iMergers and acquisitions activity in the accounting profession is booming. Many accounting firm leaders have determined that the traditional partnership model is not the way of the future. At the same time, investor interest in professional services firms is at an all-time high.
Forming an alternative practice structure is an increasingly popular approach. In this structure, a CPA firm’s nonattest business and other assets are transferred or sold to a new nonattest services company, and outside investors—typically private equity or wealth management firms—invest in that new nonattest services company.
The AICPA Code of Professional Conduct describes an alternative practice structure as “a form of organization in which [an accounting firm] that provides attest services is closely aligned with another public or private organization that performs other professional services.” A typical alternative practice structure has the following characteristics:
- The majority or all of the ownership interests in the CPA firm are owned by individual CPAs.
- Some or all of the owners of the CPA firm are also employees of the closely aligned services company.
- All attest services are performed only by the CPA firm and supervised by its owners.
- The CPA firm and the services company enter into a services agreement, pursuant to which the services company may provide professional staff, office space, equipment, technology, and back-office functions such as billing and collections.
- The CPA firm pays the services company a fee in exchange for the services.
- The services company, in addition to providing services to the CPA firm, provides nonattest services directly to its clients (which may overlap with the CPA firm’s clients).
When organized properly, the alternative practice structure allows the services company (and its owners) to (i) operate the nonattest business previously owned by the CPA firm (ii) receive a fee relating to the CPA firm’s attest services without violating CPA firm ownership rules or restrictions on the performance of attest services.
Establishing, organizing and operating an alternative practice structure poses unique challenges and requires experienced legal professionals and business advisors to help the parties avoid legal and regulatory pitfalls. The following are some of the key considerations for CPA firms and investors contemplating the formation of an alternative practice structure.
Regulatory
Designing separate governance of the two entities. CPA firm ownership requirements are designed in part to insulate attest services and related judgments from marketplace pressures. That means a CPA firm providing attest services must remain a separate legal entity from the aligned services company, with distinct governing documents and governance structures. Parties must design governance structures that comply with these regulations.
Changes to marketing materials. In addition to being separate entities in fact, the CPA firm and services company must hold themselves out to the public in a manner that does not cause confusion. In particular, the services company should avoid creating any impression that it is a licensed CPA firm or provides attest services to clients. Parties must consider all public- and client-facing material to address regulatory compliance.
Determining the reach of auditor independence rules. The independence rules that govern the CPA firm’s performance of attest services will extend at least to some degree to the services company and its owners, including outside investors. The extent of that reach is determined by several variables. If the CPA firm performs financial statement audits governed by the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) independence rules, the services company (and any entity that controls the services company) may be considered an “associated entity” of the CPA firm and treated as the CPA firm for purposes of the independence rules. When the SEC and PCAOB rules do not apply, the reach of the independence requirements will depend on, among other factors, whether the CPA firm provides financial statement audit services as opposed to other attest services. The bottom line is that parties to an alternative practice structure must carefully examine the applicable independence regimes and implement controls to monitor the CPA firm’s independence.
Client notice or consent. Most alternative practice structure transactions involve the transfer of nonattest engagements and related files. Parties must consider whether client consent is required and appropriate notice even when consent is not required. In addition, certain businesses often transferred to the services company (e.g., wealth management businesses) may implicate other specific regulatory consent requirements.
Structural
Asset Transfer. Establishing an alternative practice structure generally requires the CPA firm to effect a restructuring, which, at a high level, involves the transfer or assignment of the CPA firm’s nonattest business to the services company. Typically, even if the nonattest business assets are the greater portion of the total asset mix, the nonattest business assets are the assets transferred to a newly formed services company in order to avoid obtaining new CPA firm licenses. Successfully effecting a restructuring of a CPA firm requires the parties to have a clear understanding of the CPA firm’s assets and the mechanical steps involved in making the necessary transfers of the nonattest assets to the services company. In connection with the restructuring, the parties must consider the typical complications involved with the transfer of assets in a third-party asset purchase transaction. For example, the parties should consider the mechanics (including third party consents) associated with transferring the CPA firm’s existing benefits plans, employees, real estate leases and owned real property, vendor contracts and other third party agreements relating to the nonattest business to the services company, in addition to establishing bank accounts for the services company and ensuring insurance coverage for the alternative practice structure generally.
