308 How Accounting Firm Partnerships Work

Accounting partnerships. Maybe you've never set one up before. Maybe you're trying to find a better version than the one that you've got right now. Today we're talking through common setups, some traps to avoid, and just kind of a brain dump on wisdom. I've picked up things I've gotten wrong and how to decrease the risk of ended up in a partnership that you're not going to be happy with long term. Right. So partnerships good, bad, how to think about them. Come on in, let's talk about it. It's Jason D. Foreign. I've got a number of questions on this one lately. In fact, we touched on it a bit in a recent Q and A and I thought let's just do a deeper dive on this. From Amar600 hi Jason, would you be able to put out a video on how CPA partnership firms work? For example, if I start a partnership with someone who does financial statement audits, reviews, et cetera, and I do the tax side, how do we split profits, expenses, that sort of thing recently passed the CPA exam and I'm now setting up my first business. My experience is mainly tax. My friend does a test wondering how the how we should approach this. Two big things to be thinking about because I think folks heads go to how like big firms and like legal firms and that sort of thing approach partnerships, which is very different than the flexibility you have when you are putting together a small practice. Be thinking about what truly needs to be equity and be thinking about how to make something as reversible as possible because there is a certain inevitability to partnerships where in all likelihood you're not going to be passionate about the exact same thing until the end of your days. And that means that virtually every partnership you enter, you enter into will come to an end at some point. And unless you have a plan for what the lifecycle of that partnership looks like, it can be messy or at least you'll be coming into something that will almost certainly end someday without some sort of understanding of how to end it amicably. And the easy thing to do is to rely on the goodwill of all parties involved. But oftentimes financial upside can unfortunately be a mask for long term goodwill. I don't know like that that initial excitement that's going into something new where everybody's like yeah, we're gonna make a bunch of money on this or there's some cool opportunity oftentimes that can cover up the reality of working with someone for a long period of time. But even if even if everybody plays nice and everyone's feels like they're working together, everybody can still trust each other. The reality is people grow, people change, people end up having different interests. So in all likelihood none of these things are for everything. So some thoughts specifically are on approaching equity and approaching reversibility. Arguments for doing equity partnerships is in some ways it's like the ultimate alignment of incentives. When everything just comes down to your equity percentage at the end of the day that's pretty cut and dry. Now there's, there's still a lot of things you can fight about there, but just things boiling down to pro rat ownership percentage, that's pretty simple in some way. Sales, like ultimately sailing sailing, selling the company can be a little easier there. If you have a non equity agreement, what happens in the event of a sale gets a little dodgier. If someone's buying the equity of the company and you have 100% of the equity, but you have some sort of like management services agreement or profit share with some other company that is, it's a little more dicey, certainly things that you can all build into a deal. But if it's just equity, that's maybe a little bit cleaner. That being said, don't go into a venture optimizing for sale necessarily. So often you'll be like the one yard line starting an interesting thing and everybody will get all bent out of shape about this 1 in 100 what happens at the 100 yard line. Really a bad sports metaphor. They'll be so worried about what could happen with this like amazing outcome that really probably isn't all. That likelihood isn't all that likely. But that like prevents you from even getting started and going down the path. So don't put too much weight into like what an eventual sale would look like in the early days. And third, upside like argument for equity partnerships. It doesn't require a bunch of gymnastics of how to do certain calculations and all that stuff. Now arguments against equity partnerships because in most cases I would tell people, just don't do this. In fact, in this person's example, the question that they posed here, don't, don't even do an equity partnership in your case, I don't think you would need to. Arguments against equity partnerships. 50% of American marriages end a divorce. You really want one more marriage to manage. Buddy argument against, number two, managing like maintaining relationships, it is a lot of work. And it's not to say that you don't still have to manage that relationship if there's a non equity deal there. It just Makes it a lot more serious. Because if your livelihood is tied to this thing that you own half of, if that other person pieces out, boy, that's a big stressor. Right. As opposed to some sort of profit share where you have, you know, a clause where you can get out of it. Now can you build clauses into equity ownership to like outline what lets you get out of it? Absolutely. But I would argue a little bit simpler if we're just talking about, say a profit share agreement. Arguments against, number three, unwinding it. When equity owners, it can just be a real pain. And then number four, what will the kids say? Specifically the clients and the team. If you are business partners and you're inevitably going to have like clients and team members who are. They're Jeff people or their Tina people. Like, maybe you were the one that hired them, maybe you were the one that got the client on board, like went through the sales process with them. How does that work when you split up? If there is a natural