Unlocking Value: Private Equity's Impact on Accounting and Tax

Welcome to the Accounting for Innovation podcast, where we explore cutting edge strategies and insights into the world of accounting and finance. Presented by Decimal and the Radical cba, each episode dives deep into industry trends. Whether you're a seasoned professional or a budding entrepreneur, join us as we unpack key concepts and share practical tips to drive success. Welcome to the Accounting for Innovation podcast. I'm Jody Padar, the Radical cpa, and I've been at the forefront of innovation in the accounting space for over 15 years. I have with me my co host, Matt Tate, the CEO of Decimal, which is one of the fastest growing accounting companies in the country, and he's also an accounting innovator.

Ah, thank you, Jody. In this episode of Accounting for Innovation, we dive deep into. Into private equity and its profound impact on accounting and tax. Join us as we unravel how private equity firms transform traditional practices, drive innovation, and unlock new avenues of value for businesses and professionals alike. Jodi, you have been in this industry much longer than I have. To me, private equity is not a new thing, but it does feel like private equity is newly turned, talked about, and impactful for accounting. Tell me why.

So private equity, I think, began like around two. Well, I. No, it didn't begin, but like it was in the accounting space around the year 2000 or so, there was like the whole American Express rollup thing. And the reason that happened was. And then it got it rolled up and then it unrolled. And you know, there's. There's some. And I was even young back then, right? There's some. Some older guys that will tell you the whole story. You're still young and how it did and how it unrolled. But if you think about when that happened, it was all brick and mortar, right? Well, now fast forward 25 years almost. Right? Because that was around 2000 that happened. We have this thing called the cloud, where now you can put private equity in and you can roll these firms up in a lot more efficient manner, I think. And you don't have to worry about, like, kind of the overhead that you used to have to from like, the brick and mortar perspective. And you also now have these baby boomers who all want to retire, they all want to get out. And the traditional way of selling a partnership model firm is not really realistic because basically you trade in your equity, which is your book of business, and then it gets paid out over a number of years. So let's say it gets paid out over 10 years, but you have to have a young professional who wants to buy into that same partnership model and be around and take that firm for the next 25 years, whatever. You promote someone to partner when they're in their. Well, I now they're doing it younger, but like when I started, like you didn't even get considered for partner until you were in your 40s. And then that that person is going to take the firm to the next 20 years of growth. But that young partner doesn't want to be a partner anymore. And they haven't necessarily been developed as bench strength inside these firms. So if you're a boomer and you're ready to retire, what are you going to do? Income, private equity. And I think that's what's fueling the growth is you have all these boomers who want to retire and the partnership model isn't sustainable. And so private equity is coming in and they've done it in other industries. If you think about like dentists, there's like all this private equity in dentists and other kind of service professionals, law firms. So law firms. Right. So it makes sense. But what does that mean for us as a whole, as a profession? I don't know. And what's your take on it, man?

So to me, there are a couple of different things also at play here that I find fascinating and very exciting. Number one is I think you have a lot of people of, of my generation and younger who also look at that partnership model and say, why am I going to buy into something and then have to keep paying you out for 10 years? Why don't I just start the shop across the street, then take your clients, I get the same thing and I don't have to pay you out for 10 years. And that doesn't mechanically work out exactly like that. But that's kind of part of the thought process that you have in this is I don't feel like I need to earn this hazing again. And that I think is playing into it. The other part of it is what private equity does very, very well is it optimizes a business model for profit, period. And what it has determined as an industry is that accounting is not currently optimized for profit. And so they also look at these brick and mortar firms, not just the cloud firms, but these big, huge accounting firms that have big, huge offices. And they say, you know what, we can come in here and we can increase the ebitda. We can increase the profit on this firm instantly by making a couple of big changes. We can look at these and we can adapt the model because a partnership in general is Not a well run business. It's why when I talk to accountants and I give talks, my theme is stop running a firm, start running a business. And there's a lot of nuance that's packed into that. But to me that's one of the big advantages that private equity has. And they come in and they say, you know what, we can buy this firm for a really good multiple, we can increase the EBITDA almost instantly and we can keep growing and adding more and more firms by also using our own leverage for a quick payback period. So to me that's also where it is.

