Is your professional services firm ‘option ready’?

Rebecca Archer
Welcome to Season Five – we’re excited for another fantastic year of content on the podcast. For the past four years our podcast series, Navigating the New Normal, has provided our people, clients and prospects with information and inspiration during COVID-19. However, as we move forward and adapt to the current business landscape, it's time for a fresh start.
 
The relevant and insightful content will remain the same, but after years of navigating business in the midst of COVID-19, Grant Thornton introduces a new name for the series: Beyond the Numbers with Grant Thornton.

I’m Rebecca Archer and today I am joined by Financial Advisory Partner, Darryn Hockley, and Private Business Tax & Advisory Partner, Craig Lawson. We’re talking about the options professional service firms have when they are successfully growing and how to navigate this growth.

There have been, of course, significant changes in the way businesses operate since COVID-19, yet growth remains the key to success – so what are the characteristics of firms that achieve sustainable growth, and what options do they have that may distinguish them from their peers?

Welcome Darryn & Craig!

Darryn Hockley
Great to be with you. Rebecca's today.

Craig Lawson
Hi, Rebecca.

Rebecca Archer
Now, firstly, what exactly are those characteristics of businesses that can successfully grow?

Craig Lawson
So, first of all, they're profitable, which means they are good at what they do. They do good work, price it well and collect the cash, which is obviously an important part; there is diverse ownership of the firm; emerging talent is coming through, so the firm is good at developing and providing opportunities to good people; there's certainty about a pathway to ownership. So, in many professions, having equity in the firm is a big motivator. So, firms that provide that certainty towards equity tend to grow; risk profiles are also managed. We see experienced partners more willing to accept risk because they've obviously lived through a longer period of business time than the younger partners who are a bit more wary of risk in this day and age. And finally, these firms recognise that there are succession opportunities from growing successfully.

Rebecca Archer
Okay, so those sound like fairly strong foundations. What options do these firms have to keep their growth and sustain that momentum to keep on getting stronger and bigger?

Darryn Hockley
I guess we see a couple of things, Rebecca. We see these firms are ready and have options available to them, which means the owners can make choices and look at potential growth opportunities through merger, through bringing on new talent, and have directions available to them to continue that growth strategy.

They're often in a position where they're attracting new clients and often really quality, high quality clients. They're often attracting really good talent and it's managing that talent, possible opportunities for new investors to come in to help with that growth, and they're even in a situation where often they may have merger opportunities to merge with other likeminded businesses.

What they choose to do is not dictated by factors outside their control. So, factors like an unexpected retirement of a key shareholder, unfortunate death of a key member of the staff, a member of the team, one of their key directors, or economic conditions that will play out no matter what sort of environment, what sort of business they're operating in. So, they're factors they can’t control or issues around funding and funding that growth.

So, these are the opportunities often we see that they're option ready, ready to take control of their business and go to the next step and continue that growth.

Rebecca Archer
Okay, so how does a firm get to that point where they are option ready?

Craig Lawson
Being profitable, just to state the obvious, is a must, and it's not just profit, it's a conversion of profits into cash, and being able to distribute those funds to reward stakeholders and fund investment in the business and technology spend is a big focus these days on that.

We have an expression here of ‘make and take.’ So, we think in professional service firms, those owners that are there when the profits are made should take it. So, it's very much you make it, you take it, and those successful firms actually drive that profitability and take it and sort of generates that growth because other parties are keen to be a part of it.

That's where we work with many professional service firms, just around that three-way forecasting. So that reporting of cash flow, income statement, balance sheet really helps business plan for their future cash position and how they apply their funds, and it really provides the discipline to ensure the key drivers are being monitored.

And when you're in the business of selling time, you cannot make up a bad month. So, if you have a bad month where production is down, you can't make your people work twice as hard the next month when the work comes in. So, it's an opportunity lost. And so, we're trying to track and provide that discipline to the business so that their forecast is monitored to actual, so that when you go a little bit off the rails, you're making an informed decision in real time about getting it back on track.

Rebecca Archer
You mentioned diverse ownership earlier as a characteristic of a successfully growing firm. Can you flesh that out a little bit? What exactly did you mean by that?

