[author: Thomas Pastore]*

Accounting firm mergers and acquisitions (“M&A”) are blossoming due to strong recurring revenue models, a great record of organic growth over three decades, light asset investment requirements, and economic recoveries and growth worldwide following the pandemic. These factors have created the opportunity for industry consolidation. Major private equity firms including Hellman & Friedman, TPG, THL and Madison Dearborn have made significant investments in the mid-tier of accounting firm giants outside of the Big Four.

Several of these mid-tier firms have grown to their size by making acquisitions of local and regional accounting practices as well as those with specialty niches such as business valuation and forensic accounting services in civil litigation and family law matters. Their private equity investors bootstrap on this experience to continue acquisitions of these smaller local, regional, and niche firms.

However, the accounting industry does have challenges:

• Growing shortage of new recruits
• Disruptive replacement pressures from AI to traditional tax and audit services
• Expansion efforts into non-traditional consulting and advisory services to mitigate the technology threat
• For larger firms, optimal decisions for divestitures or selling part of existing divisions and acquisitions of other firms or some of their divisions

The recent M&A consolidation and divestiture activities have been carried out to both take advantage of the accounting industry’s strengths and opportunities as well as to address to the threats and weaknesses.

These M&A and divestiture transactions can be greatly bolstered by financial advisory services.

The financial advisory firm can provide:

• Transactions Support Services to successfully close the deal
• Quality of Earnings (“QOE”) studies to assess operational cash flow efficiencies/deficiencies
• Fairness opinions for mergers and acquisitions
• Post-acquisition Partner compensation plans

Transaction Support Services

Transaction support services (“TSS”) are customized to meet the client buyer or seller firm’s needs on a particular deal. These services include:

Select Investment Bankers, Deal Attorneys, & Other Advisers

Assistance with vetting a team to ensure that the transaction is structured in the best interest of the client is integral to the transaction process. Selection and retention of the right-fit M&A and other attorneys, business appraisers, insurance professionals, and other consultants is vital for a successful closing.

Prepare For and Go Through Due Diligence

Due diligence is an essential part of the process and requires complete investigation and examination of all details related to the deal structure. It is important to have the knowledge and expertise to accurately prepare the parameters of the due diligence and to be able to clearly discern each and every aspect of the materials and information required to adequately advise the client. This includes agreeing on and choosing which TSS team members will do which due diligence procedures.

Analyze Offers & Counter-Offers

As the negotiations move along, there are usually counter-offers made. It is just as important to analyze counter-offers. Unless a counter-offer is substantially below an offer, assessing and responding to a counter-offer moves the process along showing the potential purchaser the sellers’ and TSS team’s deep involvement. It also helps the parties make clear and concise decisions based on the analyses of the numbers and terms associated with the deal.

Analyze Purchase and Sale Agreement (“PSA”) Terms

Experienced transaction services advisors assist and facilitate the analysis and review of the purchase and sale agreement terms. It is important to ensure that all understood and agreed upon deal terms are accurately reflected in the PSA.

Perform Financial Sensitivity Analyses on Deal Term Changes

To proactively anticipate various offer/counter-offer scenarios, a sensitivity analysis is performed to identify the impact of any changes to the deal terms. This includes low, most likely, and high financial statement projections and using a range of valuation multiples.

Quality of Earnings (“QOE”) – Historical Financial Statement Reported Profits v. Going Forward

Cash Flows

In the world of merers and acquisitions, the QOE report helps the buyer and seller understand key company operating metrics, such as QOE ratios, revenues, cash flow, adjusted EBITDA, and working capital. It bridges the knowledge gap making both buyer and seller comfortable completing the transaction.

QOE analyses are a deep dive beyond financial statements and include:

• QE Ratio: Net Cash Flow from Operations divided by Net Income

Quantify quality income and compare to non-cash accounting profits arising from policy changes, foreign exchange fluctuations, allowance and reserve estimate changes, and depreciation estimates

Ratio > 1 – higher quality earnings; ratio < 1 – lower quality earnings

• Additional Key Ratios: accounts receivable turnover; accounts payable days outstanding; sustainable profit margin; realization analyses: budgeted fee billing hours versus actual billed hours; client retention and turnover history; employee turnover

• Revenue patterns and growth, such as anomalies, seasonality, client concentration, and service concentration

• Expense Adjustments: 1) additional recurring costs after the transaction; and 2) expenses not required after the transaction, such as duplicate overhead for consolidated operations.

• Working capital requirements going forward, receivables, reserves, and liability recognition

• Identify and analyze potential indebtedness not on balance sheet which may reduce the purchase price, e.g., litigation matters, and income and sales tax audits

Fairness Opinions – Testing Deal Terms

Oftentimes, an acquirer’s board of directors are subject to the business judgment rule. In the context of mergers and acquisitions (“M&A”), this means that the board must either: (1) possess the knowledge and experience to ascertain whether the proposed business transaction is fair from a financial point of view, or (2) lacking such knowledge and experience, rely on an outside independent financial advisor to make this determination presented in the form of a fairness opinion letter and supporting pitch deck.

In rendering a fairness opinion, the financial advisor will conduct due diligence procedures including:

• Extensive interviews with target[1] company’s executives
• Independent research on target company’s operations
• Detailed financial analyses of target’s historical and projected financial statements
• Scenario and stress tests on target’s projected financial statements
• Reviewing all drafts of the purchase acquisition agreement
• Industry, economic and competition analyses
• Valuation analyses of target usually employing discounted cash flow and guideline (comparable) company M&A transactions methods

If the procedures find that the proposed transaction is fair from a financial point of view, then the financial advisory firm will issue a fairness opinion letter together with a pitch deck which highlights the findings of each of the above procedures. The letter and deck are sent to the board of directors. The financial advisor project manager will make a presentation to the board and field all their questions about the fairness opinion process and the business transaction at hand.

Post-acquisition Partner Compensation Plans

For any professional services firm, effective partner compensation plans are critical to the organization’s success. A financial advisory firm will tailor a partner’s compensation plan based on individual and firm performance planned and achieved goals. This includes:

• Establishing comparative individual versus firm performance measurement metrics
• Conducting industry and region specific market benchmarking compensation studies
• Determining optimal mix of partner’s base salary, bonus, and non-cash incentive programs (typically additional equity ownership)

The compensation plan is not a one-shot deal. It should be revisited periodically, at least every two years or sooner, and revised or updated based upon changes in market conditions and partner and firm performance.

[I] Target refers to the company being acquired. There are also circumstances where fairness opinion due diligence will be done on the acquiring business if its acquisition consideration consists of thinly traded or illiquid stock rather than cash or highly traded public stock.

*CEO & Co-Founder of Sanli Pastore & Hill, Inc.