divide in the work that you're doing already, which I would argue there is with the person who asked this question. Tax work versus a test work. If there is a natural divide already, in my opinion, the place to start is do your own thing, work out some sort of commission deal where you get paid for referring work to the other. Maybe there's some referral based on production, like the amount of top line revenue, something like that. But work out something like that that you can at least do in the beginning to ensure that this all makes sense and that we're all working in the same direction. If you want to make it more formal down the road, you always can. It's the other direction that's harder. And the fact is, before you've started down that path, man, you got no idea. And that was my main concern with it was a different question about partnership I'd answered in a Q and a couple of weeks back that was something along the lines of, how do I find a partner? I need a partner. How do I find a partner? That's really hard because normally if you are sure enough of something to go into equity partnership with somebody, hopefully it's somebody that I know really well like that we've got a good understanding of how we work together. But if I'm going out and like seeking that out and being like, okay, I think you're a fit now let's do it. That just feels, feels riskier because there isn't much information there around. How are we going to work together? I would just encourage people to Be really slow. There are many equity partnerships that people get into that could probably be done in non equity ways that are more reversible, maybe even could better be crafted to ensure that everyone has the incentives that you want everyone to have. So whether you go down the equity path or not, ultimately if you're doing a deal like in a small firm, kind of the beauty of it is you can design it to be whatever you want it to be to be. So decision making authority like ultimately doesn't have to be tied to equity. It can be what you want it to be. If there is a set of incentives besides just net income that make more sense through a profit sharing agreement, a commission agreement, something like that, you can build that out oftentimes to achieve the same thing that you wanted to achieve with an equity deal in a less, less permanent way. This episode is sponsored in part by Team Up. I have a story to tell you. It is the story of of Laura. Laura was working with a BPO in India. Basically a group that hires all the staffing and the training and all that of the people. And you're more buying like the work product than you are working directly with the people. The problem was they were missing important deadlines and annoyingly they weren't able to take the work from beginning to end. They just weren't getting it done the way that they needed it. In frustration, they decided they needed to cut bait, find a new solution. And they heard about direction hiring in the Philippines. They were looking for client facing staff with very strong English skills. And the Philippines seemed to be the perfect fit. Quote, we really needed to break that language barrier. And with the Philippines being more English speaking, that just seemed to be a better fit for some of those client facing roles that we wanted to fill. The firm started small, hiring just three teammates in the Philippines, and in a matter of months had hired 10 people across a range of roles including bookkeeping, tax accountant, fiduciary, tax preparer, business tax accountant, admin assistant. Laura said the candidates were actually more qualified than we were expecting. The process of interviewing and talking with the candidates is really no different than trying to hire onshore. Nothing to be afraid of or nervous about. I tell you, when I built my offshore team, as I did, I built an offshore team in the Philippines for my accounting firm. The person who will edit this video literally is in the Philippines. Say hi Derek. Hi Derek. It's the same thing that led me to the Philippines. Really good English speaking culture. But I too prefer direct hiring because I wanna be in charge of the development of the feedback. I want them to be just like everybody else on my team. If I'm hiring like a service to do month end closes or something, I just, I don't have that same level of control what Laura did here. Actually the same thing I did. If you're interested in exploring that, well, Team up. Team up can find you some super talented peeps in the Philippines. Learn more Check out the link in the show notes. Today's episode is sponsored in part by Maker's Hub. If you want to lean into the very best of what AI is enabling, like right now, like, we're not talking about, we're not talking hypothetical what it can do soon. We're talking right now. You want to lean into that today. It is upending accounts payable. It just is Maker sub. We've done several demos of them on the channel now. I had clients who had very complicated accounts payable needs, multiple heinies in seats, processing bills, processing the detail, doing receiving, all of the stuff that goes into fiddly inventory management and complex purchasing. We could have streamlined so much of that with Maker's Hub. It's because Maker's Hub is using AI vision models to take extraction, like automated extraction further than has ever been possible before with old OCR tech. We had a whole generation of tools that were built supporting the accounting profession on OCR tech. And man, that stuff is going to get wiped out so fast. Because AI vision models, they can not only see and understand things like, they can not only visually see it like it can, it can pull like handwritten text notes scribbled on top of a computer bill, but it can like comprehend and make connections. When you pair that with a language model, that can be like, normally it's like this, but here's what I'm saying, what do you think that means that can get you so much farther and it creates an interesting place as we are standing up our own services to be like, is