eight ways to derail a merger.
by marc rosenberg
cpa firm mergers: your complete guide
as you will see from reading these examples of issues i have seen arise at second meetings, touchy or sensitive items are much more easily dealt with before the letter of intent is prepared than after.
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the discussion at this second meeting steers the parties closer to a mutually acceptable transaction in the direction that the seller is looking for, thus minimizing contentious issues that often arise when an loi is issued that amounts to a “stab in the dark” by the buyer.
here are some agenda items for second meetings i have recently led:
1. discuss how differences in billing rates will be handled. all sellers fear merging with a buyer who will “cherry-pick” their clients, weeding out small, low-paying clients by dramatically increasing billing rates and fees.
at one merger, the seller’s billing rates were 20 percent lower than the buyer’s. the buyer needed to assure the seller that increases in billing rates would be gradual rather than sudden. the buyer also needed to get the seller’s input on the extent to which their clients would accept higher fees.
2. mandatory retirement provisions. top 100 firms typically require their partners to retire at 65, if not sooner. this is virtually unheard of at smaller local firms, most of which have no mandatory retirement age and whose partners usually want to work until 68 or 70.
at the second meeting (pre-loi issuance) of a merger between a $4 million and a $35 million firm, i explained to the larger firm that their refusal to waive the mandatory retirement provision for the smaller firm partners was a deal-breaker. the larger firm relented and the exception was reflected in the transaction documents. it was much easier to “discuss” this before the loi was issued than to try to “negotiate” it after the loi would have been issued.
3. admittance of merged-in partners as equity partners. in one merger i worked on, the buyer’s policy was to never admit merger partners immediately as equity partners, preferring for them to serve a year or two as a non-equity partner first so that each side could get to know the other.
one of the seller’s four partners “deserved” equity partner status because of the control he exercised over a substantial number of key clients. however, the seller’s data didn’t document this very well. so part of the meeting was dedicated to drilling down on the seller’s clients and explaining the substantial “partner” role that this one partner played. after this discussion, the buyer had an increased comfort level at bringing in this partner as an equity partner and agreed to do so.
4. taxation of payments to the seller. at the first meeting, the buyer – who had done several small mergers in the past – stated that they normally treat all buyout payments to the seller as ordinary income.
at this second meeting, the seller suggested a more acceptable and equitable way to handle this would be 50 percent ordinary income, 50 percent capital gains. the buyer had no problem with this and made sure to include this term in his loi, thus eliminating the need to “negotiate” this term.
5. the importance of the seller giving the buyer clear guidance on what he/she was expecting to see addressed in the loi. while working on a merger, i observed that the buyer was not very experienced with mergers and tended to do things informally, without a great attention to detail.
i gave the buyer a list of what the seller wanted in the loi, and the buyer was appreciative that we’d provided this “heads up.” this helped keep the points to be negotiated to a reasonable minimum.
6. handling of past-due accounts receivables. the seller had a large number of past-due accounts receivable on the books. this naturally raised a red flag with the buyer. the seller acknowledged that this was unusual, but nonetheless, had some good explanations that satisfied the buyer.
there are two parts to this issue:
- first, the agreement that as the buyer collects the seller’s receivables, the funds are either remitted to the seller or retained by the buyer as partial payment of the seller’s capital contribution, if applicable.
- second, in cases where the seller’s receivables are to be applied against required capital contributions, if these collections fall short of the required contribution due to bad debts, then there needs to be an agreement that the seller will make up the difference in cash.
7. addressing large disparities in partners’ annual billable hours. at a second merger meeting i attended, the two firms addressed expectations regarding partners’ billable hours. the partners at the seller averaged 1,800 annual billable hours while the buyer’s partners averaged 1,100.
i’ve seen a firm demerge over this issue because the handling of this disparity was not agreed on during the merger discussions. to avoid a repeat of this outcome, i insisted that the two firms work out an arrangement for handling this disparity. the arrangement consisted primarily of setting specific billable hour targets for the seller’s partners, which gradually declined from their pre-merger levels over a three-year period. this agreement turned out to be a deal-saver because of the sensitivity of the issue to both firms.
8. any major issues that could impair the success of the transaction. i have been present at a number of second meetings at which significant items were disclosed for the first time to the other, in good faith, which threatened the progress of the merger.
examples:
- a prior malpractice case of the seller that had not totally been resolved.
- the buyer’s partners do a lot of 1040 work themselves while the seller’s partners believed in delegating as much 1040 work as possible to their staff.
- the seller disclosed that the firm did not carry malpractice insurance, so the tail coverage issue reared its ugly head.