And these firms haven't been upgraded or like invested in, in years. Like the partners haven't made the investments in technology, they haven't changed their business model to serve the customer the right way. Like the we don't have a product market fit. Like professional service firms are having a hard time servicing the customer where the customer wants to be. And private equity can come in, insert cash because partners have traditionally, you know, if the firm made, I don't know, a million dollars in profit, they divided it out amongst the partners and the partners went home and bought a new car. Right. Like they didn't say, oh, I'm going to take this money and reinvest it in my business to optimize for new technologies or innovation or any of those other things. So these firms that they're buying are somewhat archaic and that's why it's so ripe for disruption. Because like if you throw a little bit of technology that adds significant efficiency on these business models, your profit is going to be huge. And I, I think it's a good thing. And like, I don't think it's worst thing in the world. I really don't. Like a lot of CPAs are really upset about private equity coming in, but honestly I don't think it's a bad thing. I think it's going to push the market to move faster and adapt and change and innovate. And when there's innovation and money, like to me that's excitement.

Oh, I agree completely. To me what this is doing is you have an outsider that is coming in in private equity and they are well capitalized, they have enough money to start to force change. And what will guarantee happen is the rest of the industry will have to change as well or it will become private equity. Because that is just the model that exists is they are going to invest in becoming more efficient, they are going to invest in growing, they are going to invest in a higher ltv. Or long term val lifetime value of a client, which means that they're going to try to create great experiences and good economics and reinvesting that. And so if, if you are a business owner and you're thinking, gosh, the business next door to me has more money than I do, they're creating a better experience, they're improving it constantly, and they keep their clients, I'm in trouble. And I think that's going to raise the floor and the water level for the industry.

Now, what about if I'm an employee, is this good for me or is it bad for me? Because what I find interesting is a lot of the professionals who are in these firms are, have mixed emotion about do they want to work for private equity or do they want to stay in a firm. Right. Like in a kind of traditional firm ownership. And what I see is I like because they think that there's a little bit of greed there. Right. Like there's a little bit of greediness. But I think if it's done right, private equity is going to actually be better for the employee because it's not going to be so much up or out. Right. Because the partnership model is kind of going away, so you're going to have the opportunity to be a technical expert and, and still have a lot of respect. And maybe you don't want to be a partner. And I think that's an interesting perspective as well, because in the old model, you either got to be a partner or you kind of got out. But in this new model, I think there's a lot of room for technical experts as individual contributors that don't necessarily have to go to be a partner. And so I actually don't see it as a horrible thing for the employee yet. I don't know. And the other thing about it is that I can say, again, know how a lot of people tell me things I heard from someone that it was a PE firm, that the employees who are there are not liking this new pe, but other people are being attracted to it and saying, well, I want to get hired because it's pe. And so I think that's interesting that the. Because. And maybe it's because they were the original employees and it's culture change and everything. But I also see it as a positive of firms who are, or talent who are saying, I want to go work for a firm that, that got bought by PE because I don't want to live in this traditional business model anymore.

So I'm going to, I'm going to add a story to this because I think there are two answers to your question. There are certain people that will not enjoy working for a private equity firm. When we started decimal out of a good sized accounting firm, the one of our first clients we got to do a conversion to Gusto for payroll and Gusto offered to do the full conversion for us. We thought it was great, it's going to save everybody money. The accountant and the bookkeeper turned it down and they said, you know what, we need the hours and we're going to manually enter the data into Gusto. That type of workflow and that type of mentality will not work in a private equity shop because that is exceptionally poor economics and it's poor leverage. The people that want to stop doing that work, that want to start doing the stuff they enjoy, the better work, those are the people that are going to thrive and love working in an accounting firm. The other thing is, is within the accounting industry there are people that haven't always had the opportunity to be as successful or to rise to partnership. Traditionally in a cast practice, a bookkeeper doesn't rise to being a partner in a CPA firm. And those types of people now have the opportunity for more career advancement. Because if you're good at your job, if you're good at creating profit, if you're good at running a good shop, and by the way, think about this. If a private equity firm, a private equity backed firm is going to be successful, there are two things that they're going to focus on in addition to EBITDA and profit. They're going to focus on churning, making sure that they maintain the client base that they have and grow it. And they're going to focus on employee churn. They want to make sure that they keep employees, they keep them happy and it will create more opportunity for more money because you'll get compensated better. So to me, for the right types of people, it's an exceptionally exciting opportunity. For the type of people that want to manually enter payroll information, it is not going to be a great long term fit. Does that make sense and answer your question a little bit? Yeah.

And I think someone needs to talk about that because I think what we hear from the professional side is oh, private equity, the partners are getting their money, right? That's basically. And like I'm left standing. That's kind of been the, the scuttle right on the street, right. The partners took the money and they left. And you know, they have certain rules that they have to follow obviously as part of their buyouts, but the employees are kind of left holding it. And I, I think you're right, but for a profession that change has been hard or non existent for many of these firms. Hence why they're having to be bought. Because then like, then you're like more resistant to the change, right? Like you're not necessarily embracing this new opportunity. And, and I think I make the statement that by 2020, 30 firms aren't going to exist anymore because private equity, in order for them to get their money out, they're going to have to take on a new level of investment. They'll go public.

