The path to an equitable division of a firm’s profits.

Money Talks or
Partners Walk

BY CHARLES McCANN

here are about 50,000 accounting firms in the United States and nearly that many compensation methods. Right now most CPAs are having their best year ever, better even than last year, which was the best year, and so on—back to about 1994, when the current upswing got rolling. This boom is papering over flaws in partner compensation formulas at many firms. Structuring a firm’s compensation formula from a blank page at the beginning is complicated enough, but it is a monumental task to change one that’s been in place for years. Typically, some partners will be on the down side of a change—and those who are will find it painful.

The CPA profession is in flux, and firms need talented new partners to replace baby-boomers who will be retiring soon. Firms are having to reconfigure their compensation plans to create incentives for younger partners while buying out retiring partners at fair market value—at a time when the old valuation formulas are changing because consolidators competing for firms have driven up values. The challenge of partnering—whether it’s a partnership, a PC or an LLC—means professionals in client service who consider themselves of equal talent inevitably will have issues to resolve. There are some steps to take to ease conflicts and plan for the financial swings likely to occur over the course of a partnership.

FAIRNESS IS A BASIC

The natural goal of a compensation formula is to distribute income equitably based on capital, productivity and time in the firm. Partners must protect their interests, and the firm must prosper as an entity. A firm that’s had a half-dozen partners for 20 years and brings in a young partner—who does well, has a book of business and is charging ahead—has to have a policy on whether 10 years down the road he or she will be eligible to make as much as the senior partners do. Its plan must allow younger partners’ income to increase if it wants to keep them. To work well the firm’s plan has to handle potential trouble spots. Principles such as the following are a good foundation:

Revisit your compensation strategy. If your firm’s compensation plan has been around a long time and is working well, revisit it now anyway. Do a what-if model to see what might happen if income goes down 10% or 15% for two or three years in a row. What problems show up? What would minimize them? Ask the other partners what they think.

Leave some profits in the firm. Obviously you must both compensate partners and leave a little bit in the firm to keep it healthy. Some firms don’t; the partners distribute all the profits, borrow against the receivables and operate on borrowed money, which is not wise.

Have nonpirating sanctions. Typically, the way this works is that if a partner leaves a firm before retirement and takes clients, he or she has to pay for that business. If successful young partners can leave and take business elsewhere without any penalty, it undermines the firm. Compensation, an exit strategy and a nonpirating policy should all work together. Consult an attorney about relevant state laws.

Motivate to achieve results. Compensation methods have to motivate, so a firm’s game plan should build in performance bonuses.

Give to get. At some firms a partner committee assigns the next season’s compensation on a point (or unit) basis. At times the partners on the point committee may give up a few thousand dollars of their share to appease someone else. Consider it an investment. A few years ago, while sitting in on a compensation committee meeting of a midsize firm, I saw the managing partner give up $4,500 of his bonus and allocate it to a younger partner who had been having some tough personal times. The underlying faith his gesture showed has yielded benefits to the firm and to that managing partner every year since then.

Keep an eye on firm value. For 20 or 30 years a firm’s standard value was 100% of revenue—about three times earnings. Consolidators changed the game. Is a firm worth 50% of gross revenue? One times revenue? One point five? (Some consultants assert that a firm is worth about 60% of gross revenue.) Valuation rests on several factors, including the firm’s nonpirating clause and whether it operates as a unified entity or a loose coalition of CPAs pursuing their own books of business. Keep track of valuation trends.

Prepare an exit strategy. Senior partners interested in being paid out must look at the formula and decide how to maximize a retirement buyout. Many want to have their cake and eat it too: After operating as a fiefdom for a generation, they want junior partners to buy them out at 100% of gross billings. Younger partners have legitimate concerns about keeping clients that have not been institutionalized into the firm.

Reinforce client loyalty. To counteract the fact that clients shop more and don’t stay put the way they used to in the ’70s and ’80s, forward-looking firms are taking advantage of the trend toward application service providers (ASPs). Firms are providing more outsourced services—applications such as cash-flow projections, payroll and document management—that make it inconvenient for clients to switch from one firm to another and provide more service value for the fee dollar.

