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Strategically planning your CPA practice acquisition Financing for CPA professionals

a complimentary whitepaper for certified public accountants Strategies to simplify transitions You’ve decided to purchase another CPA practice. Perhaps you’re embarking on a plan to strategically grow your business. It could be that you want to expand into a new area of practice and the practice you’re looking at has solid expertise there. Maybe a friendly competitor has his or her eyes on retirement and wants to be sure his or her clients will be in good hands. No matter what the motivation for your plans, buying another practice is one of the most significant steps you’ll undertake as an owner or partner of a CPA practice. How you approach and handle that acquisition will have a lasting impact on both your business and your peace of mind. And how you finance the purchase will play a major role in determining whether it becomes a financial success or something you’ll long regret. You regularly provide counsel to other business owners, but when it comes to their own practices, most CPAs can benefit from an outside point of view. That’s why we developed this white paper, which examines issues you’ll want to consider, thoughts about obtaining an accurate valuation of the practice you’d like to buy, the most advantageous ways to structure the transaction — and most important — how to access the extra capital you’ll likely need to bring the acquisition to fruition.

For any number of reasons Just as every practice is unique, the reasons behind acquisitions are varied. Among the most common reasons are: • A desire to expand the practice’s geographic footprint, whether that’s into a nearby town or in another state. Taking over an existing practice with established relationships is faster than

starting from scratch in an area where the practitioners haven’t yet earned a reputation. • Preparation for retirement, in which a practice that intends to remain operating captures the clients of another in which one or more partners are nearing the end of their careers. An acquisition gives the buyer new clients while providing a financial reward for the seller’s sweat equity. • Expanding the scope of services offered to clients by using the acquisition to bring professionals with specialized knowledge into the practice. This also allows those professionals to access the acquiring entity’s clients to expand their business. • Adding much-needed talent to the practice. As veteran CPAs move into retirement, a strong job market is putting pressure on the accounting profession. A single acquisition can allow a practice to add many professionals at one time. 1

What sellers think about Most of what we’ll discuss here focuses on the perspective of the acquiring practice, but it pays for the owners of that practice to develop a stronger sense of what issues are likely to be important to their potential targets. One of the biggest issues centers on the nature of how equity will be divided in the practice after the acquisition is complete. First, both sides have to agree upon what equity encompasses, and then, they must decide how it will be parceled out to all who remain partners. This is an especially important question for smaller practices, in which individual shares of equity tend to be much

Whitepaper: Strategically planning your CPA practice acquisition

“Regardless of the reason for the acquisition, the single most important thing to determine is the value of the practice that’s being acquired.”

larger. It’s common to develop a fractional formula built upon the gross revenues of both practices and what portion of the combined practice they’ll represent. That formula may be adjusted to reflect unique factors. In addition to the amount involved, both sides must also agree on what equity will mean in the combined practice. Is it limited to how income will be divided, or does it also affect who will make decisions or manage the practice? Similar to the equity discussion is how compensation will be handled in the combined practice. The partners of the entity being acquired will resist the idea of reducing their compensation in any way, especially if they’ll be expected to generate the same amount of revenue and work the same number of hours. It’s common for acquisitions to include compensation guarantees that allow a gradual transition to an updated compensation plan for the combined practice. 2

The valuation question Regardless of the reason for the acquisition, the single most important thing to determine is the value of the practice that’s being acquired. Besides the fact that both sides need to agree upon a valuation to come to an agreement, how the practice will be valued and how that value will fold into the combined entity will play a key role in ascertaining whether the combination meets everyone’s objectives. The best way to begin the valuation process is to look at the practice being acquired as a standalone business, without consideration given to potential savings and synergies. That valuation then provides a baseline to which those savings, revenue increases, and other benefits of the consolidation can be applied and valued. 3 Most often, valuations of public accounting practices are viewed in terms of a multiple of the acquired entity’s annual billings. That multiple incorporates a series of factors, including the amount of cash (if any) that will be used as a down payment on the transaction, the period of time during which the acquired practice’s clients are expected to be retained, the additional profitability the buyer anticipates as a result of the transaction, and the length of the payout period. The quality of the practice, its clients, and its volume may also affect the multiple. 4 According to Sinkin and Putney, cash payments typically fall between zero and 20 percent of the price, with 10 percent or less being more common. The amount of down payment is largely affected by the time of the year and how the receivables of the target practice will be treated. The retention period generally calls for a minimum percentage of collections over a specific interval. If revenues are lower than expected, the payment to the seller may be reduced. Profitability also reflects how well the combined practice retains clients from the acquired entity. 5

Structuring the acquisition How the transaction is structured is just as important as the valuation itself. After all, the acquiring practice needs to be confident that the deal will be profitable, and the selling practice needs to be compensated fairly for both its tangible assets and the sweat equity the owner or partners have invested. 6 Rarely are combinations of public accounting practices mergers of equals. More often, one practice is essentially taking over another and some or all of the owners of the two practices will share in ownership of the combined entity. What typically guides the structure is the 866- 625- 3863 • w w w. o a k s t re e t fu n di n g.c o m | 2