Craig Lawson
So, firms that have a diverse ownership, meaning a number of owners with different ownership interests, have demonstrated that they're able to recognise the contribution to profitable growth and not be hindered by what could be a controlling shareholder group, and this is particularly important for emerging talent and just creating that certainty about a pathway, being there for good people to come so you're not left with, say, a tightly controlled, perhaps aging ownership base making all of the decisions. And I think, Darryn, you've had a recent engagement where these themes were pretty evident.

Darryn Hockley
Yeah, thanks, Craig. So, in my day-to-day role, I'm often involved in shareholder disputes, and one recent example that I can sort of highlight where I guess things went off the rails was three key shareholders controlling approximately 80 per cent of the group, which is not an unusual scenario that we see on a day to day basis; two high performing, recently appointed partners, both with expectations of future equity based on their contribution. These high performing partners were bringing in new work to the firm, new clients, and new market opportunities. So actually growing the practice rather than actually being fed work; stalling growth in some of the areas and one of the key focused areas of the business. So, one of the market segments was slowing down; that was a segment that one of the key shareholders was responsible for.

One of the founders was very keen to retain their significant profit share and the business was highly profitable, not necessarily aligned, though, to their own performance and the recent performance or their practice group. So, bit of a mismatch between performance and contribution, and also some personal circumstances that dictated the need and the requirement for ongoing cash flows.

So, I mean, that's not an uncommon scenario that we often see play out, and further to that, it's often a scenario that may end up in court, and in this example, it did end up in court, which not only a massive distraction for those shareholders involved, but also enormous distraction for the business, both from a time and cost perspective, and ultimately not necessarily a profitable outcome for all parties concerned.

So, reflecting on that and just, I guess, some of the characteristics that we saw as a result of that matter, unclear or very loose documentation around the process for progression on equity progression, misalignment of the strategy between the ownership group, inconsistency of contributions, both financial and management contributions, and reward and or return to profit, and certainly a weak cultural fit. There was a clear cultural misalignment between different members of the management group in terms of what they were intending to do with the business going forward and how they were going to manage these high performance and other senior staff that were also coming through the organisation.

So, we often see that from our experience and both Craig and myself is, it's critical for firms to have an alignment around their shareholder agreements and other documentation that is aligned to the business strategy and aligned to their culture. And where these values, cultural values and alignments aren't in accord, that those behaviors are called out and managed. And working with the team to ensure that the profitable growth is sustained by bringing through talent and managing the older, experienced partners as well on the way through to ensure that everybody builds a legacy for the business, but on the way through, as Craig alluded to, is you take the profit as it's earned during the course of the year and that the talent that's coming on is then contributing to the future profits and being rewarded for that performance.

Rebecca Archer
There are so many facets that you mentioned there. I wonder, the element of cultural behavior and the kind of culture that dominates an organisation that can be very, very hard to align. What are the key ingredients to, I guess, getting everybody on board and on the same page when it comes to the values of the business.

Darryn Hockley
So, I think it's really important, Rebecca, that there's a clear alignment between the financial performance of those high performers, but also alignment with the cultural values that the business wants to drive as well. Worst scenario could be rewarding high performers, but they're actually driving really poor cultural performance. That actually drives down the value and the performance of other partners, whereas a collective, if they're all on the same page, even though you might have high performers, if there's a clear alignment, then the actual business itself will perform stronger and the profitability will be stronger. Therefore, everybody gets rewarded at a higher level as well.

Rebecca Archer
Now, what's your experience with differing risk profiles between owners of professional service firms? I imagine that can get pretty complex.

Craig Lawson
Ah, it can. Good question, Rebecca. And it's particularly relevant today, given many emerging leaders will have limited capacity to fund equity contributions on their own. They'll likely have a significant personal house mortgage, family financial commitments, school fees, sport, holidays, and that impacts on their risk profile and borrowing capacity.

And I think obviously we've seen over recent times, the change in interest rates together with the cost-of-living changes really awakened people to, hang a minute, where would I find the funds to put into a firm? And previously, where 30 years ago, people were attracted to the fact that owning equity in a goodwill model, in a professional service firm, are perhaps less reluctant, and we're probably seeing a shift away from goodwill to non-goodwill models in a lot of sectors.

