Professional Services Firms and Their Search for Liquidity
Workspan Daily
November 16, 2023
Key Takeaways

  • Increased interest in liquidity. A growing number of professional services firms have started to explore alternative approaches to providing liquidity to senior partners while remaining partially partner owned. 
  • Potential challenges. Among the challenges with external investments are partners will no longer be the sole decision makers on firm strategy and major investments, as external investors’ value appreciation is prioritized. 
  • The case for ESOPs. 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 instills an owner-operator mindset with employees early on in their careers.  

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 manage the business and contribute to the firm’s working capital in exchange for profit allocation.  

For partners, liquidity comes from annual distributions and retirement (or when a partner leaves on good terms) when capital contributions are returned.  

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. Some firms have 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 become “agents” who manage shareholders’ assets. 

External Investment: Opportunities and Disruptions 

A growing number of professional services firms have started to explore alternative approaches to providing liquidity to senior partners while remaining partially partner owned. There is growing interest among private equity firms to invest in professional services firms, offering 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 partners may define value creation differently. 

Realignment of productivity and ownership. Over time, partnerships run into challenges when partners with significant ownership move past the peak of productivity. A transaction can optimize the balance between productivity and ownership. 

New strategic options. Cash inflows into long-term investments can be challenging because a partnership is naturally a pass-through intended to distribute all profits.  

However, external investments may also come with some potential challenges: 

  • Less centralized governance. Partners will no longer be the sole decision makers on firm strategy and major investments, as external investors’ value appreciation is prioritized.  
  • Generational equity. As equity stakes of senior partners are liquidated, the well-established value chain will break for the new generation. A new compensation mechanism or equity transition will likely be needed to maintain engagement.  
  • Potential talent gap and retention risk. Liquidation of equity stakes for senior partners will prompt some partners 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 unlocks 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. In other domains, such as the legal profession, professional protocols may prevent external investment. 

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), a tax-favorable instrument in the U.S. that promotes employee equity ownership. They have been popular among some sectors in professional services, such as engineering and construction. Here are some advantages of this approach: 

  • Less disruption to the firm’s purpose and governance model. 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 instills an owner-operator mindset with employees early on in their careers. 
  • Tax benefits. For employers, ESOP contributions are tax-deductible. For employees, ESOP distributions are tax-deferred until withdrawal. 
  • A useful tool to distribute ownership. An ESOP is effective in slowly disseminating ownership from its founders to other partners and employees while maintaining continuity. 
  • Wealth tool for employees. A study done by the National Center for Employee Ownership suggests that employees benefit financially from an ESOP 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, carving out funds for ESOP contributions may result in lower cash compensation, making talent attraction more challenging. Compared with partners, employees have greater liquidity needs and may see the illiquidity of ESOP as a disadvantage. 

Should Your Organization Consider These Options? 

It is likely that more professional services firms will explore external investment in the future. 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. 

Editor's Note: Additional Content 

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