One of the most important issues facing small and medium-sized firms today is the problem of succession: how to fund the retirement of older partners whilst maintaining the profitability of the practice and making it an attractive proposition for potential incoming partners.
The expansion of the 80s and the recession of the early 1990s has influenced the way the profession has developed in the last two decades, and because too few practices have given sufficient thought to succession, many will have to resolve major financial problems in the next five to 10 years.
To find out why this situation has arisen at this particular time, we need to examine the way in which the profession has changed during the last two decades. For the majority of practices in the 1980s the emphasis was on growth and development. This was followed by severe recession during which the main strategy for many firms was survival and there was little thought for expansion. In recent years growth has again become a possibility, but this has come predominantly through merger and acquisition and not through robust organic growth.
As a profession the partners in practising firms are mainly middle aged. 45% of partners are aged 45 or over. Most of them will be looking to retire at 60 or 65, and unless the average age of partnerships can be substantially reduced in the next few years funding these retirements will place a heavy financial burden (repayment of capital and goodwill) on any practice that has not had the foresight to develop a succession plan.
Practices with a high proportion of older partners should be looking to appoint younger replacements to develop the business and help fund their exit routes. However, attracting the right calibre of prospective partners is proving very difficult. There is a dearth of younger members of the profession who are prepared for the risks of being in practice and who find the concept of partnership an attractive one. Many young accountants simply do not want to make the financial commitment or take on the responsibilities and risks associated with partnership. They are quite happy to remain as salaried employees, or to work outside of practice in industry or commerce in a senior role, and for some this is a very attractive option.
It is clear from all benchmarking surveys and available evidence that, in real terms, the financial remuneration of equity partners has changed very little in the last ten years. This is undoubtedly a key reason for this risk averse attitude. Coupled with financial considerations are the major lifestyle changes that have occurred in the last twenty years (later marriage, divorce, second families, younger families and education needs) as well as the increased work-related stress caused by practice regulation and new legislation. Quite clearly the culture and structure of the average accountancy practice will require a shake-up if a partnership is once again to become the career goal of most young accountants.
It is not simply in the area of human resources that changes are required if practices are to achieve continuity. Partners must have a very clear idea of the range of services their clients require in both the short and the long term, and must be prepared to implement the structural and cultural changes that are necessary in order to service those needs in the most efficient and profitable manner.
Technical and compliance work forms the bulk of the activity but is not a growth area for small and medium-sized firms. It will become even less significant in the short to medium term when the audit threshold is raised towards £5m. Practitioners must therefore develop a greater range of business advisory skills and be prepared to diversify into new areas of corporate and personal advice if they are to maintain business growth and profitability.
Growing businesses, principally owner managed businesses, comprise the primary target market for the profession. Their need and requirement is for business planning, managing growth, raising finance, profit improvement, tax planning, retirement planning, pensions and investments and mergers and acquisitions. The ability to provide these skills will be vital for maintaining profits and fees in the practice. Partners will need a considerable investment in skills by either re-engineering existing personnel (and partners), or by recruiting in the desired abilities, some of the recruits possibly having a fee following whilst others may have none.
With the emphasis moving from compliance to advisory work, the trend is for practices to divisionalise. Essentially, this involves separating compliance and non-compliance work. Taken a stage further, the assurance services (for example, audit) can be separated from all other activities, which are then placed in a corporate entity. This creates a business with value which can provide a dividend income for the shareholders (who could also include retired partners) and a saleable asset to create an exit route.
Some firms are adding specialist departments through merger or acquisition. The majority of small and medium-sized practices have given very little thought to creating a practice structure that will service the needs of the clients, improve profitability and ensure continuity through effective retirement and succession planning.
Succession planning should be included in the Partnership Deed through appropriate drafting. Experience shows that over half of all partnerships have no Deed or a Deed that has not been regularly reviewed or updated for present circumstances.
Partners’ anticipated retirement dates and their entitlement (let alone their expectations!) on retirement should be set out in the Deed together with the pay out period and basis. The business strategy will include planning for retirement funding; failure to plan well in advance could place an intolerable financial strain on the practice.
Figure 1 sets out a summary of partnership and partners’ succession concerns.
