Thinking Merger? A Proper Courtship Can Avert a Nasty Divorce

By Joanie E. Sompayrac and D. Michael Costello

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JANUARY 2008 - What were once the Big Eight accounting firms have merged into what some call the “Final Four.” Small and mid-level firms are following suit, and merging at an ever-increasing pace. As accounting firms seek to increase their client bases, broaden areas of expertise, and grow geographical presence, mergers afford many firms the opportunity to make these dreams a reality.

Without proper preparation, however, the dreams promised by firm mergers can quickly turn into nightmares. Being aware of the potential pitfalls when two or more accounting firms join their operations can go a long way toward enabling all parties to anticipate and address problems before they arise.

Issues to Consider

What is each firm seeking? Some of those experienced in negotiating firm mergers believe that firms do not really “merge.” They assert that most often, a dominant firm acquires a smaller firm. In these cases, the acquired firm is looking to expand its practice in terms of size, clients, or expertise. The dominant firm may be seeking entry into a market that the acquired firm could enhance. The acquired firm may be receptive to the advances of the dominant firm if it is having a difficult time attracting larger clients. In some cases, smaller firms are interested in merging or being acquired because the small firm’s partners seek to spend less time in administration and more time with clients and client development.

Despite initial appearances that each firm can benefit from the combination, it is imperative that each firm find out what the other is seeking from the union. They may discover that they each desire very different things. The authors spoke to a partner in a large regional accounting firm that has acquired and merged with firms in both the Midwest and the Southeast. He noted that when discussing a potential merger or acquisition, the answer to the question “What do you want from this union?” frequently differs depending on the ages of the other firm’s partners. For example, while virtually all partners of acquired firms want monetary assurances, older partners (over 60 years of age) tend to say they want respect, while younger partners say they want opportunity. The aforementioned partner asserts that combinations will often fail if the partners from the acquired firm think they will not secure the respect or opportunity they seek when joining the new firm.

Are the firm cultures compatible? When people work together closely in any office setting, workplace efficiency often requires that people get along with each other. This includes, in many cases, sharing similar values and beliefs. Suppose a firm whose members share conservative family values were to merge with a firm whose members have hedonistic, materialistic values. Chances are good that these very different individuals will not work well together and workplace efficiency will decline.

A managing partner of a large accounting firm that operates in Ohio described to the authors a merger candidate in a large city in the Southeast with which his firm had been having merger talks for four years. He finally discontinued the talks when he spoke with each partner from the candidate firm and discovered that they never really functioned as a team. He reasoned that if these “partners” had not yet found a way to operate as a team, how could they be expected to adopt the team concept by which his firm operated? This partner believes that a firm merger is much like a marriage, so firms should strive to minimize any indicators of failure prior to combining.

A female partner of a midsized firm in the Midwest described to the authors what happened when her firm merged with another local firm. During the talks, she expressed concern that the firm with which they were merging had no female partners. Partners from both sides of the merger talks continued to assure her that the absence of female partners in the other firm was not an indication of bias. Despite her concerns, she went along with the merger. She told the authors that, within months of the merger, the new firm environment adopted what she described as a “locker-room mentality,” and after two years with the new firm, she left. She claims many of the other women with the firm left with her, taking their clients with them. When firms ignore these indicators and unite anyway, they may be setting themselves up for disaster.

Has the quality of each practice been assessed? As firms explore the possibility of a merger or acquisition, they should look at peer review reports, examine workpapers, evaluate employee educational backgrounds, and assess the firms’ reputations. Firms should ensure that they are bringing people together who have similar educational backgrounds, experience, expertise, and professionalism. Firms should also send questionnaires that ask basic questions (no confidential information) about software systems, types of clients, financial measures, firm mission and philosophy, billing rates, and fee collection policies. The questionnaires should help each firm identify potential problem areas during merger negotiations. If, during this assessment period, one firm finds the other lacking in a key area, then that firm should give serious thought as to whether the merger should proceed.

Who covers subsequent malpractice liability claims? With new people entering the firm, the “acquiring” firm will need to increase its malpractice liability insurance coverage. As the managing partner of one Louisiana firm notes, however, “The firm that no longer exists may later have malpractice claims against it, and we all have to worry about who is responsible for those.” The Louisiana partner recommends that these acquired firms make sure they have some type of reserve or other coverage in case any subsequent claims arise.

In most states, successor liability tends to be the exception rather than the rule. In other words, when one company sells or otherwise transfers all of its assets to another company, the successor company is generally not liable for the debts and liabilities of the transferor company except when—

  • the successor company expressly or implicitly agrees to assume such debts or obligations;
  • the transaction amounts to a consolidation or merger of the company;
  • the purchasing company is merely a continuation of the selling company; or
  • the transaction is entered into fraudulently in order to escape liability for such obligations.

These guidelines help establish who would be liable in situations where the firms have not contractually defined the parameters of responsibility prior to the combination.

