How to value a CA firm – Back to Basics

The most common question our team get asked at accounting conferences is ‘what am I worth?’ Of course, what practitioners mean is: What is the value of my accounting firm, or a partners’ share of a firm upon succession or transfer?

The reasons for asking this question are: someone wants to buy into or exit the practice; buying or selling; key person insurance being renewed; death, divorce, illness or someone trying to extract money from the firm.

The two most common methods for establishing the value of a firm are cents in the dollar or a multiple of earnings before interest and tax. Both have pros and cons. So why choose one over the other?

The more popular cents in the dollar rule of thumb is where the buyer agrees to pay a fixed amount for each $1 of gross revenue generated in the most recent financial year. A firm with slim profit margin will almost always opt for this method. The other method, a multiple of earnings before interest and tax (EBIT), is favoured by profitable practices because it fetches a higher price.

Many factors contribute to a firm’s valuation – location, for example. A city-based practice will fetch a higher price than one in a regional centre. Each city has hotspots. In Sydney, the CBD and Parramatta are especially attractive.

THE VALUE OF SME AND SPECIALIST CLIENTS

A client register consisting of small and medium enterprises (SMEs) also trumps one made up of individuals. Unless of course they happen to be high net worth individuals.

Practices that operate in high-value niches, such as medicos, are also considered prime real estate. Sharp buyers will dissect the client base by age, profession and location, as well as examining any cross-selling or expansion opportunities.

Don’t underestimate the value of your firm. Buyers see opportunity in areas yet to be worked. Accounting practices are currently fetching record prices due to intense interest from financial planners, many of them with foreign backing. They want to replicate the lifelong relationship that accountants have with clients and apply it to financial advisory services.

In sizing up a firm, staff profiling and cultural issues emerge that also affect the valuation. An astute buyer will examine the age, experience, tenure and contractual obligations of staff, including trading restraints. Red flags go up, for example, when all or a large percentage of staff have their own tax agent licence. This is a classic indicator that a vendor is trying to sell client relationships they may not really own.

On the flip side, there may be legislative reasons for having staff with individual tax registrations. So what a buyer really wants to see are robust employment agreements, with effective restraint clauses clearly stating that if an employee wants to exit with a client, they have to buy the client.

By itself, neither the type of clients nor the staff profile will determine cultural fit. We work in a relationship business. Culture eats strategy for breakfast. A quick sale for a quick dollar will hurt all parties involved. Get to know your suitor, business masks off, personalities out on the table. Having advised more than 600 accounting firm transactions over a decade, we can say that transactions where the parties take the time and effort to do this always produce superior outcomes.

Ultimately, it’s the sales terms in the contract, not the multiple of EBIT used, that has the biggest influence on what you end up paying (or pocketing) for a practice. This second phase of negotiations is the most crucial. Read the contract.

SALES TERMS: HOW THE SALES PRICE IS SLICED AND DICED

There are a number of factors that govern sales terms, including cash upfront, the clawback, length of the handover period and the ongoing role of an exiting practitioner and current staff. A clawback is essentially an insurance policy in case income or client retention doesn’t meet expectations.

Cash is king. From a seller’s point of view, the more cash secured upfront in a transaction the better. In reality, a vendor usually pays between 50% and 90% of the agreed sale price upfront. The remainder is paid over one or two years linked to a ‘clawback’.

So how does a clawback work for a single tranche or one-year term? Say a deal is struck on a cents in the dollar ratio of one dollar for every dollar of revenue generated in the previous financial year. The firm generates $1 million in gross billings and the buyer agrees to take 50% of the sale price ($500,000) in cash upfront, while the other half is linked to a clawback over one year from settlement date. So for every dollar in revenue generated over $500,000 in that first year, the seller collects one dollar, up to a value of $1 million.

Spreading the clawback term over two years on the same calculation of $500,000 upfront and the balance in clawback position – 50% each year – spreads the risk for the purchaser.

In the first year, every dollar over $750,000 belongs to the vendor (so $250,000 if the firm makes $1 million). However, if the firm overshoots the mark and achieves $1.2 million in gross billings that first year, the vendor has already achieved $200,000 of their second year target of $1 million. If the firm does not achieve the $1 million target in the first year, the opportunity rolls over into year two. A balancing out scenario would be in the first year the practice achieves $900,000 and the second year it achieves $1.1 million, so the vendor will be paid the full clawback.

Reverse clawbacks may also be included for extraordinary events – a health issue or family breakdown, for example – which causes the firm to miss a revenue target that under normal circumstances would be achieved.

There is no hard and fast rule for how clawbacks and reverse clawbacks are applied. It’s best to assume nothing and check everything. A purchaser might try to link the clawback terms to specific client billings, rather than a firm’s overall gross revenue, ignoring the fact that accounting firms are living breathing beasts. A client might spend more this year than last, and vice versa. Client attrition is a fact of life.

When buying an accounting firm, you’re buying the opportunity to generate the same amount of money that was generated last year. Clawbacks and handover terms should be considered in tandem. The principal of a $1 million firm with a 20% clawback spread over two years who exits after six months is looking at 18 months in which they don’t really know what’s going on within the firm. They’ve no way to know if the new buyers are under-servicing clients and perhaps utilising the clawback as a discount mechanism. They’re risking $200,000 at the end of their career – that’s a lot of money. Audit clauses and quarterly reports should be part of the sale contract.

There are different schools of thought on handover periods, which can range from three months to two years. Some favour a gentle handover by incumbent management, so clients can be properly introduced and staff have time to adjust. The existing practitioner slowly fades out, till finally he or she is on a phone call basis relationship.

Others like to put a broom through the practice and cull personnel, especially if the outfit is haemorrhaging. Given what’s at stake, giving a principal an incentive to stay on in a reduced capacity can be beneficial. Outgoing vendors can be a great source of referrals and wisdom.

Internal sales are usually (but not always) discounted and often have little to no clawback, because that person has contributed in sweat equity to the gross billings of the firm. They have also seen the client base from the inside, so don’t apply the same risk weighting an external party might.

In brief

  • Accounting practices are fetching record prices due to intense interest from financial planners.
  • Cash is king. From a seller’s point of view, the more cash secured upfront in a transaction the better.
  • Practices that operate in high-value niches, such as medicos, are also considered prime real estate.


Magnus Yoshikawa, Jadeja Partners

www.jadejapartners.com

Magnus Yoshikawa

Magnus Yoshikawa

Director at Jadeja Partners
Jadeja Partners are committed to the founding philosophy established by Dip Jadeja in the early 1990’s; giving back to the accounting community through full cycle support. We focus on more than just helping you sell your accounting practice; Locum, Overflow and Add-ons complete the circle.
Magnus Yoshikawa

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Magnus Yoshikawa

Jadeja Partners are committed to the founding philosophy established by Dip Jadeja in the early 1990’s; giving back to the accounting community through full cycle support. We focus on more than just helping you sell your accounting practice; Locum, Overflow and Add-ons complete the circle.