Figure 1
Partnership and partners’ concerns
New partner appointments
A key element of the succession plan, and indeed the overall practice development strategy, is the appointment of new partners, either through internal promotion or external recruitment. New equity partners help to provide the capital to fund retirements. At a time when recruitment market alternatives make it difficult to attract the right calibre of partner, it is essential to ensure that the practice is as attractive as possible for the candidates. Equally, it is just as important not to grab the first candidate who comes along, but to take the time and effort to select the right people who will be able to service the changing needs of the clients, ensure profit growth and fund partners’ exit routes. Sources of new partners will be, inter alia, internal training and promotion, recruitment from other practices, merger or acquisition, or non-chartered accountants with appropriate skills.
Many larger firms now take the view that client needs can often best be served by non-accountants. They appoint partners from other disciplines and professions; for example, banking, corporate finance, financial services and the legal profession. Smaller practices, particularly those who are prepared to diversify into niche areas, could well find that having a non-accountant partner has considerable advantages. The ICAEW has introduced an ethical guideline that allows for 50% of the partners in a firm to be non-chartered, subject to certain rules.
Whatever their source, new partners should not be appointed solely for their technical skills. They will need to have other attributes if they are to contribute to the successful development of the practice, in particular the ability and acumen to run the practice as a business, find and develop new clients, and generally create value. 10 years ago up to 80% of the gross fees of the average firm were recurring, but today the target figure for recurring work should be at least 30%/40%. This means that marketing and selling skills are vital to attract the added value business which is the source of better profits. Partners must be team players, effective human resources managers and conversant with the latest technology. Not every partner will be an expert in every area. Indeed it is important for the health of the practice that there is differentiation at partner level. It is the role of the managing partner to ensure that the partnership as a whole can muster the range of required skills to fulfil client needs and ensure that the practice is working effectively. He has to act as a mentor to new partners and ensure that they are successful.
The training required to qualify as a chartered accountant does not include all of the skills required by a partner in a modern accountancy practice. Practices are OMBs, very much like many of their clients, and the practitioner requires the business skills that are essential to be a part owner. Firms who plan to promote partners from within must identify the required talents within the workforce, and be prepared to invest in the necessary training to equip potential partners with the abilities they require to function effectively in what is now a highly competitive marketplace.
The downside of partner promotion from within to the exclusion of other means is a lack of breadth of experience. Where all the partners have worked in the same practice for many years it is quite possible that they become insular and resistant to changes in working practices. Recruiting new partners from outside the practice will avoid this pitfall.
Recruitment from outside the practice demands that sufficient time is allowed for background research on the potential partner which goes a great deal further than simply checking references. Talking to previous employers and colleagues will often reveal more than the CV or references. Some firms adopt personality tests or skill profiling.
The new partner must be are fully incorporated into the firm from day 1. The appointee must have their own portfolio and responsibilities.
Competition for high-flyers who will be future partners will be fierce and firms must to consider adopting staff retention methods that have been used for some considerable time in industry and commerce if their investment in the acquisition and training of human resources is to be worthwhile. Happy people perform better! Consequently it is a must to invest time, care and a percentage of profits in strategies to incentivise staff, make them feel part of a team and increase their loyalty to the firm.
Partner rewards and incentives
Financial rewards must include a realistic salary and profit incentives geared to both individual and team performance. For many people status and a challenging environment are as important as financial rewards. Firms should strive to create a stimulating atmosphere where staff at all levels are pushed to achieve and are supported in their efforts to do so through training and the encouragement of their superiors.
Profit sharing arrangements are traditionally based on equality amongst the partners, either after a period of years or immediately. Alternatives which are appropriate to a changing business environment and require strong consideration for their ability to attract and retain key people include, inter alia:
No matter what exit route the partners are planning to take, a healthy and profitable practice is vital if they are to capitalise on a lifetime’s work. This can only be achieved through investment in human resources.
Alternative arrangements
Not every firm is in the position to buy-in expertise to ensure succession. There are alternatives that will enable them to provide a wider range of services to their clients without investing heavily in organic growth.
Networking on an informal basis by small firms with other local practices can provide the desired breadth of service breadth they need. Joint ventures with specialist boutique firms can provide expertise in a single area.
