10 red flags for firms to avoid after COVID-19

July 15, 2020 11:32 AM

Many small and midsized CPA firms have the potential to fail post-COVID-19 if they don’t address the issues that will inevitably pop up after the pandemic subsides. Here are 10 common red flags to avoid:

1. Insufficient partner cash capital and high dependency on banks for working capital

This becomes particularly problematic when monthly draws are paid from the bank line and not from earnings. In best-of-breed practices, every equity partner is required to put a minimum amount of cash capital into the firm upon admission and, as the years progress, continue to put in cash capital every year as a reduction of compensation until the firm’s required capital amount is achieved. If it is subsequently determined that the firm needs additional cash capital from the partners, such amounts will subsequently be funded.

2. Ineffective governance and an unwillingness to make tough decisions

These include addressing partner issues such as too many partners, ineffective partners and partners who don’t play by the rules. Sometimes the CEO is a benevolent dictator and sometimes partners just run amok and do as they please. Many of the Top 100 Firms have effective executive committees who are responsible for approving strategy, making sure that plans are executed in a timely fashion, and evaluating and compensating the CEO.

3. Promoting their largest biller or best business developer to CEO

Being CEO is often not the highest and best use of a partner’s talents. Other firms are run by committee or responsibilities are shared by two partners. Generally, these arrangements are also ineffective. To ensure they are getting the best candidate to be CEO, firms are “protecting” the CEO with a compensation and severance agreement that ensures employment for two or three years, with commensurate compensation after the person steps down as CEO.

4. Too many small acquisitions that create little or no long-term value

Acquisitions of $1 million to $2 million practices are usually a short-term play with little, if any, stickiness to them. They often are, pure and simple, buyouts of retiring partners with low-quality practices and professionals who are not as technically proficient as they need to be. The best of breed shy away from small acquisitions unless something very compelling is being presented. These firms look at mergers and acquisitions differently. They are strategic and/or talent plays, and are usually larger, with some excellent clients and people. If everybody plays by the rules, there is a good chance larger mergers and/or acquisitions will create long-term value for a firm. It’s very dicey with small acquisitions but some firms fail to comprehend that “buyer beware” signs.

5. Not recognizing that advisory/consulting work is the future

If a firm is operating under the old accounting firm model and is doing principally low-margin compliance work, sooner or later that firm will be out of step or, worse yet, out of business. Compliance work post-pandemic will be generating lower margins than it did before the crisis. It’s difficult to generate more profits for the partners in this environment, particularly as the cost of doing business continues to increase. Smart firms have begun to realize they need to shift from a compliance shop to a professional services firm model by beginning to develop advisory and consulting skills such as transaction advisory, cybersecurity and litigation support. It’s where the money is!

6. A bulging, unfunded partner deferred comp plan

These will be difficult, if not impossible, to fund unless a firm is continuously tracking high growth in revenues, profits and young, junior partners. Some of these plans also have no caps on distributable income available to retired partners, and many others are very burdensome when accrued capital payouts are added to deferred compensation payouts. The larger, more successful firms have a cap on distributable income available to retired partners of about 12 percent and do not pay retiring partners their share of the accrued capital on top of a deferred compensation amount that is generally paid over 10 to 12 years.

7. Not recognizing that not all partners can perpetuate the firm

This is a particularly important acknowledgment in a slow-growth environment when it is difficult to grow revenues and profits. In the old days, when people were admitted into a partnership, they were immediately admitted as equity partners because that’s the way it always was. Some firms continue with this outdated practice. As a result, they become top-heavy and burdened with heavy retirement obligations and a clogged pipeline for future partners. Many Top 100 Firms have recognized this business challenge years ago. Today these firms are moving toward a 40 percent equity/60 percent non-equity mix, which is much more realistic in a slow-growth environment.

8. Inability to create a culture that is 'firm first'

Some firms operate as if they were a bunch of independent contractors working under one roof sharing operating expenses. It is an eat what you kill environment that is unable to sustain itself over the long term. The focus is on “I” not “we” and partner compensation is heavily weighted toward personal charge hours and books of business. The firms with staying power, on the other hand, have figured out many years ago that they need to operate as a team if they want to perpetuate the firm for the long term.

9. Lacking a strategy with teeth in it

Lots of firms have strategic plans, but they are sitting on a shelf collecting dust. They develop a plan at an annual off-site retreat, but when they get back to the office, they ignore it and go back to serving clients. It is business as usual. The best firms use their strategic plans as “living documents.” They hold their partners accountable for executing on their piece of the plan and, when it comes to compensation time, take into account results vs plans.

10. Lack of a credible succession plan for senior positions

Too many firms promote new partners because they have to get the work out the door, but while these partners serve an immediate role, they provide little, if any, promise that they can help perpetuate the firm down the road. It is hard to get the work out the door and at the same time plan for the future by promoting and developing partners with potential to lead the firm. While it is difficult, it must get done and can be done if given the right priority and focus.

If your firm is experiencing one or more of these red flags, it behooves you to do what is obvious and address the issues head-on. These are common reasons why firms fail or at least fail to reach their maximum potential. All of these issues can be fixed, although some will take several years before they are fully corrected. The good news is that others were smart enough to recognize they had a problem and did something about it. Are you that firm or are you the firm that will continue to keep its head in the sand?