Practice valuation: thumb rules and common sense.

Traditional measures should be applied with care and with an eye toward the long term.

How much is my practice worth?"

Contrary to popular opinion, an appropriate and equitable selling price can be found quickly and inexpensively for most small practices, with relatively little need for complex analysis or valuation consultants. All that's needed to find the answer are a working knowledge of basic valuation concepts and a healthy dose of common sense. The rest is easy.

THUMB RULES AND THEIR ORIGINS

One year's fees, or two and one-half years' sole practitioner or partnership pretax income, plus the net value of tangible assets included in the transaction, is widely considered to be a normal price for a small accounting practice and the transition services and other agreements that are integral parts of a typical sale. Payment is usually spread over five years, frequently in 60 equal monthly payments, without interest and often without down payment.

Obviously, no one would apply the above formula without preparing at least a rough pro forma income statement that eliminates fees from doubtful clients and atypical expenses. But once that's accomplished, is it really reasonable to use bottom-line and revenue thumb rules to find the right practice value? I believe it is.

Most professionals become skeptical of practically all generalizations, but more than a decade of practice valuation work has convinced me the traditional rules for valuing an accounting practice--properly applied-constitute the most appropriate and reliable approach to practice valuation for most practitioners.

Thumb rules in any profession or business ordinarily reflect the accumulated knowledge of hundreds or even thousands of people who have, through years of trial and error, figured out what works in the real world. To dismiss such guidelines out of hand, as is sometimes done in academic circles, is presumptuous and unwise.

A PROFIT-SHARING VENTURE

Retirement-minded sole practitioners and small partnerships have recognized for years that they weren't selling a business in the usual sense. They also knew they were able to turn over their established positions in the business community to successors and that this had significant market value. How did they arrive at a selling price? They bargained.

For decades the bottom line in a good solo practice or small partnership has run from one-third to one-half of revenues, with the average hovering quite steadily around 40%. The typical payout period for a practice sale always has been roughly five years, usually without interest, and the thumb rule price has stayed close to one year's fees, plus net assets.

It would seem early practice sellers and buyers simply priced at net asset value plus an even split of anticipated profits over five years. The seller would step aside, probably keeping accounts receivable; the buyer would assume the practice with occasional assistance from the seller; and they would split the profits for five years. Later, I suspect, some cautious seller or buyer wanted to fix the total amount in advance, so he or she multiplied five years times half the 40% annual profit and concluded one year's fees spread over five years was close enough. Since it was based on profit-sharing over five years, as opposed to a current price, there was no need to add interest.

Whatever its origins, the notion of splitting the profits for five years is worth considering as a benchmark. The seller gets five years at half-pay for little or no work and eases into retirement. The buyer tightens his or her belt for five years and ends up securely established in practice. The length of the arrangement encourages the seller to remain interested in the practice and in the buyer's welfare, especially if the payout is based on collections, as is often the case. The payout time period also encourages the buyer to take a hard look at the practice before signing an agreement and to make every effort to strengthen and expand the practice afterward.

In short, the traditional buy-out amounts to a kind of five-year economic joint venture that permanently replaces one professional with another, despite its legal status as a purchase-sale arrangement. If more buyers and sellers would think of it as a joint effort, there would be fewer problems and disappointments along the way.

THE CPA IS THE PRACTICE

For most accountants, the successful practice of accounting defines their personal identities and their personalities define the character of their practices. Practitioner and practice are one and the same for solo practices and for most firms below the $1 million mark. Practitioner and practice often die of the same heart attack.

When practitioners sell the practice, what they really are doing--for a price--is relinquishing their ability to work at their profession, thus leaving an established place in the profession to the buyer. By means of a covenant not to compete and carefully orchestrated joint visits to clients, they attempt to transfer their jobs and compensation to the buyer in order to reduce the latter's risks in getting started professionally or in expanding an existing professional practice.

Unlike a well-established restaurant or retail store, a modest public accounting practice has little momentum of its own. Client loyalty generally is to the person ("my accountant"), not to the firm. The buyer purchases a kind of insurance policy, in the form of the seller's agreement not to compete and the seller's recommendations to clients that the buyer be engaged to perform professional services for them. The seller's personal reputation and standing induce clients to give the buyer a head start in establishing his or her own practice and reputation.

A successful transition should be of paramount concern to both parties for a long time after the agreement is signed. Too often, both parties want to walk away from each other before the ink is dry to begin new stages in their respective lives. They fail to see they must share the next stage in the practice's life.

THE PRACTICE ITSELF HAS NO VALUE

An accounting practice itself ordinarily has no value beyond net asset value because it has no true net income. To put it bluntly, when a CPA buys a solo practice or an interest in a small partnership, he or she is buying a job. If CPAs work hard at these jobs, they earn approximately what they would earn at any other job suitable to their education, skills and experience. If a CPA hired a competent individual to assume total responsibility for running a newly acquired practice, he or she would find that after paying that person fair compensation, there would be little or no return on the investment.

