Change the way you value your practice

By Chris Johnson
Capital Investment Counsel, Inc.

Over the last several years, the accounting profession has experienced massive changes, except in one major area: the method used to value an accounting practice. But now that is changing, too. It is time to throw out the traditional method of valuing your business and embrace a new way — a way that can mean a significant increase in the value of your practice.

Currently, when an accounting practice is purchased, sold or merged with another, there is one basic standard of valuation — a formula based on a multiple of gross revenues plus the value of the hard assets such as furniture, computers, etc.

Many CPAs typically value a practice at 1 times the gross revenues plus the market value of the hard assets. In addition, three key things can impact the multiple.

First, if the current owner is willing to stay on board long enough to transition the clients smoothly to the new owner, a higher premium is typically applied. If the existing owner is not willing to stay on through an extended transition, the new owner is more likely to lose existing clients, thereby assuming a greater risk. This devalues the practice.

Second, if the practice is fairly well institutionalized, meaning the clients are not tied to just one individual but instead know more than one professional at the company and are willing to talk to or meet with anyone concerning their situation, it will command a higher multiple or premium.

Finally, business with a higher chance of repeating year after year usually commands a higher premium. So, it is not unusual to see a practice valued at 1 times tax revenue, 1.2 times audit revenue and 1.4 times write-ups.

Still, there is a major downside to this valuation technique. In today's environment, profit margins are being squeezed in accounting practices.

Due to major competition from discounters like H&R Block and software like TurboTax, CPAs are finding that they have little pricing power and are unable to raise their fees substantially every year for preparing tax returns. On the flip side, the costs associated with running an accounting firm are increasing substantially. This includes the rapidly increasing costs of real estate, rents and especially labor.

So, with margins being squeezed so heavily, gross revenues are becoming much less important and free cash flow or profitability is now the paramount consideration. Soon, profits, or free cash flow, will become the only asset that has value to a potential buyer of an accounting practice. Let's look at some examples:

Firm A has $500,000 in gross revenues, does not run very efficiently and has 800 tax clients producing an average fee of $625. Three partners each pull salaries of $75,000 and the overhead, including additional staff, totals $225,000. This leaves free cash flow of $50,000.

Meanwhile, Firm B also has $500,000 in gross revenues, but operates very efficiently and has 250 clients producing average revenues of $2,000 per client.

Two partners each pull salaries of $100,000 and the overhead, including additional staff, totals $150,000. This leaves profits of $150,000.

Under the old system of 1 times gross revenues, both Firm A and Firm B would be worth $500,000. But if you had a half million dollars and wanted to buy an accounting practice, how many seconds would it take you to decide that Firm B is the better value?

That's why the new method of valuing accounting practices is so important. It is the only way you can command maximum dollars for your company.

The key is to apply a multiple to free cash flow — typically from 3 to 7 times with an average of 5. Characteristics that determine where in this range a firm falls include revenues per client, longevity of clients, the current owners' willingness to stay on for the transition, and whether or not the firm has alliances to provide financial services (investment management, insurance, financial planning) to clients. This last variable is critical. Financial services not only increase the revenues per client, but also tie the client to the firm for numerous value-added items, thus increasing the chances of that client staying with the firm for many years to come.

Going back to the two examples and using an average multiple of 5 times free cash flow, Firm A would be worth $250,000. We already know that Firm B should easily command a price several times higher than Firm A, and using this method Firm B would be worth $750,000.

So, if you are planning to retire or sell your practice in the next five years, spend less time being concerned with revenues. Instead, examine your practice and look for ways to operate more efficiently, increase your sellable profits, increase your revenues per client and offer your clients more services beyond tax preparation. As an added benefit, your clients will perceive more value, making it easier to increase their fees and reduce margin compression.

Overall, your practice will not only bring in more revenue for you but will also command a higher price when you finally sell.

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