So successful firms tend to balance this by managing transitions in and out of the firm and making it easier to provide that pathway so you can manage the risks, because on one side you've got generally your senior partners who happy with the financial risk, but much more financially secure, but used to receiving a good flow of profits, versus the younger generation coming through who are concerned about the continuity of those profits and making sure they're being well rewarded.

And once again, just to throw to Darryn, we had a great example recently where we helped some founders. They wanted to drive growth in the business and recognise they needed to share their equity. And Darryn did quite a large piece of work across our teams to achieve that.

Darryn Hockley
Thanks, Craig. Yeah, so without sort of going into too much detail, the founders recognised that they had some really good talent coming through. They themselves were in a position where they had their own personal debt as well. So, what we worked with them is firstly a valuation proposition, to look at the value of the business as it sort of was at the time, and then worked with them in terms of flow through of profits and a self-funding model.

So, looking at cash flow still going to the founding shareholders as they sold down, but over a period of time, so to allow the new investors to come in and to fund their own acquisition through really the dividend flow. So, we modeled that out, and Craig's team was instrumental in that modeling piece around the flow through of dividends and profits to ensure that the new shareholders coming into the practice could fund the acquisition, and at the same time, there's cash flows coming out to the founders as they're selling down, but over a period of time, to allow management of the cash flows of the business, both in and out, as the two different shareholder mixes are coming in and coming out, and obviously noting that those founding shareholders were going to be integral for a long period of time for the success of the business and to recognise that as well.

The other piece of work that often goes with that is to ensure that there's a market continuity. So, market salaries are paid to executives, often around tax planning, it may not be market, but when we find that the shareholder mix gets larger and larger, it's very important to ensure that the shareholders are rewarded for their own personal contribution. From a remuneration point of view, that's one of the other factors that often needs to be reflected in the cash flow modeling.

Rebecca Archer
As you're both describing this kind of work, I can't help but think that there's a strong degree of diplomacy that must have to be applied from your end when you're dealing with this kind of delicate subject matter for a lot of businesses, I'm sure. How do you navigate that?

Darryn Hockley
I guess what we do often, Rebecca, is we have what we call owner forums or owner catch ups, where we start to flesh through those issues. Often we do it at two levels; we might do it initially with the senior partners, the main controlling shareholders, to get an understanding of what they would like to see and what the vision of the business that they see going forward, what they're looking for as well, obviously around returns, but also time frames of potential retirement to get an understanding of what their lens is.

And then we often bring in both that group and the new shareholder group and start to flesh through those to try and find strategic alignment. So, we often say the first point is not necessarily the profitability and the outcomes for different partners, but to ensure strategic alignment across the shareholder group.

Once you've got that strategic alignment, or at least a consensus around alignment, you can start to then work through, well, what are the options around? Sell down of equity, contribution of equity, bringing in potentially new partners from other firms, or merging. So, it actually gives you a better platform to say, okay, we're pretty much aligned with our strategy. That creates options, and those options then create the opportunity to work with management around, well, does that look like new shareholders coming in? Does it look like the existing shareholders retaining the shareholding base at the moment and looking for a strategic acquisition?

So, I guess, it creates options by knowing that everybody's pretty much on the same page.

Craig Lawson
And I'll just add to the fact that Darryn and I love working in this space because they're very much people, businesses, and so you are dealing with those relationships, and it's really interesting across different industries how people react to financial versus, say, design, or getting into the nitty gritty of what they do and helping to manage that and just calling out behaviors as we see it, because we come in as an independent generally and are able to give a view, and sometimes they take our view and other times they disregard it.

But yeah, people, businesses are a lot of fun, and when you're involved with that success, when they're able to get there and are successfully growing and people are being rewarded for what they do, it's a great place to work in.

Rebecca Archer
I'm curious, Craig, you mentioned earlier about there's a shift underway from that goodwill model to not so much in that goodwill space. What's prompting that and driving that kind of change?

Craig Lawson
It's moving away from that traditional, I'm going to be in this firm for the rest of my career. So, starting out, and really the longevity of profits, people quite often come in and out of firms today, and that changed to, does the firm offer remote working opportunities or not, and also location and geographical locations.