Most common professional-practice valuation methods try to value the stream of expected future earnings. There are differences, to be sure, but whether it is called capitalization of earnings, the excess earnings method, capitalization of cash flow, earnings multiple or whatever, the approach is fundamentally the same.

In effect, the seller says, "Look, if you buy my practice, you'll get X dollars per year for as long as you own the practice. You should be willing to pay Z dollars at this point for that privilege. Think of it as an investment..."

But is it as an investment? I say no, because unlike an investment, an accounting practice demands hard work all day, every day, and a CPA is entitled to be paid for that hard work at a competitive rate. The practice's income, if there is any, is what is left after the practitioner has been properly compensated.

In addition, a CPA is entitled to a modest return on the money tied up in a practice. Statistics show most practitioners have nearly two months' worth of billings tied up in accounts receivable alone. Add furniture and fixtures, security deposits, work-in-process and other items, net out the payables and the figure is too big to ignore. This investment should yield at least as much as a bank account would.

To put it simply, unless a CPA earns enough beyond compensation to pay a modest return on investment and still have money left over, the practice itself isn't really turning a profit. It has no earnings or excess earnings. (For valuation purposes, earnings are a small corporation's pretax income after adjusting owner-employee compensation up or down to competitive levels; excess or residual earnings are earnings less an amount equal to a modest return on assets tied up in the business.) Valuation methods that capitalize a practitioner's or partner's total income may be very misleading.

In short, the excess earnings approach and other variations of earnings capitalization, if properly applied to pro forma net income after reasonable partnership distributions or officers' salaries---including a reasonable return on invested capital--will show little or no value for most practices with under $1 million in revenues.

Most small accounting practices are worth no more than the current or fair market net value of their tangible assets because they fail to generate excess or residual earnings--the most widely accepted test for goodwill value. This point is easily proven, emotionally unacceptable to many practitioners and the root of much misunderstanding.

It is well established that the value of any enterprise rests on the current net value of its tangible assets and its ability or inability to generate excess earnings (often called residual profit) over and above a fair return on the current value of such tangible assets. Appraisals of ongoing enterprises invariably include consideration of both factors. Current net asset value sets the lower limit on valuation, and any goodwill value, when added to the current net asset value, defines the upper end of the valuation range. Goodwill value usually is a multiple of any annual residual profit the business can generate.

Since current net asset value and production of residual profit determine value, and since the typical small accounting practice generates, at best, little more than fair compensation for its owners, there is no residual profit, no goodwill value and, in addition, no value to the practice beyond current net asset value.

The traditional selling price for an accounting practice consists primarily of substantial payment (the amount in excess of net asset value) for a contractual package that generally includes covenants, introductions, consulting as well as interest-free financing.

All of these are the sellers' personal or financial services that are rendered on or after the sale.

(An important implication of this conclusion, incidentally, is that these elements are irrelevant in valuing a practice when, as in a typical divorce, no portion of the practice is being sold.)

UNCOMMON SENSE SOLUTIONS

Common sense suggests something of value changes hands when a retiring practitioner sells a practice. But proper application of valuation methods based on assets or earnings suggests the typical small practice or partnership interest has little true value, because buying one amounts merely to buying oneself a job.

Common sense suggests the price of a small accounting practice, like the price of a share of common stock, may have little or nothing to do with fundamental analysis of financial performance. Generations of accountants have struck deals that serve both buyer and seller well. The traditional selling price formula for an accounting practice is reasonable for a small practice.

CPAs should feel comfortable relying on thumb rules, but they should apply them with care. It is always necessary to develop a pro forma income statement based on more than one year's information. Practitioners should carefully review and, if necessary, edit the client fee list to eliminate lost or troubled clients and fee categories and make allowances for unusual expenses.

The commonsense solution is to pay or accept net asset value plus an even split of the profits for five years. CPAs can reduce the payout to a fixed amount if they wish, but both buyer and seller must plan to work together and stay in touch. Any other type of deal isn't worth accepting.

ROBERT B. SCOTT, Jr., CPA, is an independent practice management consultant, publisher of practice management materials in Wickford, Rhode Island, and a faculty member at Roger Williams University in Bristol, Rhode Island. He is a member of the American Institute of CPAs, the Institute of Management Consultants and the Rhode Island Society of CPAs.

EXECUTIVE SUMMARY

* CONTRARY TO POPULAR opinion, an appropriate and equitable selling price can be found quickly and inexpensively for most small practices. All that's needed is a working knowledge of basic valuation concepts and a healthy dose of common sense.

* THE TRADITIONAL RULES for valuing an accounting practice--properly applied-constitute the most appropriate and reliable approach to practice valuation for most practitioners.

* ONE YEAR'S FEES, or two and one-half years' practitioner pretax income, plus the net value of tangible assets, is widely considered to be a normal price to pay for a small accounting practice and the accompanying transition services and other agreements. Payment is usually spread over 5 years, frequently in 60 equal monthly payments, without interest and often without any kind of down payment.

* IT'S ALWAYS NECESSARY to develop a pro forma income statement based on more than one year's information. Both buyer and seller must plan to work together and stay in touch.