this an arbitrage opportunity for firms to step in? Is this a shrinking opportunity? If it's something that you know all clients are going to adopt over the next five years, either way, you know what it is is a phenomenal advisory opportunity where we can step in and be like, gang, there's a fundamentally better way to do this. Talked with people who literally sent my Makers Hub demo videos to their clients to be like, we need to do this now. And in an age of AI hype where you're kind of getting fed up with all the marketing, right, to see something that is actually crushing that's really exciting. Makers Hub is doing this really well for AP and we got a few providers starting to do this really well for 1040 tax prep. The exact same technology, AI vision models, pulling stuff off of documents in much more compelling ways, doing a bit of reasoning and then like getting it way closer to the end zone than OCR ever got it before. If you're thinking about this for bill pay, check out Makers Hub link down in the show notes on the subject of profit splits and calculating that sort of thing, few different ways you can do that, you can certainly do it pro rata across everything. So that is like if the net income is 100 bucks, you take 40, I take 60. Some upsides and downsides to that. When it's calculated based on the bottom line, the net income, then everything between revenue and the bottom line can become subject to debate. So let's say I got my G wagon and I just saw a TikTok video and I'm going to ride off my G wagon. Now this is a bad example but you know what I mean, say I mean a car. I'm going to put something like that in the business. Well, I mean it's, you have the same problem if, if you have equity, an equity owner. But if I'm doing a profit split based on the bottom line, was that fair to the other person? If I can buy a car, does that mean they need to buy a car? If it's reasonable for me to buy a truck in this business but someone else has a 30% profit share in the business, well should they buy a truck too? But it's like kind of around that same percentage of how expensive it is. Or is this just an add back now? Okay, well what if I, what if I finance the truck now I'm making debt servicing payments that are not impacting the bottom line so that the cash available to pay out is less than what the accounting income says it is. So I'm getting stuck with a pile of the taxable income but not the cash because I've got debt servicing. Well I got you wrote off the truck in year one so you got that back up front. If you're doing it based on the bottom line, there's just a lot of things in that process that can muddy the waters and create all these add backs and end up with this really complicated calculation. The closer up you can get to the top line, the simpler it is. In my experience, the further down that income statement you get, the more things there are to argue about. And so what I would Steer people towards if they're doing some sort of profit share is more of a like production based allocation. So allocating it by the top line. This could be revenue by a test, you know revenue, revenue by tax work, whatever it is. Top line is a little simpler. This is what you see most common with say you got an outgoing partner that's getting some sort of payment because they're sticking around to do some work. This is why you see in like most medical and even a lot of legal profit shares by and large they're driven by production, the top line. But then they will oftentimes do this like cost share thing of everything below that like G and A. And that makes these like way more complicated. The more can just be built around that top line, the easier it makes that. I think if you start getting into making allocations by department, particularly if costs involves, then the fight becomes, well, what bucket does each of these costs fall into? I'm going on this trip to a conference over here. Well, how much of that is department A versus department B? We have this software subscription. Well then now how do we allocate this if it's shared across department A and department B? And what, what ought to be the driver for that allocation? Is it revenue, Is it time, Is it the number of staff? So as soon as the costs get involved, like you have this exponentially increasing complexity of just the admin of calculating all these things, but they're also creating more things to fight over with your partner. And if you have a great relationship and everybody's trusting that you're all working in the same direction, maybe that's fine. It's just inevitably a little more involved than the simple version. And anytime there's a more simple version of this, we ought to have a really good reason not to do that. Like if we're not just going with the very basic version, it needs to be for a really good reason. Another mechanic here that that folks will use sometimes is like certain milestones. So certain milestones you'd have like some sort of step change in a profit calculation or equity or something like that. Maybe in the beginning one party needs more salary than the other, which is a very like real life that happens quite a bit. So maybe they take more than the other side for a bit and then longer term there's like some sort of pay down of that extra amount that they got. Kind of the beauty of these small firm deals is you can genuinely build them to accommodate whatever everybody needs within the scope of a deal. But when you go to larger firms and you're getting pulled into partnership. All that stuff is very, very locked down. Like, there is a very specific approach and calculation and things that are inbounds and out of bounds. And when it's a bigger machine, I think it's probably a little easier because you've got a lot of rules around what's allowed to be put in the bucket and what isn't allowed to be put in the bucket. And a lot of organizational inertia to say, here's how we've always done this thing and here's what the norm is, as opposed to maybe a smaller firm where it's like, Mike just went out and bought a big fancy