Whitepaper: Strategically planning your CPA practice acquisition

amount of time the seller or sellers intends to continue in the profession. A transaction in which the seller intends to keep working for 20 years will need to be structured very differently than one in which he or she will retire in the next two to three years. In some transactions, only part of a practice will be sold. These are often referred to as “cull out” sales. 7 Ultimately, the deal must be structured in a way that satisfies the interests of three parties: the acquirer, the seller, and any external sources of funding. As with valuations, a transaction involves a variety of elements, most notably: • the amount of cash used as a down payment • any working capital needed to make the transaction viable • the impact any new or acquired debt will affect future cash flows • assets that can be leveraged to facilitate funding • negotiation of any differences in opinions about valuation, and • the effects of potential synergies created by the combination. 8 In situations in which a practice owner anticipates retirement (or a significant work reduction) within the next five years and recognizes the value of building client comfort with the acquiring practice as quickly as possible, Sinkin and Putney suggest what they call a two-stage deal, in which the seller first moves into the buyer’s practice or functions as a satellite. The seller remains responsible for maintaining his income as his clients become comfortable with the new firm. The second stage of the transaction is the formal buyout. 9

How to finance the acquisition Most acquisitions will require some degree of outside funding, either because the practice lacks sufficient capital or is unwilling to tie up a large portion of its working capital. In fact, an acquisition typically involves two processes that take place fairly simultaneously: negotiating a structure for the transaction and securing the funding to support it. 10 As you’re developing a plan for acquisition, you should also be working on a formal plan for the financing. Based on the valuation and financial health of the practice being purchased, determine how the combined entity will perform based on the factors that are most important to you. Consider the amount of risk you and any partners are willing to assume and base the limit for your investment on that risk tolerance. Get to know potential financing sources that may be willing to handle such a transaction and share a business plan that supports your ability to create value through the acquisition and qualify for financing. Before committing to a particular lender and structure, it may be beneficial to ask those sources to look over your plan and provide an honest assessment of their appetite for funding it. 11 So where should a practice turn for funding? The logical place may seem to be a commercial bank in the community, but that’s not as likely a source as one might think. For one thing, the last recession and subsequent regulatory reform have tempered the willingness of commercial banks to lend money. Even if a loan officer initially expresses optimism about the financing,

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Whitepaper: Strategically planning your CPA practice acquisition

“Generally, lenders will expect to see your practice demonstrate liquidity by making a down payment, perhaps 20 percent of the valuation or more.”

after the application spends weeks or even months working its way through underwriting, the loan committee, and other internal steps, it’s likely to be rejected. The reason is simple: banks are most comfortable with credit that’s backed by tangible collateral, and a fee-based business like an accounting practice isn’t likely to have enough collateral to please a banker. 12 That’s why it’s so important for a CPA practice that is seeking acquisition funding to invest some time in due diligence related to the potential financing source. For example, if a bank has little or no previous experience with lending money to accounting practices for purposes such as acquisitions, they’re not going to be likely to agree to your request. Generally, lenders will expect to see your practice demonstrate liquidity by making a down payment, perhaps 20 percent of the valuation or more. They will also expect your plan to address working capital needs until the combined firm’s receivables provide sufficient cash flow to cover compensation and debt service. 13 If your practice has the opportunity for an acquisition, but you need additional capital or don’t want to tie up your existing capital, one source that may be able to help is a specialty lender that is already accustomed to working with the accounting profession. Such lenders understand how a firm like yours operates and are familiar with the nature of your structure and revenues, so they can approach the underwriting with realistic expectations and an appreciation for the inherent risks. Another advantage is that as private companies, these lenders are not restricted by the federal limits associated with some other types of loans.

Working with Oak Street Funding® With a loan from Oak Street Funding, you can borrow against the future cash flows from your clients. It’s a solution other CPA practice owners have used to finance acquisitions, as well as other strategies for growth and competitiveness. Oak Street can customize a loan for your needs and situation, up to $3.5 million, with a term of up to 10 years. The goal is to help you finance growth with minimal out-of-pocket cost by leveraging the power of your firm’s cash flow. Learn more or request a free quote at www. or 1-866-OAK FUND. The strategic opportunities available to CPA practices are limitless. Access to affordable capital is the key to taking advantage of those opportunities, and Oak Street Funding has money to lend.

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Whitepaper: Strategically planning your CPA practice acquisition

About Oak Street Funding The materials in this paper are for informational purposes only. They are not offered as and do not constitute an offer for a loan, professional or legal advice or legal opinion and should not be used as a substitute for obtaining professional or legal advice. The use of this paper, including sending an email, voice mail or any other communication to Oak Street, does not create a relationship of any kind between you and Oak Street. Loans and lines of credit subject to approval. Rate may vary at any time. CA residents: Loans made pursuant to a California Department of Business Oversight Finance Lenders License (#6039829). Potential borrowers are responsible for their own due diligence on acquisitions.

1 Sinkin, Joel and Putney, Terrence, “Mergers and Acquisitions of Accounting Firms: When, How, and Why to Merge,” CPA Journal, December 2017. 2 ibid. 3 Marks, Kenneth, “How to finance an acquisition,” AICPA Store, November 6, 2014. 4 S  inkin, Joel and Putney, Terrence, “How to value a CPA firm for sale,” Journal of Accountancy, November 2013. 5 ibid. 6 Sinkin and Putney, December 2017. 7 ibid. 8 Marks, op. cit. 9 Sinkin and Putney, December 2017. 10 Marks, op. cit. 11 ibid. 12 H  ayes, Chuck, “Financing the Acquisition of an Accounting Firm,” Accounting Practice Exchange, undated. 13 “Financing an Accounting Practice,”, undated.

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