Learn from the competition. People are combining to be able to compete with other firms that are joining forces. Smart smaller firms are forming alliances with financial-services, employee-benefits and other entities to offer a range of services such as asset management, life insurance or financial products. Larger firms don’t have to be the only answer.

THE BAD (AND THE UGLY)

Compensation formulas are based on strategies. The following four compensation strategies constitute shortsighted, flawed approaches. Avoid them because they don’t work.

Eat what you kill. This attempts to directly correlate net profits generated to compensation earned. An eat-what-you-kill strategy can succeed in the short term, but it also can hurt a firm. Simply put, a partner gets paid for what he or she brings to the bottom line. A partner brings in clients; the firm measures their after-overhead net profitability. Obviously, the firm factors in write-offs. A partner who brings in a client but is not the one to serve that client can put it on another partner’s run and get a percentage of that revenue forever. Theoretically, a partner might never have a chargeable hour and make a good living by bringing clients in and giving them to other partners.

If partners successfully build books of business with this strategy, what’s the problem? The firm lacks a way of compensating vital technical partners who don’t bring in business. If there’s no teamwork, how can it designate a marketing partner, develop and train staff, provide for succession or take care of firm infrastructure? When nobody wants to give time, money and resources to support functions, the firm comes apart at the seams. It’s like being on a superhighway without exit ramps: The speed is there but the firm soon runs out of fuel.

Ownership heavy. Some firms still pay partners based strictly on a percentage of ownership—and thus may play down the contribution of partners who do not own a substantial amount of the firm. For example, a six-partner firm in the Southwest has a managing partner who owns more than 70% of the equity of the firm. Although compensation isn’t directly in proportion to ownership, the firm’s decision making is skewed and the other partners see no reward in their future—everything is done for the current dollar.

The equal (no guts) strategy. Firms with this policy pay everybody the same because no one has the guts to tell somebody he’s worth less—or more—than somebody else. The problem: There are not two partners in any firm—unless it’s just statistically coincidental—who should make the same amount of money. The system doesn’t provide for succession if a firm partner dies. And it doesn’t offer incentive. Partners with little incentive may not put much into building the firm, and partners putting a lot into it anyway resent those who don’t.

The discretionary free-for-all. This fight-it-out approach works well in good years—and destroys in bad ones. Partners meet annually to discuss what each partner should make, and by the end of the day the firm’s net profits are divided up. They then go back and make subsequent adjustments and trades as needed. Because you can take income away from someone, a partner can walk in with $600,000 in income one year and walk out with $60,000 for the next. The partnership doesn’t limit the reduction to a certain amount. This gives an advantage to dominant, intimidating personalities. Obviously, the partners with the most client-fee revenue, the most power and the loudest voice will walk away with the most money.

THE GOOD

No two partnerships are the same, but a couple of compensation methods offer firms a workable system. Both strategies will likely serve a firm well from start-up to maturity.

The points system. Partners set a bottom-line target for the next year. They meet in advance to distribute the projected profit on a point, or unit, basis. Say, for example, a firm has eight partners and it projects $1.6 million in profit for the next year. The partners leave 10% in the bonus pool, and then allocate the remaining $1.44 million in units, or points, almost like a share of stock. A partner is allocated 100 points, and if the firm makes its goal those points are worth $1,440 each. If the firm hits the target, the partner gets $144,000 and is eligible for part (which can be none to all) of the $160,000 bonus pool.

At MHM a committee of three partners determined the allocation of points and the related bonus. Everybody knew what their potential compensation was if the firm made the target. Two partners with the same points got the same amount of money before the bonus pool was divided. But if one had more success (as determined by the committee from measurable, revenue-commanded data and discretionary evaluations) and one didn’t, the one with a better evaluation got more of the bonus pool. A poor performer could even have his points cut back, but MHM couldn’t cut him more than 10% in any particular year according to the agreement.

A virtue of this method is that it forces partners to think about the firm rather than just react to events. The firm is managed on a profitability basis, and decisions about training, hiring, marketing and other support functions are made three or four months before the year starts. The system is flexible enough to accommodate productivity surges and dips. And since the partners own income rights that are difficult to take away, they focus more on long-term profit growth. Combining this strategy with an exit plan and a nonpirating clause tends to build a one-firm philosophy.

