Practice valuation

Executive Summary

Valuing an accounting practice starts with assessing a combination of annual gross revenues and normalized earnings. Buyers and sellers should be aware of the most common factors that will affect the valuation.

For accounting practitioners looking to buy or sell an accounting practice, this is a life decision that should be carefully considered. For a practitioner looking to retire in three to five years, it is recommended to have a rough estimate of the value of the practice for planning purposes. However, as the retirement date approaches, the estimate should be upgraded to the actual valuation. A comprehensive valuation is essential for a successful practice transition and must be properly documented and executed.

Valuation method

In our experience, there are two major indicators that can help a buyer understand and value an accounting practice.

Gross revenues

Gross revenues indicate the ability of a public practice to market professional services. While higher gross revenues may indicate a more profitable practice, this is not always the case. For example, a practice that is servicing a large number of personal tax clients may have significant revenues; however, to realize such revenues, the practice needs to hire more staff, which in turn result in lower margins. Therefore, other metrics should be considered to provide useful information for evaluating the profitability of an accounting practice.

Normalized EBITDA

Earnings Before Interest, Tax, Depreciation, and Amortization (“EBITDA”) is one of the most used financial indicators for valuing professional services firms. This is a valuable indicator as it can compare profitability among companies and industries while eliminating the effect of financing and accounting policies. It considers only the expenses needed to run the business. It also ignores historical cash outflows that affect current income. For example, annual depreciation of capital assets is a non-cash expense that does not help the buyer understand current net earnings.

Adjustments to earnings

Adjustments are required to normalize the earnings of an accounting practice and account for expenses or revenues that are not indicative of future operations after the sale is completed. The following are a few examples of adjustments that may be relevant when calculating the normalized EBITDA.

• Payroll for family members
  Family members may be on the payroll, but this expenditure should be adjusted to reflect the fair market value of the services performed for the business. For example, if the spouse is engaged as an office manager and paid a generous salary, normalized EBITDA would be adjusted for the fair market value of this expenditure.
   
• Club memberships
  One of the most frequent items in this category are golf or hockey memberships. The previous owner may be an avid sports person that has taken his clients on the golf course or to hockey games. However, this may not be the case for the buyer and this expense may be eliminated after the acquisition takes place.
   
• Revenues and expenses from non-arm’s length parties
  The amounts transacted between non-arm’s length parties may be higher or lower than the fair market value. The seller should disclose non-arm’s length transactions as part of the valuation process and adjust the earnings accordingly. An example of non-arm’s length transaction would be when the accounting practice makes a large monthly payment for janitorial services to a company owned by the principal’s spouse. The value of monthly janitorial services would be adjusted to the fair market value of such services.
   
• Rent
  This is an item that requires a more in-depth analysis. There are cases when the seller will merge their practice into the buyer’s operations. Therefore, the buyer does not need to take over the lease for the premises. However, normal public practice operations would require some physical presence, unless the business is cloud-based with no physical presence (in our experience, this type of practice is becoming more and more popular due to the reduced overhead costs). EDITDA should be adjusted for a reasonable rent amount unless the practice has no physical office.
   
• Non-recurring costs or revenues
  Non-recurring items must be excluded from the normalized earnings. While the revenues and expenses may be valid, they are not representative for the ongoing operations. For example, when professional fees were charged for a tax reorganization, but it is expected that on a going forward basis the client will be charged for tax compliance only, an adjustment to earnings is granted.

Multiples

After gross revenues and EBITDA are normalized for items that are not indicative of ongoing operations, a practice value is determined by applying a multiple, which encompasses a rate of return required by the buyer. We see accounting practices valued at 0.8x to 1.5x gross revenues or 3x to 5x normalized EBITDA. Ultimately, a practice is worth what someone is willing to pay for it. When several buyers are interested in the same accounting practice, the multiples are usually in the upper range.

Understanding how the value of the practice is measured and the key value drivers, is the first important step towards buying the ideal practice.

This article was prepared by Dorin Bogdan Mihalache, (d@practiceforsale.ca), Founder, and Melanie Russel, B. Comm., CBV, CIM, CFE, CFF, ABV (melanie@practiceforsale.ca) of www.PracticeForSale.ca, a Canadian practice transition advisory firm.