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How to value an accounting firm.

As accountants, we often need to place a value on accounting practices in situations such as the sale of a practice, the acquisition of another practice, estate and succession planning, and acquisition or loss of a partner. Our training leads us to search for the formula, the rule of thumb or the checklist. While all of these factors exist, they usually are used only to derive a "ballpark" number and are not intended for transaction purposes.

PRICE AND VALUE DISTINGUISHED

As indicated by Ray Miles, Director of the Institute of Business Appraisers, in the book Valuing a Business by Pratt et al., "Price is what you pay, Value is what you hope to get." A value calculation presupposes a cash purchase. In the real world, pricing of a particular transaction is impacted by the perceived synergistic or strategic components in the eyes of the purchaser. Pricing is affected by the terms of the transaction. For example: Will the owners stay on or will they retire? What level of participation will the seller commit to during a transition? These types of issues will impact the price to be paid by a willing buyer. In each of these cases, the value of the underlying enterprise would remain constant.

FORMULAS AND RULES OF THUMB

"Some industries have rules of thumb (sometimes given an aura of credibility by being referred to as industry valuation formulas) about how companies in the particular industry are valued for transfer of controlling ownership interests. On the one hand, if such rules of thumb are widely disseminated and referenced in the industry, they probably should not be ignored. On the other hand, there usually is' no credible evidence of how such rules were developed or how well they actually comport to actual transaction data.

Rules of thumb usually are quite simplistic. As such, they obscure much important detail. They fail to differentiate either operating characteristics or assets from one company to another. They also fail to differentiate changes in conditions for companies in various industries from one time period to another." (1)

Rule-of-Thumb Formula

The traditional rule-of-thumb formula for an accounting practice is .75-1.25 multiple of revenue. For instance, if the practice generates 33.3% of net income to the owner in the form of compensation and distributions, this equates to a multiple of net income of 2.8-3.8 times net income. In the frantic consolidation days of the 1990s, practices were being acquired for a "price" of six times net income. Since many of the acquisitions were "paid for" with an equity interest in the acquiring firm, the "value" of the transaction was significantly less.

The traditional rule of thumb indicates a firm that was substantially a compliance practice (tax preparation, write-up and compilations) would be valued at .75 times revenue. A practice with a significant audit, tax planning and consulting clientele would be valued at 1.25 times revenue. In practice, however, these rules usually are not controlling. Recently, a friend of mine, a partner in an accounting firm, acquired a compliance practice for 1.10 times revenue. The reason for the variance from the "rule" of .75 times revenue was the quick receivables turnover. The average collection time for a receivable of the acquired practice was less than 21 days. My friend believed this and other positive factors created "value"

The bottom line: rules of thumb are acceptable starting points, but a transaction needs to take into consideration the operating characteristics of the practice being valued.

MARKET DATA--TRANSACTIONS

Transactional databases are readily available via the Internet. One of my favorites is Pratt's Stats (www.bvresources.com), which is a public database from Business Valuation Resources.

A search in NAICS Code 541211 (Offices of Certified Public Accountants) on Pratt's Stats yields five transactions dosed between May 1997 and August 2001. Various ratios are calculated. For example, Equity Price/ Net Sales yields a range of.716-1.492, with a mean of 1.055 and a median of .992. It is important to remember that this database reports "price" not "value" The information also includes the purchase terms, transaction structure (asset acquisition vs stock purchase), operating information, location, etc. Other transactional databases are available, but require a subscription or membership in a particular organization.

Information on accounting firms acquired by public companies (CBIZ, H & R Block, American Express, etc.) is frequently detailed in filings with the SEC (www.freeedgar.com).

Although not a transactional database, www.integra.com provides (on a fee-for-service basis) an industry analysis against which you can measure the subject practice.

ITEMS TO CONSIDER IN YOUR ANALYSIS

In valuing an accounting firm, the following items, at a minimum, should be considered. Of course, the results of the analysis of any one item may create other areas for consideration.

* Operating ratios.

* Balance sheet ratios (especially accounts receivable).

* Realization rates.

* Staff turnover and retention rates.

* Client turnover and retention rates.

* Policies and procedures.

* Transaction structure (asset purchase vs equity purchase, i.e., what is being valued).

* Staff competence.

Pricing Considerations

Once a practice is valued, the next step is pricing an individual transaction. The following items will impact price, but may not impact value.

* Synergies or strategic components.

* Transaction terms, i.e., cash, securities or owner take back.

* Seller's transitional commitment.

* Expected client loss, if any.

* Lease assumptions.

* Seller's non-competition or consulting agreements with purchaser.

* Tax ramifications.

CONCLUSION

"Cash is King" and the amount and sustainability of that cash flow is the lynchpin of value. Rules of thumb and formulas without competent analysis will not derive a value that is credible.

Reference

(1) Pratt, Shannon P., Reilly, Robert E, Schweihs, Robert P., 2000. Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th ed. (McGraw-Hill, New York), page 274.

P. Dermot O'Neill, CPA, a partner with Bederson & Company LLP, West Orange and Cherry Hill, NJ, is a Director of the firm's Valuation/Litigation Service Group. He is a graduate of Villanova University with a BS in Economics. Since 1998, his practice has been limited to business and intangible asset valuation as well as damage measurement in civil, criminal and bankruptcy litigation. His growing transaction practice includes mergers and acquisitions and succession planning. O'Neill can be reached at doneill@bederson.com, (973) 736-3333 or (610) 604-4714.
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Author:O'Neill, P. Dermot
Publication:The National Public Accountant
Geographic Code:1USA
Date:Aug 1, 2003
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