The economics of professional services firms are distinctive in that they are driven directly by the productivity and performance of their members. Most professional services firms are operated by partners who, in addition to managing and driving the business and serving clients, collectively contribute to the firm’s working capital. In exchange, they receive an allocation of the firm’s profits. Liquidity typically comes in two ways: 1) distributions annually and at retirement (or when a partner leaves on good terms), and 2) when capital contributions are returned (often with appreciation) and deferred compensation payments commence. Such liquidity is funded by new partners entering the ranks as retiring partners depart. This “partner model” helps drive an ownership mentality, a culture of professional service and — just as important — a need to develop the next generation of partners who will eventually “buy the firm” from those who are retiring.
This owner-operator model is at the heart of most professional services firms. Until recently, transactions within the professional services sector have been mostly in the form of industry consolidation (i.e., larger firms absorbing small firms). This has provided partners or founders of smaller firms with an opportunity to either liquidate their ownership or rollover to equity stake of a larger firm. Other firms have also explored initial public offerings (IPOs) as a means to provide liquidity and scale, but very few have succeeded. Among the challenges of going public is the significant cultural shift from an owner-operator model to an agency model where “partners” are “agents” who manage shareholders’ assets.
External investment: Opportunities and disruptions
Over the past few years, a growing number of professional services firms have started to explore alternative approaches to providing liquidity to senior partners while remaining partially partner-owned. One viable alternative can be found in the growing interest among private equity firms to invest in professional services firms. While professional services firms are not highly scalable businesses, their healthy margins and cash flows make them attractive opportunities for external investors. These investments can offer professional services firms some significant opportunities:
- Managerial focus. External investments drive a stronger focus on efficiency and managerial priorities based on a clear agenda of valuation growth, contrasting with traditional partnerships where various partners may define value creation differently.
- Realignment of productivity and ownership. Over time, partnerships run into challenges when senior partners with significant ownership move past the peak of their productivity. Some partnerships have mechanisms to wind down their ownership organically, but for those that don’t, a transaction can serve as a stimulus for optimization between productivity and ownership.
- New strategic options. Inflow of cash can fund long-term investments that are otherwise challenging, because a partnership is naturally a pass-through intended to distribute all of its profits to its owners. Those partners nearing retirement can be averse to longer-term investments that could put their distribution at risk and cause liquidity issues in the near term.
As attractive as external investments may be, professional services firms should be wary of the potential challenges:
- Less centralized governance. Partners will no longer be the sole decision makers on firm strategy and major investments, as external investors and their value appreciation over the investment time horizon are prioritized. The board will now consist of operators and non-operators.
- Generational equity. As equity stakes of senior partners are liquidated, the well-established value chain will break for the new generation, as future partners will no longer have the same wealth opportunities as their predecessors. A new compensation mechanism or equity transition will likely be needed to maintain engagement (and may be required for the transaction to be approved in a one-partner-one-vote governance structure versus voting power by share).
- Potential talent gap and retention risk. Liquidation of equity stakes for senior partners will prompt some partners — including those at the prime of their careers — to consider retirement or other career options. If not managed carefully, senior departures will create a void of senior sellers and know-how.
- Perception from other stakeholders, such as retired partners. For firms that track equity at book value, external investment will effectively change equity tracking to market valuation. While this can potentially unlock a lot of value for current partners, retired partners may see this as current partners reaping benefits from generations of value building.
- Specific industry requirements. In the U.S., audit firms must be majority-owned by certified public accountants. This means that accounting firms must restructure or split their businesses to enable the transaction. In other domains, such as the legal profession, professional protocols may prevent external investment; however, these protocols may evolve as professions see disruption.
ESOPs: An alternative pathway to liquidity
Another viable approach to liquidating some partnership interests while keeping the firm among insiders is to establish an employee stock ownership plan (ESOP). ESOPs are tax-favorable instruments in the U.S. that promote employee equity ownership. They have been popular among some factions in professional services, such as engineering and construction. According to the National Center for Employee Ownership (NCEO), as of 2023, there are roughly 6,500 ESOP plans covering 14 million workers in the U.S.
In August 2023, BDO USA became the first large public accounting firm to implement an ESOP, which would include more than 10,000 participating employees. This development marks an important milestone for the professional services sector. Is establishing an ESOP a better alternative to providing senior partners liquidity and unlocking firm value? Let’s begin by exploring the advantages:
- Less disruption to the firm’s purpose and governance model. Unlike external investment, an ESOP provides liquidity to senior partners without disrupting the governance of the firm, which remains tightly owned by the firm’s operators and employees. It also begins instilling an owner-operator mindset with employees early on in their careers, reinforcing the culture of a partnership and improving talent retention and engagement.
- Tax benefits for the firm and the participants. For employers, ESOP contributions are tax-deductible. For employees, ESOP distributions are tax-deferred until they are withdrawn from the plan.
- A useful tool to distribute ownership for closely held businesses. An ESOP is effective in slowly disseminating ownership from its founders to other partners and employees while maintaining continuity in the business.
- A good wealth tool for employees. A study done by NCEO suggests that employees benefit from an ESOP, both in terms of wages and retirement assets, compared with their non-ESOP counterparts.
However, ESOPs can be costly and complex to set up and administer. They may require restructuring of the firm, as ESOPs are only available to corporations (C or S) and not partnerships (limited liability company or limited liability partnership). In addition, firms thinking about taking the ESOP route should also consider the following:
- Value at liquidation. The transaction value is likely higher with an external investor than for an ESOP, especially in a competitive bidding situation. An ESOP transition also does not drive as much growth as an external investment.
- Debt financing. The transition of ownership in ESOP takes place over time and requires debt financing to provide immediate liquidity. This may exert pressure on the firm’s long-term solvency.
- Competitiveness of employee remuneration. Assuming that the firm’s economics and leverage model do not change, firms cannot significantly increase employee remuneration, which will be partially carved out to the ESOP either through employee or employer contributions. This may result in lower cash compensation, making talent attraction more challenging in a highly competitive environment. Compared with partners, employees may have greater liquidity needs (e.g., mortgage, expenses related to life events), which will be limited by the illiquidity of an ESOP.
Should your firm consider these options?
It is likely that more professional services firms will explore external investment in the future, and BDO’s attempt to circumvent some of the drawbacks in launching an ESOP is a fascinating case study. For the firms weighing their alternatives, the right answer lies with the objective of the liquidity event and the culture of the firm. In professional services, a note of caution is warranted: Regardless of the alternative, a shift from a partner-owned model to one involving non-partners will fundamentally change the culture and decision-making paradigm of the firm.