Caveat: The disadvantages of the point system are that it takes time to correct financial disparities and it’s bad when income goes down. If you can cut partners only 10% and income starts to fall and the economy is slumping and a couple of partners are rising, the firm will have a problem. A bonus pool may not adequately hedge this scenario.

Another important aspect of the partner compensation formula is the need to have capital in the firm. At MHM a partner’s capital equaled his point compensation: If he had $160,000 of points, he had to have $160,000 of capital. A partner who was allocated another $20,000 worth of points the next year had to come up with $20,000 of capital. He was given three years to fully fund the capital. Thus, firm capital always equaled 90% of projected profits. So if the profits next year were $1.6 million, then the firm would have $1.44 million as capital, which helped keep it financially strong.

Three-piece combination. This method attempts to take into consideration ownership and productivity while leaving room for discretionary adjustments.

No successful compensation plan should ignore ownership. The problem arises at firms with, for example, eight partners, one of whom owns more than 80% of the firm. Although it’s clear who makes the decisions, the firm can’t compensate based on ownership because it’s going to be so hugely weighted toward one partner. Still, a partnership has to have some way to recognize the ownership or pay a partner a return on capital. Whatever method it uses to compensate based on ownership, a firm would be wise to limit the amount to no more than 30% of total profits. In other words, leave 70% of the firm’s profits open to allocation based on productivity and other factors.

Increasing a younger partner’s ownership is one of the more complicated issues a firm faces. Partners expect ownership, but every time a firm creates a partner or gives one partner more money, it basically dilutes senior partners’ ownership of the firm. To get around dilution, let younger partners buy more ownership from the existing partners at fair market value. If needed, consult a business valuation specialist for help.

The second part of the compensation combination is measurable productivity. It’s almost an eat-what-you-kill formula. In other words, the firm is going to determine what each partner’s contribution is to the after-overhead net profits of the firm. Partners need to be aware of the overhead, so they can feel it when it goes up or down. There are successful productivity allocation methods that do not deal with the allocation of overhead. The point is to try to measure the true profit contribution of each partner. Then one-third of net income can be allocated based on the relationships determined under this measurement.

Bonuses are part of such a system, and amounts vary widely. If one partner were to bring in almost $400,000 himself, he would probably get most of the pool. But the tendency is to spread it around more evenly, like whipped cream on top of a cake. There’s considerable variation in the amount of the bonus fund, too, but the biggest percentage I’ve seen in a bonus pool is 33%.

The formula therefore is based one-third on ownership, one-third on measurable productivity criteria and one-third on discretionary compensation relating to goals of the firm and partners. Does it make everybody happy? No, it can’t—but this combination formula works because it’s not all eat what you kill, it’s not all equal, it’s not all ownership, and it’s not a free-for-all. It aims to balance some of the inequities that come up in ownership and productivity weighting.

NOTHING SPEAKS LIKE MONEY

After the firm makes a profit, the partners must be sure there is still ground under their feet—so make compensation complement the firm’s strategic plan. Always look to the health of the firm’s infrastructure.

The managing partner should have power to allocate income. Without it, he or she can’t do the job. Some of the most successful firms in the country—many of which are now owned by a consolidator—have succeeded because they had a strong managing partner (almost a benevolent dictator). If the firm has an income-allocation committee, the managing partner should definitely be part of it.

The elements of a workable compensation plan have to be based on performance, and the reward for results must be substantial. Nothing speaks like money. If you’re measuring, recognizing and paying for it, you’re paying attention to it.

To implement action to obtain a firm’s goals and objectives, a compensation plan has to be flexible enough to move with the needs of the firm and motivate partners and staff to meet them. For example, if your firm is growing by leaps and bounds and you’re having recruiting problems, compensate staff for bringing talent into the firm. If you never discuss bad debts or receivables, then you’re going to have a lot of bad debts and receivables. But if the firm pays people a bonus based on how well they eliminate bad debts, it provides incentive. Offer higher rewards for the important needs.

No matter how wise a firm is in implementing a compensation strategy, any firm not making money is in trouble. Remember, nothing beats mature, caring partners doing the right thing. In good times it works. In bad times, it also works.