This article was first published in the March 2014 UK edition of Accounting and Business magazine.
The UK Top 60 accountancy firm league tables reveal mainly modest growth in fee income. Some of this is driven by merger activity, but this is only the tip of the iceberg as, although not so visible, the remainder of the independent sector has been equally active. Many practices have seen their rivals growing and becoming ever more aggressive in the marketplace. They feel that they simply will not be able to compete unless they, too, jump on the merger and acquisition (M&A) bandwagon.
In the current business climate firms may be looking for a quantum leap in growth rather than the more pedestrian speed of organic development, and may also be driven by other factors including the need for geographical expansion, improving profitability, acquiring additional service capability through the recruitment of specialists or gaining general practice work as a platform for delivering services already offered by the firm.
The impending retirement of a partner also requires the reconsideration of what the firm will need going forward. Does it need a like-for-like replacement, or is a strategic merger the right route for all concerned to financially stabilise the outgoing partner, safeguard the continuing client base, provide the services clients need and maintain and improve profitability? Merger or acquisition always requires the right reasons and not a knee-jerk reaction; a good business and financial case has to be made, avoiding the pitfalls and the potential deal breakers that experience shows can impact.
Practice growth comes from two sources: organic development through the acquisition of new clients and the development of added-value services; or the merger/acquisition of compatible and appropriate practices where the combination will make good business sense and add value to both parties.
Although there is a perception that mergers always confer benefits, the record in recent years does little to support this view. Few have proved disastrous but, equally, few have resulted in clearly defined beneficial outcomes. One of the biggest stumbling blocks is lack of experience. Larger firms may merge several times over a period of years, but the majority of small practices only have one chance to get it right and the potential for disaster is therefore greater. The principle often forgotten is that clients must benefit; the provision of service value will produce additional benefits for them, and thereby additional profitability for the practice. Other factors have a bearing but even where succession issues are the underlying reason, added value should still be a key driver. A well-constructed deal does not have to follow conventional lines if all the parties involved are to benefit, regardless of the size of the firm involved. A certain amount of nipping and tucking can improve the outcome of the deal provided the basic rule is never forgotten: Vision + strategic fit + effective leadership and management = enhanced and sustainable profitability
Increasing the size of the practice through a merger or acquisition will not necessarily and automatically lead to greater profitability. Few of the things that determine a firm’s success – client service, developing new services, productivity enhancements – are critically dependent on size. Firms can, and should, be working on these aspects anyway, long before they look to size to solve their problems.
Taking account of the partners’ personal views is essential as they are probably the biggest prospective deal breakers in any merger. No matter how closely they agree on the business aspects of the deal, when it comes to their own aspirations and expectations there is a huge potential for conflict.
All of these should contribute to improved minimum and average partner earnings within the short term, but where succession planning is the major issue the aim should be for the final merged firm to provide reasonable partner exit routes without damaging future profitability.
Merger or takeover?
There are few true mergers. The reality is usually a takeover of one firm by another, with the stronger gaining the most advantage, ensuring that there is one management style, organisational structure and working methodology adopted across the combined firm. Often this means that the partners in the weaker firm must accept terms that they do not find ideal, or accept a lesser value on the business than they think it is worth. Arriving at a true valuation of the business may be difficult. Those firms that have changed to a more corporate structure such as an LLP or limited company will need a valuation mechanism for the interests of the equity holders in the business and a means of confirming what happens on retirement.
For a traditional equity partnership there are two principal methods of calculating the purchase price: either a valuation based on a percentage of gross recurring fees (GRF) or a multiple of superprofits available in the practice. The arm’s length market emphasis is on the GRF multiple basis, whereas the superprofits method is of particular value for a specialist practice or as a check on the GRF basis.
There are a range of issues on which both parties must be agreed if the merger is to be successful. The management structure and the development of the business going forward, individual aspirations of partners and the compatibility of working practices and methodologies all require in-depth discussions before any deal can be considered. Cultural fit is vital. Those firms that have undertaken the most successful mergers all agree that they cannot risk damaging their culture and are prepared to devote time to ensuring that the people are the right fit. Other potential issues include agreeing a name, adopting a common policy for profit-sharing arrangements, agreeing retirement plans (and in particular the issue of goodwill), the hierarchy of the partners within the merged practice, and even the management of debt and the control of working capital.
Due diligence procedures should begin once there is a willingness and commitment on both sides to make any necessary adjustments in order to create a harmonious fit between the two firms. This process cannot be skimped if there are to be no problems that will be difficult or expensive to resolve. Both parties must be willing to divulge financial, client, staff and other relevant information, and prepare a financial evaluation covering the first two years based on realistic and prudent assumptions.
Caveat emptor! The final piece of the jigsaw is a considered post-merger integration strategy to reassure clients that the service they are receiving can only improve as a result of the merger, and to bring staff quickly up to speed on the aims and objectives of the combined firm and the part they are to play in achieving them. Always remember, though: marry in haste and repent at leisure.
- What are we aiming to achieve?
- Is a merger or acquisition required to fit an identified gap in the firm’s infrastructure or service coverage?
- Will acquired/merged growth improve the quality of service to clients and improve profits per partner?
- Acquisition of quality clients
- Greater geographic coverage
- Potential cross-selling of professional services
- Acquisition of specialist services
- Acquisition of specialist people
- Marketing the firm’s existing and new services and adding value.
Andrew Jenner FCCA and Phil Shohet FCCA are directors, Kato Consultancy