Future Think

May 01, 2012

Why Your Small Firm Needs a Practice Continuation Plan

By Mark R. Schaim, CPA, MA
Did you hear the one about the sole practitioner who became disabled and couldn’t return to work? Within several weeks she lost all of her clients and employees.

Not much of a joke, is it?

But situations like this happen all too often because no provisions are made for another CPA to immediately call clients and pick up the load. But it doesn’t have to happen that way. In this case, all the practitioner would have needed was a little planning and a practice continuation agreement, which would helped preserve the value of her practice—something she may have spent years building and could be the largest asset in her estate.

If you become disabled, die or otherwise are unable to continue running your practice—and haven’t adequately planned for someone to immediately step in, properly notify your clients and take over for you—you will be lucky if your clients stick around for a month. Why should they if there is uncertainty about your condition or about their continuity of service? With no capable person contacting them and seamlessly continuing the practice, they will find another accountant, and quickly. And, truth be told, most of your clients already know of another competent CPA they would use. 

You also risk losing your employees. What quality staff members would stick around if they had no idea of the firm’s future and saw clients leaving?

What is a Practice Continuation Agreement?
A practice continuation agreement is a contract with another CPA or group of CPAs to take over your practice in the event that you can’t for health or other reasons. It provides for the transfer of your practice to a compatible, preselected practitioner. Additionally, the agreement can be used as a retirement vehicle.

Implementation Steps
Ensuring the continuity of your practice by using a practice continuation agreement requires three major steps:

  1. Identifying a successor;
  2. Determining the value of your practice; and
  3. Negotiating terms.

Identifying a Potential Successor
The successor is the key to the benefits you and your heirs will receive in the event you can no longer run your practice. Your ideal successor will share your values, commitment and technical skills. To decide who will be a potential successor, you must first determine your firm’s characteristics and attributes. Then:

  • Review your goals and procedures. Consider your reputation, specialties and billing rates, salary structure, location and business culture.
  • Consider your firm’s financial health, including its financial ratios and historical performance.
  • Create a summary of the basic data for each client (without using identifying information). You will compare these aspects of your firm with those of any potential successor.
  • You want your successor’s operating  philosophy, personality, experience and management style to be compatible with your firm’s culture and goals. The successor must also be in a position to manage the additional work required by the agreement—regardless of the time of year—and have the wherewithal and sense of financial responsibility to pay the purchase price should a sale be necessary.

Where to Look for a Successor
Your own circle of practitioner friends, referrals from attorneys or bankers, or other practitioners involved in CalCPA are great places to start identifying a successor. But perhaps the best choice might simply come from within your own firm or from former employees: someone you know well who has the right qualifications and experience. 

It’s generally not a good idea to select someone near your same age as they might not be active or healthy enough to take over when the time comes.

Points to Negotiate
The important points to negotiate in a practice continuation agreement include the amount, method and timing of payments to your successor; the method of valuation and payment terms for the practice upon sale; cancellation provisions; arbitration provisions; details of a non-compete agreement; billing and collections practices by your successor; arrangements for the retention of workpapers and files; and the handling of receivables and payables, leases, insurance and employment records.

Payments to Your Successor: Temporary Disability
In the case of a temporary disability, how much should your successor be compensated for temporarily replacing you? This is negotiable, but I have seen payments in the range of about 75 percent to 125 percent of the billing rate of the person temporarily taking over for you. If that seems high, remember that your successor is the key to retaining your practice value.

Valuation and Payment Terms if Your Practice is Sold
There are several methods that can be used to value a small CPA practice. Among them:

  • A multiple of historical annual fees collected (usually between 100 percent and 120 percent).
  • A projection of future fees or future net income discounted to present value.
  • An amount equal to the difference between the practice’s annual net earnings potential and the annual net earnings potential of a new practice, discounted to present value.

The price so arrived at is frequently adjusted for things like any non-operating assets included in the sale, whether the buyer expects strategic benefits from the purchase, whether there are non-recurring expenses or income in the prior years, and the type of clients being sold.

Don’t forget income tax consequences. Frequently there are advantages to a tax savvy allocation of the purchase price between fixed assets, goodwill, a covenant not to compete and customer lists.

About five years is a customary amount of time for most payouts, with annual payments being a fixed percent of each year’s collections over the payout period. For example: Assuming a sales price of 100 percent of annual collections, a five-year payout would have payments of 20 percent of that year’s collections. Many agreements include a limit on collections over the payout period so that any increase in collections attributable to the buyer’s efforts goes to the buyer. Disability buy-out insurance is available to fund an unforeseen sale or purchase in the context of a practice continuation agreement.

Down payments are not unusual, but seem to be a relatively small percent of the full price because buyers need to pay wages and operating expenses and there may be no guarantees of client retention.

Now What?
You have a practice continuation agreement, what’s next? You must notify your attorney and your spouse of the details. They, along with your successor, will be the first responders. And time will be of the essence.

The timing of when your clients and staff should first be made aware of your succession arrangements is debatable. Many practitioners believe that both should be notified immediately. It’s thought that this will prevent surprises and give them comfort. Other practitioners believe it may cause your clients and employees unnecessary concern. Ultimately, you know your family and firm best and will know when the time is right.

What is your practice worth if you are no longer able to run it? In a word: Nothing. Unexpected events happen and when they do, it’s too late to get your house in order. A practice continuation agreement can preserve one of your most valuable assets while providing your clients with the service and continuity they deserve.  
Mark R. Schaim, CPA, MA
 is a founder and co-owner of San Diego CPA firm of Schaim, Hyde & Company, Inc. and a member of the CalCPA Management of an Accounting Practice Committee.

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