Is My Firm Big Enough to Support an Additional Equity Holder?

One of the many areas that we consult with firms is around the introduction or admission of new / additional equity holders. We consult on such matters, we perform valuations for such admissions, and so on. However, it is really important to appreciate that your firm may not necessarily always have the ability to admit a new partner, irrespective of whether you really wish to. The timing might just not be right, and if you get this wrong, the ramifications can be disastrous.

Now, probably one of the most significant concerns or fears that we hear from a firm is the desire not to lose a potential successor. One of the main reasons why smaller firms end up selling in the open marketplace is a lack of internal successors. Thus, when a firm finds someone who they feel would be appropriate to become a partner, and this party has expressed an interest in becoming an equity holder, there is often almost this ‘rush to the alter’, so to speak, without properly mapping out timing, returns and cost, amongst other factors.

We experienced this during the last six months when we spoke with a sole practitioner firm who was looking to admit an additional partner. Both parties were keen, but both parties also wanted to do the right thing by the other and ensure the longer term success of the future partnership. Following some discussion, it became apparent that the practice really wasn’t quite big enough, in terms of fees, to adequately support both equity holders.

This is probably one of the biggest mistakes that we see all too often, impacting significantly on a realistic buy in value as well as the ongoing return to the continuing equity holders. It may also dictate whether the successor actually buys in. I remember performing and dispatching a valuation report to a practice in which I valued their goodwill at three cents per dollar of fees. It was probably the lowest value I had ever placed on an accounting firm, and a process and report that I didn’t enjoy preparing at all. However, the fundamental issue behind this outcome was that the size of the practice simply couldn’t support the future number of equity holders, and provide reasonable market salaries, let alone, a return on investment. On this basis, I simply couldn’t advise the party buying in that they should pay much, if anything, for this equity. A message no current equity holder wants to hear, which I completely concur with, however that was the way it was.

Thus, what we really like to encourage is some forward planning. Often what this entails is:

1. Finding or developing future successors. We have one regional client who is exceptional at this with their 10 year succession plan. Part of this may include outlining what is required in terms of performance, attributes, characteristics, skills, expectations and the like to become a partner. This just doesn’t happen overnight.
2. Developing a plan so your future successors can see when this opportunity is likely to arise. We are strong believers that once future successors know what is required amongst the firm in terms of benchmarks, and the like, for that succession door to open, and progress is being made towards that event, they are less likely to leave your firm; although there is a time limit on this.
3. Part of the plan includes ensuring the fee base and/or profitability of the firm is sufficient to support a reasonable and fair entry value whilst also underpinning a return on investment that will enable to new purchaser to pay off their acquisition. What notional level of fees per partner does your firm require to be able to admit another partner? A key benchmark to know.
4. Another part of the plan is setting expectations regarding buy in values. Discounting a fair value simply to ensure the admission of a new partner can be a dangerous precedent to set. Likewise, having unrealistic inflated opinions of value will also likely end in failure. Having an opinion of value prior to making an offer of partnership is preferable to endeavouring to set the entry value once the partnership offer has been accepted in principle.

In essence, the more planning, timing, and forethought that goes into these processes, the more likely the success all round, leading to a happy successful partnership.