity for more financial certainty – and vice versa.
That is because, by pushing the business forward, the “Younger Partners” can have the freedom to create a bigger, more valuable CPA business – and that means more financial certainty for the “Older Partner” to extricate the existing value (probably with some “up-side”).
“The Mechanics of the Plan”
The method by which an “Older Partner” realizes that financial certainty (“gets their money out”) is by periodically selling (possibly notional) Partnership “Equity Shares” at a future (largely fixed) value and where the “Younger Partners” are contractually committed to buy those shares over fixed periods of time (at a fixed price).
It’s just like any other business investment. If the business performs well then the “Younger Partners” will have been rewarded and made a good investment (and vice versa). There is risk and reward – it’s called “capitalism”.
Getting into Detail
The “Rolling Succession Plan” separates (until the transaction is complete):
- Rewards for “doing a job” (salary)
- Rewards for “doing a job well” (bonus)
- Rewards for ownership – “Partnership Equity Share” (dividend on profit)
This means that “Older Partners” can potentially retire from their job (or work reduced hours) – and in return they would not receive salary or have bonus potential. However, they would continue to receive “partnership dividends” and capital payments due, until such time as the “Equity Shares’ have been fully purchased. Exactly like a “proper business” normally works.
Obviously there is a lot more detail to agree. The “Rolling Succession Plan” will involve a legal contract that spells out what is expected to happen and by when. The contract will also spell out the consequences for under-performance (Risks for buyers of shares) and the rewards for over-performance against the targeted “norm” (Opportunities for buyers).
This strategy provides a “win-win” scenario for all parties, but doesn’t rule out or get in the way of a future third-party sale that might benefit all of the respective parties (in fact it’s made easier because equity ownership has been properly established and agreed).
What about the “Bacon & Eggs” reference?
This refers to the “trap” that many professional partnerships like CPAs fall into (along with other “professionals”).
The partners in the CPA business have often been elevated into that partnership (“business owner”) position by being “clever and technically very good at their profession” rather than because they really wanted to own and run a business.
In our experience “professional partners” should be divided into 2 types:
“Pigs” and “Chickens”
“Pigs” are committed to the process of making bacon and eggs.
They literally give their lives to “make bacon”. They are analogous to the type of partner who really wants to own and run a business (with all the inherent risks and rewards that involves).
“Chickens” are very important – and very involved in the process of making bacon and eggs – but they are not as committed. They are analogous to the type of partner who is great at dealing with technical professional issues – but who really does not want to take the financial risks inherent in buying/owning a business.
A successful “Rolling Succession Plan” recognizes that both “Pigs” and “Chickens” are massively important in a professional partnership – but that they need to be motivated and rewarded in very different ways. One prefers equity and opportunity and the other prefers salary and bonus and a rewarding job.
It’s never a good idea to base your CPA Partnership Succession Plan around the notion that a very bright and technically able “Chicken” will magically turn into a “Pig” one day – and be interested in buying the CPA business for proper value.
So if you are planning for a CPA Business Succession – aside from everything else that you need to think about with regard to the HOW – remember the importance of “Bacon & Eggs”!