Alternatively, many medium-sized firms have found the range of specialist skill and support they need through membership of more formal organisations such as CharterGroup or UK 200 Group whose services enable them to compete effectively with much larger practices. A few have taken the route of a formal alliance with a larger (perhaps Top 20) practice. This allows the firm to offer a wider range of services under its own identity, whilst retaining independence. This arrangement offers many of the advantages, but fewer of the potential pitfalls associated with a full merger. Indeed, it can be a most effective vehicle for each to assess the other with a view to a future merger or acquisition if they prove compatible.
Merger or acquisition is an alternative method of growing the practice, either as part of the general practice development strategy or to finance partners’ exit routes. For those who have not given any thought to succession planning it could be a route they are forced down as the only means of financing retirements and, as with any forced sale, the likelihood of achieving a satisfactory level of financial compensation is not very high.
Recent years have seen a huge increase in the amount of M&A activity at every level of the profession; however, the road to a merger or acquisition is full of pitfalls. Unfortunately a significant proportion of mergers are not nearly as successful as the parties involved had hoped. This can be due to the unrealistic expectations of the partners. More often it is because either or both of the firms involved have not taken sufficient time and trouble in their due diligence investigations, including ensuring that the personal chemistry so necessary to make the combined business work is right and comfortable, before signing on the dotted line.
It makes no difference whether a merger or sale is being considered as part of the firm’s overall development strategy, or primarily as a method of funding partner retirements; the essential procedures remain the same. All partners must be agreed on exactly what it is they are expecting to achieve through a merger, and what they are looking for in an ideal partner. In a sale situation (and many older partnerships look upon sale as a means of realising their goodwill) they must agree on the value of the practice. Ultimately, as with any other commercial transaction, it is the marketplace that decides the value, but unless the partners have a minimum figure in mind on which they are prepared to negotiate, there is a very real chance that they will not achieve the optimum financial compensation.
Finding the right merger partner is not solely a matter of ensuring that the financial arrangements are satisfactory. There are many other factors involved that require investigation. All too often firms do not take sufficient time and trouble to ensure that the many other ingredients that make a successful ‘marriage’ are given the attention they deserve. (See figure 2.) Figure 2
Some due diligence considerations
A very recent development and potential exit route for partners who wish to free up the capital tied up in their practices is the arrival in the UK of consolidators. They offer an alternative, primarily for medium-sized firms.
The consolidators’ intention is to build practice value through added value business advisory work. The prospect of incorporation, capitalisation and limited liability status should prove attractive to the firms who predominantly service medium-sized and owner-managed businesses – a sector of the market that offers a major opportunity to sell an increasing range and level of services both within and without the current scope of the accountancy profession.
The arrangements are likely to include the offer to buy practices using a mixture of cash, shares and share options. Partners will receive a mixture of cash and shares in the holding company, locked in for a minimum period, with a view to long term capital appreciation. The audit business of each acquired practice would be hived off into a separate company of which the audit partners may become directors. The remainder of the practice would be absorbed by the consolidator with the partners becoming directors. Branding and identity will be an issue.
Firms who have failed to make sufficient provision for financing partner retirements may not find an exit route through traditional consolidators unless the practice is otherwise successful. Nor are firms where the entire partnership wishes to sell up and retire. Consolidators look for successful firms where the majority of the partners wish to become actively involved in the new venture and help to develop the business.
For equity partners it means the release of the capital they have invested in the firm. It also means that, as directors with limited liability, many of the risks attendant on the partnership structure disappear. This will undoubtedly help to encourage younger members of the profession to set their sights higher. With no capital investment required, coupled with a much lower risk factor, the prospect of a directorship in a professional services company, as opposed to a partnership in an accountancy firm, is more attractive.
The range of services that the consolidators are expecting to provide, coupled with the significant degree of capital investment in maintaining and expanding those services that they are promising, will certainly help to allay any client fears caused by such a major culture shift on the part of their professional advisers.
Conclusion
At a time when the accountancy profession is facing greater challenges than ever before it is vital that every practice devotes sufficient thought and resources into succession planning. The future for many partners who plan to retire in the next ten years is dependent upon their business maintaining and improving its profitability and cash flows. Equally, they must be clear as to who will inherit the firm as the next generation of partners. Without this emphasis and clearly defined retirement plans in place, with properly costed and funded arrangements, their own retirement aspirations may not be met.
Phil Shohet and Andrew Jenner are directors at KATO Consultancy. Tel: 01622 851330
