Valuation

Source: Journal of Accountancy

The price of a CPA firm is a function of five interconnected factors: the initial cash payment as a percentage of the total, the payout term, the profitability of the successor firm, the holdback period for potential loss of clients, and the ratio of price to annual revenue.

Smaller Firms:

The greater the initial payment, the lower the total price. Timing is important—generally a purchaser will want a smaller cash payment if the transaction is consummated in May as opposed to December. If the seller collects the receivables, the buyer will want a smaller initial payment.

A longer payout term will affect the price. Most terms are between three and seven years for smaller firms.

The successor’s profit depends on whether overhead will be increased or decreased.  If no additional space or personnel are needed and the seller’s space is not absorbed, the price may be higher. If the buyer is able to get a current deduction rather than amortize goodwill, the price may be higher. 

The holdback period may be affected by the client mix. A preponderance of annual engagements (which affords the buyer limited contact with the client) will make a one-year period risky for the buyer. The periods range from a year to the length of the payout term. Defining the meaning of the holdback period is important. Most transactions provide for an adjustment to the price if a specified amount is not collected from existing clients. Some require only that the clients must stay with the firm. Some agreements lengthen the term if clients move or go out of business.  In the interest of fairness, some sellers are given a share of increased business to compensate for the risk of lost business. 

The ratio of price to revenue is a function of these four factors.

The price is further affected by profiles of clients, billing rates, cross-selling opportunities, turnover of staff, status of noncompete agreements, billing practices, tangible assets and liabilities, aging of receivables, etc. Other factors are below market rates for leased space, name or brand identity, databases, Web sites, and technology.

Audits and other business engagements are thought to be more valuable than personal tax engagements, but this is possibly a myth. Personal tax preparation can be profitable and add value, especially with an appropriate holdback term (e.g., 2 years).  They also afford opportunities for work in estate planning, and financial services.

With low interest rates, buyers are motivated to make larger initial payments and thus be able to bargain for lower prices. 

Larger Firms:

The price of larger firms is further affected by the compatibility of niche services.  Where one party offers a niche service not offered by the other, the combination may create new revenue opportunities. (Editor’s note: Where the parties offer the same niche services, one may complement the other, or there may be an opportunity to dominate the niche.)

The value of talented staff in today’s environment can be a particularly valuable asset that a buyer may seek.

Larger firms may have geographic strategies that cause them to value certain targets and these targets may be small or large firms. (Editors’ note: But some firms have opted to start de novo offices where the asking prices were too high.)

The perception that the ratio of price to revenue is higher for large firms is not always right. The acquisition of a large firm by a larger firm can increase overhead and squeeze margins.

Buying Partners’ Interests:

Multiples will be lower than in an outside deal.

The determination of the price of a retiring partner’s interest is often based on the additional cash flow created by the retirement. 

A common methodology is to pay a multiple of the retiring partner’s recent income (e.g. two times the last three years income paid over seven years).

If planning for the partner’s retirement begins several years in advance of the event, a holdback period may not be necessary.

To plan for a buyout in the event of death or disability, some firms pay partners for the cost of personal insurance policies. This offers tax advantages to all parties. Insurance face values should be updated yearly as the value of the firm grows.

For more information, see Journal of Accountancy, December 2004 or http://www.aicpa.org/pubs/jofa/dec2004/sinkin.htm