How will all of the employees be incorporated into the new firm? When multiple firms unite, the uncertainty that it can create for the employees of each firm involved can create unrest and, in some cases, substantial turnover. If management anticipates this issue and addresses employees’ concerns up front, then much of this unrest can be avoided. The managing partner of an Ohio firm meets with each new employee who enters his firm as a result of a merger or acquisition. He says: “Generally, in a CPA firm merger, all employees will keep their jobs after the merger. They might have legitimate concerns about their long-term status with the firm, but they will have ample opportunities to prove themselves worthy of promotion with our firm.” He goes on to say that most firms are “as concerned about keeping people as people are about keeping their jobs.”

Can the firm use a noncompete agreement or other provision to prevent partners from leaving and taking clients? Once a merger occurs and all parties have made a good-faith effort to work within the framework of the new firm, some partners may find they are not happy with the new arrangement. They may perceive that they are not getting the respect or opportunity they expected from the merger. In some cases, partners who were less involved in the merger negotiations may find their share of the pie in the new firm amounts to less than what they expected. Whatever the reason, partners will sometimes choose to leave the newly combined firm after a short period of time and, in many cases, take clients with them. Because the point of most mergers is to grow the client base, the departure of a partner who takes clients raises questions, including: Can the new firm prevent the client exodus, and if so, how?

In the past, merged firms have required partners of the new firm to sign noncompete agreements or agree to pay certain fees to the merged firm if they take clients away. This practice has been challenged in many legal cases, such as Peat Marwick Main & Company v. Lawrence Haass (818 S.W.2d 381 Tx. Sup. Ct. 1991), in which a partner named Lawrence Haass left Main Hurdman (MH; a predecessor to Peat Marwick Main & Company) after his firm merged with MH. Haass had been a partner in a San Antonio, Texas, accounting firm that merged with MH. Haass’ partners negotiated the merger and, for the most part, pressured him into going along with the deal. Haass signed the merger agreement, which included a provision that “if Haass withdrew from MH and took MH clients with him that he would compensate MH as provided for in the partnership agreement.” When the merger became unpleasant for Haass, he and some other members of the new firm left and started Haass and Company. It was undisputed that Haass and his fellow employees planned the new company while they were on MH’s payroll. Furthermore: “Many MH clients who had been served by Haass or one of the other departing accountants then became clients of Haass and Company, some of them almost immediately.”

When MH sued for damages, arguing that Haass was prohibited from taking clients without paying compensation for servicing these clients, the Texas Supreme Court ruled in favor of Haass. The court noted that many jurisdictions have examined similar issues, and they ruled that such agreements must be reasonable in their scope or they are considered to be unlawful restraints of trade. The court held the following:

To be reasonable an agreement not to compete must satisfy each of three conditions. First, it must [be] ancillary to an otherwise valid contract, transaction, or relationship. Second, the restraint created must not be greater than necessary to protect the promisee’s legitimate interests such as business goodwill, trade secrets, or other confidential or proprietary information. Third, the promisee’s need for the protection given by the agreement must not be outweighed by either the hardship to the promisor or any injury likely to the public.

The Texas Supreme Court examined the damage clause applied to Haass’ situation and determined that it functioned as a restraint of trade. The court opined that even if Haass were not restrained from competing with the merged firm for any reasonable period of time, the effect of the damage clause would prevent him from competing with the merged firm. The decision stated: “The practical and economic reality of such a provision is that it inhibits competition virtually the same as a covenant not to compete.” With respect to the enforceability of the damage clause, the court said it was unreasonable, and thereby unenforceable against Haass, because its terms were overbroad. The court further noted the clause was oppressive to Haass and injurious to the public by limiting its choice of accountants.

What types of clients does each firm have? Can they benefit from the merger? Are there independence issues? Over time, different firms begin to develop areas of expertise with certain types of client bases. When firms consider merging, it is very important that they consider the types of clients each firm has. For example, will a firm whose client base is largely composed of individual doctors and medical practices be compatible with a firm whose clients include the large hospitals in the area? Will all of the clients believe they are benefiting from the merger? Will there be independence issues? Most of the time, capabilities will likely be enhanced, but these issues cannot be ignored during the merger negotiation process. The impact of the merger on each firm’s client base must be evaluated and addressed.

What other issues might arise? When two or more firms consider merging, countless issues can arise. Smart negotiators can attempt to anticipate and address as many as possible. Additional issues to consider are as follows:

  • Are the firms’ billing rates compatible?
  • Can skills or services that are in demand be added to the new firm?
  • Is the combined firm enhanced?
  • What are the risks of the merger to each firm?
  • Can the risks be mitigated? How?

Plan for a Successful ‘Marriage’

Despite the complexities and the risks associated with mergers and acquisitions, accounting firms are finding that combinations with complementary firms offer opportunities that are beyond compare. Just as many fearless couples enter the bonds of marriage every year, many accounting firms boldly enter the merger arena hoping for a successful marriage. With proper planning and a firm commitment from everyone involved, benefits can be maximized while risks are minimized.

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Joanie E. Sompayrac, MAcc, CPA, JD, is a UC Foundation Associate Professor of Accounting of accounting at the University of Tennessee at Chattanooga.
D. Michael Costello, CPA, ABV, provides consulting services for Decosimo Corporate Finance and Joseph Decosimo & Company, LLP, and has testified as an expert witness in U.S. District Courts and Chancery Courts throughout Tennessee and Georgia.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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