What is Clawback?

What is Clawback?

It’s vital that you understand the important concept of clawback when it comes to buying or selling an accountancy practice, say Jeremy and Lucinda Kitchin

 

Most practices being sold will have a clawback clause in the Sale Agreement, which is a risk-sharing agreement between buyer and seller. It protects the buyer if clients leave during a specified period (usually the first year) with the result that the business is not worth its selling price.

When a practice is sold, a percentage is typically paid up front (usually 50% for micro practices), with the balance often being paid a year later. In some deals, there are three payment instalments: one-third upfront, one-third on the first anniversary of the sale and the final tranche on the second anniversary of the sale.

If the vendor is selling for, say, £100,000 in a one-year agreement at a multiple of once times, he will receive £50,000 (£50k x 1.0) on completion and the other £50,000 a year later.

If some clients leave in the first year and the fees retained on the first anniversary are, say, just £90,000 then the new owner can ‘net off’ this shortfall and pay a lower second instalment of £40,000. In the case of a claimed shortfall, the vendor has the ‘right of discovery’ – the right to look at the files, before he agrees to the lower second payment.

The definition of a shortfall is when, at the end of the warranty period, the fees that were sold and purchased have not materialised, and are not likely to materialise – then a shortfall has occurred. This takes into account a situation where, say, a client has not made his books available so that the work can be undertaken.

It is usually only the individual clients listed on the schedule itself that will be part of the sale.

Often the two parties will agree that if a client indicates that he is going to move on to another accountant, the purchaser will tell the seller so that he, the seller, might try to recover the situation – the logic being that there is no point in the client’s fee being lost to both parties.

Although it sometimes happens that the new owner will find that, at the end of the first year, he has billed more fees than he purchased for the same work undertaken for the same clients, the seller cannot normally claim a claw forward. After all, the new owner has bought the goodwill, which entitles him to benefit from any increase in business.

It makes sense for the seller to sell the aggregate sum of the fees sold, namely £100,000, not the individual clients. That way there is an automatic trade off between clients that have contracted or been lost with those clients that have expanded and given rise to more fees being billed to the same clients. New clients do not go into the kitty for the purposes of calculating the clawback. After all, new clients will have joined the firm as a result of the goodwill already purchased.

The vendor can limit his potential loss to a certain extent by adding a clause in the contract to say the new owner will not raise fees by more than an agreed percentage during the warranty period.

Legal advice

Legal advice should be considered before entering into a Sale Agreement, especially where a clawback clause is included. It is in the best interests of the new owner to have the longest clawback period possible, while it is in the best interests of the seller to have the shortest.

Any fees that were lost during the first year are normally deducted pound-for-pound (times the multiple). As it is a seller’s market, the seller will not normally agree to the clawback operating over the second and subsequent years.  But nothing is written in tablets of stone!

It is normally written into the Sale Agreement that if the new owner wishes to make a claim under the clawback clause he must inform the seller in writing of an intended claim before the first anniversary of the sale. If he does not do this, he may forfeit the opportunity to net off the shortfall, in accordance with the terms agreed in the Sale Agreement.

We sell draft contractual paperwork through our website which includes the necessary clauses catering for the clawback facility. There you will find documents available for purchase such as various draft Sale Agreement templates, which come with supporting notes, master Heads of Agreement documents, a valuation thesis, guidelines for carrying out due diligence, and so on.

  • Jeremy & Lucinda Kitchin, APMA. For advice call 01623 883300 or email Lucinda@apma.co.uk

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