SUV and he just put it on the company card. And I'll be honest, I don't even know how we should feel about that. Or Steve's flying first class, or Tina just chartered a private jet for this trip. We don't even have a policy about that. Is that fair? Should that be some sort of add back? The more you have to fuss with all of these variables, in my experience, it just ends up being yet another thing to fight about. But guiding principles here on whatever you set up, you need to think really hard about what everyone's incentives ought to be. Is that person just incentivized to bring in new work? Are they incentivized to hang on to existing work? For example, if you're buying somebody out, I would never do a buyout, I would never buy a firm unless there was a clawback that reduced what I had to pay out to the previous owner. If we lost clients, if I'm just cutting them a check all at once, there's nothing to stop them from running my name through the dirt. Like, they have no incentive to try to keep the clients to stay, which is what I ultimately bought. So if all those clients leave, what value in that is there to me? So, like, the firm purchases I did were usually on a five year payout according to a percentage of revenue, like a snapshot of revenue at the time of sale. And they only got paid based on the clients that were still around. And that ensured that, like they were still trying to be helpful in that relationship. And then any work that they did for our firm, they got basically a percentage of that production, just flat straight off the top. And in that case, if I'm, if I'm buying something, my incentives are I want to keep that work because I paid for it. Unless I decide for it to go away, I want the person I bought that from to be incentivized for that work to stay around. If you're going into partnership with another provider, do you want them to bring you new work? Are you more interested in them just doing that type of work year over year? Kind of like a divide and conquer type of setup. Like they're talking about here with one person doing tax work, maybe another doing a test work. We're thinking about conflict of interest there too. Like if you're actually doing audits, if you don't have independence, like I'll kind of cruise past that. But in your case, like, worth thinking through that a bit. Oftentimes, either intentionally or unintentionally, we will design systems where the incentives are just not aligned the way we want them to. But then we will get mad at the people involved when all that they're doing is trying to make the most of the system that has been set up in front of them. And like, you know, paying accountants to come work for you hourly or salary is a great example of that. Where we're like, we want to be more efficient and do all these things better, but the team isn't incentivized for output to go up. Or you have a sales team and they're incentivized just to close deals. But if they're not paid based on actual revenue or production, then like they're just going to be closing deals. However they can not, you know, maybe trying to lean into value pricing or get just a little bit more out of every, every sale. So I'm a big advocate of production based pay of people on your team actually be being paid according to production. So they have upside on being able to do extra work. Also, people at different stages of life will have different appetites for work and how much they want to take on. If they're paid based on production. That is a framework that is more aligned with what my incentives are the owner than simply paying them to sit in a chair for 20, 80 hours a year. Inevitably these structures are games and they're end up being ways of gaming that system. But your job is to create the system that best aligns with your incentives. And what you want to see it is, it is trading one game for another type of game. And oftentimes people use that as an argument to not do that. But the reality is you're already playing a game. So if we can trade one game for a better game, that's progress. Inevitably it is a game. Everybody's trying to optimize their own outcomes. This episode is sponsored in part by Stanford Tax eight Tax firms. You got an eye on that calendar, buddy. Next tax season it is. It's gonna be here before you know it. I know we're thinking about extended deadlines, and I don't want to be that guy, but the time to start testing your next tax season workflow, it's now. It's not January when you can't afford for it to go sideways. It's now. Let me tell you about Stanford Tax, Kay. Big problem with 1040 workflows is asking intelligent questions, putting personalized questionnaires in front of your clients rather than the dumb boilerplate ones that ask a whole bunch of questions that don't apply to them. Right? Stanford Tax, great way to do it. In fact, they've beefed up the platforms they support. Cch Access Pro System, fx, Gross Ultra Tax, Lacert Pro Series, Drake. Generate personalized questionnaires that only ask the questions they need to using actual Pro forma data from their prior year return. Oh my gosh, somebody did it. Only ask the questions you need to ask in a modern web interface, get them to upload the required docs, and buddy, you're off to the races. You just asked for all the goodies that you need and none of the goodies that you don't. Leaning into what, like web forms can enable for you without losing that, like, personal touch. The worst version of completing the thing online is the thing where it's like none of these things apply to me, and my tax professional knows that. Okay? So if you're looking for a smarter way to do intake, check out Stanford Tax link down in the show notes. Hey, this episode is sponsored in part by liflow and do I have big news for you, buddy. Live Flow now supports Xero Xero accounting ledger Xero for the first time, it's big news. I ran a primarily Xero practice and I can tell you what a headache it was to have like some tools that worked with my QuickBooks clients, some tools that worked with my Xero clients drove me