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How to build an effective succession plan for SMPs

Succession is a common issue facing small- and medium-sized practices (SMPs). However, because of the more urgent needs of dealing with daily operational issues, there is a tendency to perpetually relegate succession planning to the backburner. Practitioners should devote time to their succession plans so that the primary goal to transition a client relationship to the successor can be successfully followed and the value of the practice realized. What are the options?

Internal succession

Internal options include identifying and grooming staff with the hopes of getting them to partner-level, hiring new partners and staff who have partnership potential, and buyouts by existing partners.

It is critical to improve the attractiveness of the practice for future partners to ensure buy-in. Remuneration and job prospects, for example, are some of the determining factors. One should also implement programmes to enhance the technical and soft skills of the potential candidate. Interpersonal skills, such as good leadership can also attract more business. It is important to develop criteria and key performance indicators for what it takes to get promoted to partner-level and have them communicated clearly to all members of staff. Furthermore, for larger firms with a view to build a perpetual practice, the “zero-in zero-out” system can also be considered. Under such a system, newly admitted partners do not have to buy an equity share but neither can they cash in on retirement.

The buyout option implies that there is an existing partnership, and that remaining partners are prepared to take up shares of the retiring partner under certain conditions, usually already enshrined in the partnership agreement. These cover areas such as pre-emptive rights and valuation methodologies. A good succession plan should also address the potential problem of multiple retirements within a short period of time, especially where there is a core group of partners approaching the age of retirement.

Sale or merger

A sale can be the sale of whole practice or fee parcel. Another option is a progressive sell-down where the practitioner progressively sells down a percentage of their business. This means that during the period of selling-down, there is a partnership in place. In a sale to an existing member of staff, it is likely that the practice will continue to operate in very much the same way. If an external buyer or merger candidate is sought, it is important to partner with one that offers the greatest level of continuity to its clients and staff. The determining factors include areas of specialization, client service, management philosophy, work style, systems compatibility and billing rates. There should be a comprehensive integration plan to ensure a smooth transition.

Valuation and deal structure

The value of a practice takes into account the quality of earnings, growth prospects and risks. One should also consider the synergy effects from combining practices such as economies of scale, costs lowering, and the starting of a new service line.

There are two commonly used valuations methodologies, capitalization of future maintainable earnings and “industry standards.” Capitalization of future maintainable earnings involves the determination of the current value, based on expected future earnings. By applying a capitalization rate, a multiplier can essentially represent an expected rate of return on investment. The rate, which is often within a range, is based on factors such as interest rates, the length of time the practice has been in operation, associated risks, the degree of reliance on the retiring practitioner, clientele and staff quality, and the ratio of price earnings of listed accounting practices, etc.

The simple industry standard model is popular among smaller firms, which is a multiplier applied to either the earnings before interest and tax, or the fee revenue. A typical norm is two to three times the average annual earnings. The main drawback of this method is that it assumes all firms are run and managed in the same way.

An earn-out model is often adopted, where the payment is contingent upon the continuation of the retiring practitioner for a specified period and client retention rate. Most payment is structured over a number of years.

To conclude, succession is an inevitable issue that SMPs have to deal with. It is simply never too early to plan ahead.

This article was originally published in the April 2018 issue of A Plus. You can also read the digital edition.