Right.

Or they'll have to switch over. They'll have to, to, to, to change it up.

I think there's a fallacy that's kind of built into this which is is it really that great for, for everybody that works for a partnership? Because as far as I'm concerned, it's really great for partners and people that know they're going to be a partner. But sometimes it's not all that great for every other person. And so to me that's the other thing is this is democratizing the industry more than it ever has been. And I think that's important. And you see it in any time this happens economically or politically, haves and have nots have a different take on what happens. And comfort level and change is very tough no matter where you are in business or in life. But at some point everybody's going to have to look and private equity is only jumping harder and faster into this industry and it's not going to stop because the economics make sense. And you're right, the boomer phenomenon is making it so that this is going to happen because you have all of these aging out partners in firms that are in the top five, top four, all the way down to five person shops and they're aging out and they are figuring out what is the best economics. And that leads me to another point and you and I had been talking about when, when it comes to private equity, how is this going to change the industry and what are businesses that are maybe even looking to sell? Thinking about earnout is a really, really important aspect. When you're selling a firm you have your. I get paid some upfront and I get paid some over three, five, seven years, whatever you build in as an earn out.

And I think based on client retention, right.

And so you're looking who is going to be the best steward of my clients so that I can continue to make that money. Because if a bigger firm buys a smaller firm, you look and you say look, 10 to 40% of your client base, I'm pricing out pretty quickly and that's just part of it. Now I'm going to grow the fees on your other part so it'll probably even out. But do you really want to lose your earn out there?

Well, and so I would argue that's one of the reasons that like firms haven't changed for years prior to private equity is they bought these book of businesses from smaller firms. That's how most of the big firms became big. It wasn't because they organized acquisition. They, they, it's a bunch of mergers and acquisitions. And, and then even though they were like I'll say a small type of, a small firm type of client, they, the larger firm didn't price them out. They let the partner manage the billings. And so they may have a client that the price never increased for the size of the firm. So these clients are not profitable to the firm, but the partner has a handful of clients that are extremely profitable. And so the other partners kind of look the other way and let these like I'll say small type businesses that won't pay more. And again, that's a whole nother pricing conversation continue to be serviced by this big firm that has no business serving these clients. It's not optimized for it. And then those clients don't necessarily get the, the best service. Their needs aren't being met, but they weren't allowed to necessarily release them because the partner wouldn't let them. And the partner continues to charge his like old fee schedule billings on it. Right. Well, private equity comes in and that doesn't happen. Right. Like they, they're very particular about how you bill how much you're going to bill. All of this other stuff that in the old model when mergers and acquisition happened that, that was never really addressed because partners didn't want to ruffle feathers. So they wouldn't necessarily say, hey look, this small business client of yours that you're still only charging $3,000 a year for is not part of this, you know, top 400 firm billing model. Why are they still here? And, and you would think that there weren't that many of them. But if you talk to many of the top 100 firms, 20% of their work is doing, I'll call simple write up work or accounting and tax services at a lower rate. That should never be in a top 100 firm. But they kind of accumulated all of this work which in I'll say a, a really solidly run business. And I'm Sure, I'm offending lots of partners here would have been discarded or it would have been put under a separate brand even and said, look, we'll keep it, but we're going to do it under this brand over here because it really doesn't fit in our business model as a top 100 firm. And that's what's in these firms. And it always amazed me. And when you. Because I don't think the customer is getting the right level of service and I don't think the firm is happy and, and that doesn't like it doesn't. It makes for a lot of complaining on both sides. I'll say that basically it's not the right fit.

What people have to remember in this whole conversation is that private equity coming into this space is also matched with another phenomenon that will force and require change. And that is the talent shortage of accountants makes it so that even the firms are now more and more looking and saying, you know what, we have to, we have limited resources. We don't have the breadth of resources always coming in that we used to. And so we actually have to look at our staffing and say, you know what, we can't take these anymore because it is actually not only, not only is it losing us money by doing the work, but it's stealing the good revenue that we could have. So I think those both phenomenon are really, really important. And, and I think this is a great topic. And so with that, thank you for tuning in to the Accounting for Innovation podcast brought to you by Decimal and the Radical cpa. You can find more insightful episodes of Accounting for Innovation wherever you listen to podcasts. And please don't forget, pick up Jody's new book, Radical Pricing how to Optimize Profits, Delight Clients and Build a Top Value Firm or company. Interested in joining the conversation? Jody and I would love to connect with you on LinkedIn. Thank you.

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