The ESOP alternative for CPA and accounting firms

Private equity’s run through the ranks of the accounting professions showed no signs of slowing in 2024. But recently, employee stock ownership plans have emerged as an alternative succession strategy for middle-market firms. Long-viewed as a tax-advantaged transition tool for accountants’ business clients, CPAs are now embracing ESOPs for their own firms.

Why? Because leveraged ESOPs circumvent deferred compensation dilemmas. At most firms, new partners must pull in revenue and generate profits to gradually pay departing partners. Paradoxically, departing partners are generally among a firm’s biggest producers. As a result, a single ownership transfer period can last as long as 10 years and is often completed below fair market value.

ESOPs enable new accountants to earn equity without having to fund a deferred compensation arrangement and without having to pay out of pocket to buy-in. Instead, an employee ownership transaction can provide for a seamless, rolling transition of ownership. Partial ESOP transactions are common, enabling firms to sell targeted blocks of retiring partner stock to an employee trust. But CPA firms can only unlock the utility of an ESOP when they fully tap into the relative flexibility of these strategies.

Creating supplemental incentive opportunities

Anyone who has advised an employee-owned client knows that ESOPs are ERISA-based, non-discriminatory benefit plans. All eligible employees receive stock based on the same egalitarian formula. That makes sense for a typical business, where tangible assets are created and monetized at an organizational level. But an accounting firm’s value creation rests largely on the shoulders of its tenured partners. A standard employee ownership structure may not offer enough upside to entice or retain high-performing talent. 

Instead, CPA ESOPs are generally formed in tandem with nonqualified plans for firm leadership and top producers. These complementary structures are commonly used to create meaningful, discretionary phantom and synthetic equity opportunities.

Add-on benefits still need to be ERISA-compliant and negotiated as part of an ESOP formation. Nonetheless, supplemental plans are common fixtures at employee-owned professional service firms. These two-tiered strategies deliver short-term incentives to a firm’s established value creators, and long-term equity opportunities for all employees and future hires.

Normalizing EBITDA

Many broadly held accounting firms zero-out their net income in any given year. Meanwhile, ESOP valuations are often rooted in adjusted EBITDA multiples. To bridge this gap, firms often perform compensation scrapes, a common staple of private equity deal transactions. The resulting retained earnings will drive pre- and post-sale enterprise values.

Scrape calculations generally factor in a partner’s overall performance, productivity and tenure. A thoughtfully constructed scrape offers valuable trade-offs for impacted team members. Senior partners may take outsized reductions in their income to generate that excess retained earnings, with the expectation that they are near-term ESOP buyout targets. Junior partners can expect additional warrant or phantom stock grants that offer greater mid-to-long-term economic upside.

In addition to formalizing a firm’s valuation, EBITDA normalization and the resulting earnings retention creates a durable funding source for firm modernization and expansion. These investments are critical to continued competitiveness in an ever-consolidating industry. 

In a properly structured ESOP, these earnings are also tax-advantaged. Employee-owned firms can receive corporate income tax deductions equivalent to the value of stock sold to an employee trust. In other words, a $50 million ESOP sale should yield a firm $50 million in deductions. Furthermore, a 100% employee-owned accounting practice can effectively operate income tax-free in perpetuity.

Understanding the big picture

So, let’s study these lessons in a practical context. Consider a 300-member, $50 million revenue accounting firm with a broadly held ownership group. Thirty percent of the partner base are senior members of the firm, eyeing retirement within five years. An ESOP strategy is developed to acquire equity from these senior partners at a fair market valuation.

First, a firm-wide compensation scrape (weighted toward senior partners) is performed and yields $10 million in EBITDA. Based on prevailing industry multiples and adjustments, the firm’s assumed valuation is set at $100 million. So, there’s an expectation of a negotiated $30 million ESOP sale price for 30% of the firm.

Next, commercial financing is secured so that senior partners receive up-front cash for the equity they’ve sold. These partners will have the opportunity to defer capital gains on their sale proceeds, thanks to an ESOP-exclusive tax benefit — the 1042 rollover. Over time, the firm will pay down the bank loan on the employee trust’s behalf, using pre-tax dollars.

Steps are also taken to make younger partners whole post-scrape. A stock appreciation rights plan is developed to deliver formal equity-sharing opportunities to established team members with longer time horizons. They’ll also have opportunities to sell their retained equity to the firm’s employee trust in the future, potentially with rights to exchange some of their shares for warrants. New partners will receive standard ESOP allocations and consideration to take part in the firm’s supplemental incentive program (at leadership’s discretion).

Either through retained equity or ESOP shares, the firm’s next generation of leaders will have concrete opportunities to monetize their stake in a more efficient, employee-owned firm — one that is retaining earnings for internal investment or potential acquisitions and realizing enhanced cash flow, fueled by the ESOP’s tax incentives.

From initial conception to final negotiations with an independent trustee, the transaction takes roughly six months to finalize. An experienced ESOP investment banking advisor and knowledgeable ERISA counsel help keep everything on track. In the end, retiring partners gain liquidity while remaining team members earn broad-based equity upside and additional incentives in a firm that’s primed for greater competitiveness — one in which all staff are rowing in the same direction to grow the practice over time.

What makes a good CPA ESOP candidate?

ESOP strategies are generally geared for top 500 accounting firms that aspire to sustainable, long-term growth. There must be an appetite for broad-based ownership and a willingness to build internal capacity. To build an employee stock ownership plan is to bet on yourself.

It’s not the right shareholder liquidity solution for every firm. But for forward-looking firms with leadership teams that seek market leadership for the foreseeable future, employee ownership represents a powerful tool. ESOPs take the industry’s greatest challenge — attracting, retaining and rewarding talent — head on, while aligning all staff behind a common goal at independent, CPA-led firms.