So, it offers up something which is a lot more short term, and so, people want to come in and be rewarded and not necessarily incur a significant debt to earn that certainty, and we're definitely seeing a shift, and in a lot of instances, it's arisen where firms will be in a position where they're trying to pay out their long term shareholders who are moving into retirement. Often, the younger generation won't pay cash up front, and so, it needs to be managed down over time.

So, we've worked on a couple of interesting scenarios where we've moved from goodwill to no goodwill models, and once again, if we're able to do that and provide a pathway, you end up with a good result for those retiring shareholders and the next generation coming through.

Rebecca Archer
So, I'm curious about what you're maybe seeing as coming to the fore in the next, maybe 18 months, even longer, maybe two years to five years for professional services. Are there any pieces of legislation that are potentially on the table that might really shake things up, or any trends that you're potentially thinking might really upend a few different growth models?

Craig Lawson
I think technology and artificial intelligence. Obviously, professional service firms are people business, and the biggest cost in a lot of instances is labour, and so, there's no doubt there's an opportunity with artificial intelligence from the perspective of professional service firms using that to help deliver to clients, and it's not necessarily to reduce labor, but it's probably to get the benefits of as if you had additional labor.

So, we're seeing a reduction in graduates coming out of university in commerce, for instance. So, there may not be the pool that we've got today in three to five years’ time. So artificial intelligence may be a bridge to help with that. So, I don't see necessarily the number of people in teams reducing, but certainly how businesses use artificial intelligence to help better deliver to client outcomes – that'll be a big change or opportunity. How firms grasp that, and obviously from the financial perspective, how do they fund the investment in technology, and that will depend on their model in terms of how they distribute profits, and allocate funds for investment as well.

Rebecca Archer
Darryn, what about you? Anything that is on the horizon that you think is worth mentioning?

Darryn Hockley
We've been talking about it for a long time about the transition from the baby boomers to the next generation, and there's no doubt that that will continue and that will continue in professional services firms. It's a matter of how the different shareholder groups manage that will be critical. My experience, obviously, in doing a lot of litigation work in professional services practices is that it can go pear shaped very quickly. So, it's a matter of alignment and goodwill – and I say goodwill from more, from this perspective of a cultural goodwill, goodwill between those exiting and those coming in, you may not necessarily get the ultimate outcome that you want on the way out, or ultimately the lowest risk on the way in.

I think it's important that that cultural alignment is critical, and we're seeing that with a number of professional services firms where cultural alignment has caused significant interruption in their businesses. So, I think that's one of the biggest pieces, is that continuity, the baby boomer sort of professional services partners retiring and the new talent coming in, because we know that some of the new talent aren't interested in being partners. So, what is the pathway or exit strategy for some of those retiring partners when there's potentially a smaller pool of potential buyers?

And I think that's where we can play a significant role in terms of that cultural alignment, but also the profitability opportunities that it is created for the younger generation of being a partner or being a shareholder in a professional services practice.

Rebecca Archer
Now, before we wrap up, just wondering if there's anything else that we haven't touched on that you think that we should cover and have people know about?

Craig Lawson
Obviously, Grant Thornton is a large professional service firm, so got a lot of divisions, a lot of geographical locations, now offering a nine-day fortnight in a trial on that at the moment. But what it means is that we've lived many of the issues that Darryn and I advise on and have come out the other side, and so, we have really good knowledge and love working with professional service firms, so we can help provide the discipline that the businesses need and hopefully get them on the pathway to sustainable growth.

Rebecca Archer
Well, Darryn and Craig, thank you very much for your time today. If people are wanting to perhaps get in touch with you who were listening today and are interested in hearing more or learning more about specifically what it is that you do and how you might even be able to help them, how should they find you?

Darryn Hockley
Thanks, Rebecca. Both our contact details are on the Grant Thornton website, and also we've got LinkedIn profiles as well. So, they're probably the easiest ways to get hold of us. And by all means, we're more than happy to take any phone calls of anybody that's interested in speaking further on this topic.

Rebecca Archer
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