nuts. Live Flow. Let's just zoom out and recap everything that Live Flow is doing for you because it's bringing everything together. Google Sheets support check, Excel support, checkeroo QuickBooks online, you betcha. Zero support now. Exciting stuff and sneaky, sneaky feature like valuable feature consolidations. Consolidations. Being able to roll up a whole bunch of different like chart of accounts that like no matchy matchy required. Various charts of accounts, rolling them all up in a super simple, really nice ui. And then because it's Live Flow, you can pull just about any report from the accounting system into your favorite spreadsheet either one time or on an ongoing basis, like it continues syncing out and it works across your whole stack now. Okay, I honestly don't know what more they could do for you. Learn more about LifeLow, check out the link down in the show notes. But last, to like super emphasize, consider what are reversible and non reversible ways to do this. Most of the time if you're thinking about going into a partnership, there is a non equity way to do it. And it doesn't mean that five years down the road, one year down the road, you couldn't do an equity version of the same thing. But if you're considering going in with somebody like that, consider, is there a version of this that we could agree to just for 24 months that doesn't involve equity, where either party could opt out at any time? What are the upsides and downsides to that? Maybe there's a little more risk in it because they're not as, as committed as they would otherwise be potentially. So think through all that stuff. Maybe there's a penalty if one party wants to get out in a way that's going to harm the other. But permanence is like the last resort. This isn't me getting married and not wanting to do a prenup because I'm a nice guy. This is business. Should we still try to be the nice guy and like build good relationships with people and follow through and be flexible and human, all that stuff? Absolutely. But the default shouldn't be permanent. The default should be something reversible. Even how that incentive structure evolves is probably going to be a moving target as everyone's getting into different things and you're growing in different ways and you're super passionate about this thing now. So maybe that changes your role a little bit and the things that you can bring to your firm. There's a degree of flexibility there. Where you want some flexibility to be like, is everybody still working in the best interest of this, of this operation? Great. And that's kind of the argument for like just a straight up equity approach is you just trust that everybody's going to be working in good faith trying to do the thing that makes the whole business better. And sometimes those will be financial things and sometimes those will be non financial things. But I encourage you to think outside the box of equity to see how else you could achieve that. You're almost never going to get it right on your first try. Nothing here is going to be forever because people change. And think about that as you're coming into the deal. What's a version of this that accommodates the reality that people go through different seasons of life? This, I mean, there's a 0.01% chance that this is a forever thing. And knowing that now, don't be afraid to collaborate with other people because there's a tremendous amount of value in that. Like this isn't a reason to put it all on your back, but it is a reason to give a little extra thought to the permanence of these deals that you enter into and exactly what an exit from that deal looks like too. So is another thing that's really nice about small firms is you get to make up the rules yourself. Are there best practices? Absolutely. But it's not like going to a giant firm where that machine has already been designed and you're kind of just along for the ride. You get to make up the rules here. It's really between you and your partners. It is so much about the not business side of things. It's about the trust that you have in those people about the skills that they bring to the table that are complimentary to yours, whether they are technical skills or not. Like, if we're only looking at the building a partnership based on technical skills, we need to also be considering what are all the squishy things that some folks need to bring to the table. Can they do sales? Can they develop people? Do they have other skills like going out and being able to attract talented folks to the firm, Social media promotion, stuff like that. It's. It is a lot more than the technical. We heard from Chad Davis recently actually when he started Live Ca his, his practice in, in Canada that was at one point over 100 employees. He started out with a partner that was like totally the yin to his yang. They very naturally had complementary soft skill sets that let each of them focus on the part of the business that they really, really wanted to do. And it was not a technical thing. It wasn't. I can do this type of work. You can do that type of the work. Because ultimately for most firms, this ultimate success of the firm will actually come down to non technical things. If you're going to grow that beyond five people, the success of that firm is probably not going to be based in technical capabilities. It's going to be all the other things. So it's worth giving that stuff stuff some thought as well. This is an area where y' all are going to have a ton of insights of things you got wrong things you did right wisdom and how you've seen clients get this right and wrong as well. That's where a lot of my wisdom has come from is just seeing business deals that went well and didn't go so well with my clients. That stuff is gold in the comments. Quit lurking. Engage. That one little like call out that you may drop in the comments could save somebody a whole world of hurt. So drop that stuff below. Thank you for the question. Questions lead to conversations like this that help everybody. Keep those questions coming. I'll see you in the next one.