Tuck-in complexities. Given the need for separate ownership and governance of the CPA firm and services company, and the requirement that any attest business be owned and operated by the CPA firm, parties must assess the mechanics and economics for future “tuck-in” acquisitions, particularly as to target firms with significant attest practices.
Commercial
Go-forward economics. Investors and CPA firms need to align on fundamental go-forward budgeting, including addressing debt servicing obligations, resources to fund acquisitions, and annual profit distributions during investors’ holding period. Precedent transactions have included, among other constructs, partner income buy-downs in exchange for additional transaction consideration for high-earning partners in order to aid go-forward economics. Parties need to negotiate whether investor securities in the services company will include any preferred return rights or interest. Often, any form of retirement arrangement existing at the CPA firm is terminated in connection with the transaction, while puts and calls may be applicable to partner owned equity in the services company.
Partnership promotions. Related to the economic considerations, CPA firms need to consider how the next generation of firm accountants will be rewarded as they achieve seniority that would typically be accompanied by partnership. Considerations include (i) whether the investors will accept dilution to accommodate making new partners in the services company both through organic development and acquisition, and (ii) assuming some level of dilution is acceptable, whether new partners will be granted equity, profits interests or some combination of both. Both investors and CPA firms will need to balance the competing interests of avoiding dilution while properly incentivizing future firm leaders.
Governance rights. Investors and CPA firms need to address post-closing governance matters in the services company. An investor considering a control investment (and associated governance) in the services company should consider the expanded reach of the auditor independence rules in that situation as compared to a minority investment. When investors acquire a majority of the ownership of the services company, former CPA firm owners should consider whether to seek control of or veto rights over important services company matters such as CEO and other executive officer appointments, compensation pool size and allocation, significant acquisitions, or partner promotions. In addition, investors should know that certain individuals involved in governance of the services company may be subject to independence restrictions. Investors may consider whether the accountant owners should be required to roll over a certain portion of their equity in the services company in connection with a subsequent transaction.
Debt valuation. CPA firms often have debt associated with prior acquisitions and deferred compensation obligations to retired partners. This debt may be payable over a period of time and vary in amount based on performance metrics. In addition, this debt often does not contemplate the restructuring associated with an alternative practice structure and may include below market interest rates. Given these variables, investors and CPA firms should consider whether this debt is paid off at closing or kept in place and, if kept in place, the liability that should be assigned to such debt for purposes of determining enterprise value.
Allocation of transaction consideration. Selling owners of a CPA firm typically receive two forms of consideration: cash purchase price from the investor and equity in the new services company. CPA firms need to consider whether these forms of consideration will be distributed amongst the selling owners pro rata or whether the distribution should be adjusted to account for seniority and anticipated role in the go-forward business. Potential approaches include allocating a greater portion of the equity in the new services company to individuals with less seniority and a greater portion of the cash consideration to more senior individuals; increasing allocation of either form of consideration to individuals who may be foregoing partially earned retirement benefits in connection with the transaction restructuring; or increasing allocation of either form of consideration to high-earners in exchange for a post-closing salary reduction.
Tax
Partner taxation. Professionals who have an equity interest in the services company can be compensated either as partners through guaranteed payments or, alternatively, as employees. In either case, these individuals also will be eligible to receive distributions of operating profits made to all holders of the same class of equity. Individuals who receive compensation as employees may need to hold their equity interest in the services company through a holding company.
Basis, capital gains treatment. CPA firm owners will want to structure the transaction in a manner that maximizes the portion of the purchase price receiving capital gains treatment, and investors will seek to implement a structure that results in a step up in the basis of the assets of the CPA firm for tax purposes to equal the purchase price paid by the investor, which may require addressing the anti-churning rules under the Internal Revenue Code.
Labor
Go-forward non-compete enforceability and mandatory retirement. Any new structure will impact the strength and enforceability of the restrictive covenants (including non-competition restrictions) and mandatory retirement provisions that are typical in CPA firm partnership agreements. Where the partners have individual equity ownership and meaningful voting rights in the services company, those restrictions may be enhanced. On the other hand, in alternative practice structures with significant investor ownership or that result in firm partners becoming employees of the services company, those restrictions may be weakened. Parties must therefore consider the importance of restrictions on partners who leave the firm and of mandatory retirement provisions when designing the economics and governance of an alternative practice structure.
