Stop issuing small equity ownership pieces

There is a recurring problem that emerges when accounting firms issue small amounts of equity to a professional. Some do it as a wonderful thing to reward a highly valued employee. Others do it to keep an employee satisfied and part of the firm. No matter what the objective is, this can and often does cause problems later.

They issue or sell 5% or 10% of the firm’s equity. How they sell it and at what value is a topic for a different article, but let’s focus on the 5-10% equity issue. Take a $5 million firm that issues or sells 10% of its equity. That professional now has $500,000 in equity or an equity stake.

This can materially handcuff a firm. If the firm needs to sell or merge upward because they cannot pull off an internal succession, they have a problem. Most firms outside of the smaller-firm market are targeting a revenue per equity partner of $1,500,000 to $3,000,000. Some are larger and a few will go lower, but those with equity levels below the acquiring firm’s minimums have the potential to create difficult and costly discussions. They cannot afford to admit a partner at this level because of the leverage needed to run their firm and the current professionals on their team seeking partnership that need to attain that higher target.

No matter what the intentions are, when you have equity partners with lower books, you have just complicated your exit if you need to sell or merge upward. Those lower equity partners are going to have to give up their equity status in almost every situation. While it might be a “feel good” position to issue that level of equity, it is a crushing blow to take away the equity later.

The impact can be devastating on your upward merger or dirty effort. A major part of the value of the firm is the professional bench that can support the client base. Very few firms buy a book of business anymore without the staff that comes with it. Lower value equity partners who cannot be admitted as equity partners into the new firm may become disillusioned and may seek another position.

The public will have no idea they are not equity partners. These partners can come over as income partners in many transactions, so their title and business card still read partner, but the loss of equity is a hard pill for many to swallow.

What are the transitioning partners who need the upward merger or sale to get the value of their firm supposed to do? Do they not sell or merge up? If an internal succession is not possible due to a considerable risk of not getting paid by the succession team, if the succession team decides the value is too high, or if the succession team has not proven to be capable of bringing in work to sustain the revenue to fund a buyout, the major equity partners do not have a choice. There is an emotional element to wanting to keep a key employee by offering equity, but you might need to reward the employee using bonuses or other benefits before issuing limited equity amounts.

Either make a larger commitment to bring their equity position to a level closer to what they would need to integrate into another firm, or be dead set that they can pull off the internal succession and make the payments to the retiring partners.

Too often we see a $5 million firm with five equity partners or a $2 million firm with four equity partners. In either scenario, there is probable damage. The $5 million firm does appear to be closer with $1 million per equity partner, but when you peel back the pieces, it is rare that the five equity partners have equal value. A more common situation is two partners have 60-70% ownership, leaving the other three with 30-40%. Forty percent on $5 million is $2 million divided by three partners — about $667,000 in equity each. That’s still not enough to bring them over as equity partners in an upward transaction.

There might be firms willing to admit a smaller dollar equity partner. The question to ask is would an upward merger or sale into a firm operating that way really put you into a secure position of feeling comfortable with this firm as a safe transition partner? Before you make the plunge and issue small amounts of equity, carefully measure the potential consequences. A great intention can turn into a complex, disruptive element in obtaining your value.

Another factor in all of this related to equity is the value of the firm. The above numbers are based on a 1x multiple value of a firm. If an equity partner has a $600,000 stake and the firm’s value is a multiple of .8, then the adjusted equity value drops to $480,000. We conducted 20 transactions in 2021, and 2022 is on a similar pace. The difference between the two years is the level of succession engagements and partnership/operating agreements engagements are higher than ever.

It’s not a mystery why this volume is increasing. Owners are getting older. Many are realizing their transition is either in jeopardy or unclear — and with that in mind, it doesn’t make sense to add another obstacle in the form of small-dollar equity partners.

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