Equity: From Goodwill to no Goodwill
In recent years I have been engaged by a number of firms to change their equity arrangements and transition from a ‘goodwill firm’ to a ‘no goodwill firm.’
The push to make these changes usually arises from one of two managerial requirements, both of which are due to the success of the firm. The first reason is a desire to move to a differential profit share and the second is to make an equity stake in the firm more affordable for new partners.
DIFFERENTIAL PROFIT SHARES
I have long maintained that one of the strengths of smaller firms in Australia and New Zealand is that in most firms, all equity principals (new and existing) have an equal number of points, or are on a pathway to equality over a defined period of time. The rationale should probably be the subject of a separate article, but one benefit of equality in a smaller firm is that ‘performance’ can be measured on effort as opposed to revenue or profit, because not everyone can do the work that is profitable given the general nature of most of these practices.
I have worked with a number firms recently that have wanted to move away from equality to a differential profit share. (I should note that not all partners are keen on this idea for obvious reasons.) The snag has been that these firms sold goodwill to incoming partners on the basis that it was an equal profit-share arrangement, and in many cases the most recent entrant paid the most and is now being subject to questions over contribution.
Moving toward a differential profit share without changing the equity admission and exit mechanics of the firm will result in years of unhappy partnership before the whole thing implodes.
ADMITTING NEW PARTNERS
There are an increasing number of first-generation firms that have become so profitable or carry so much work-in-progress that it is not affordable for an employee to buy equity at fair market value. The equity partners in these firms are faced with a decision to either significantly discount a sale / purchase price, not sell any equity and drive the firm as hard as possible until the end then walk away, or change the equity structure to make it more affordable.
A WORKABLE SOLUTION
From an accounting perspective, removing goodwill from a firm can be relatively simple. Resistance to making a simple accounting change understandably comes from those who have paid goodwill either directly when buying in or via ‘sweat equity’ to establish the firm.
When advising firms that need to make the change, almost all can see the rationale and benefits that arise from bringing new partners into equity via a lockstep, as opposed to the sale and purchase of goodwill, but most struggle with working out how to extract their embedded value in the process.
Doing away with goodwill and transitioning to a lockstep firm will provide firms with the flexibility required to overcome many of their equity challenges. Broadly this will require:
- The firm agreeing on the value of goodwill;
- Borrowing a portion of that value and distributing to each partner according to their equity holding;
- The balance of the goodwill being paid via a ‘superannuation’ fund or similar at an appropriate time.
The benefit of doing this is:
- Compensation is no longer linked to Return on Investment;
- You have flexibility to provide additional points to the absolute standout star performers (plus the capacity to take points away from the under-performers);
- No one will be bound to stay in a poisoned relationship due to the financial handcuffs of their buy-in price and/or an onerous partnership agreement;
- Partners are not obliged to keep someone they would rather not work with;
- It is easier to admit new partners
The mindset of the incumbent equity partners is key to the success of such implementation. The above will involve some pain, and in the short term there will be some winners and losers. If you start the journey early enough, any short-term loss will be washed away by the longer-term gain. This will not work if the primary focus of any of partner is to win in the short term (or to ensure that someone else does not win).
I get a sense that we will be seeing more of these transitions occurring in the near future as the pace of succession in the law increases.
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