Multiplying the Value of Your Practice

The accounting profession has experienced massive changes over the last several years, except in one major area: the method used to value an accounting practice. But now that method is changing in a new 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 standard formula of valuation, based on a multiple of gross revenues plus the value of the hard assets such as furniture and computers.

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

A higher premium is typically applied when the current owner stays on board long enough to transition the clients smoothly to the new owner. 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.

A practice can also command a higher multiple or premium if clients are not tied to just one individual but instead know more than one professional at the company and are willing to talk with or meet with anyone concerning their situation.

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

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 discount tax preparers and desktop software, CPAs have little pricing power and are unable to raise their fees substantially every year for preparing tax returns. The costs associated with running an accounting firm, meanwhile, are increasing substantially, with the rapidly rising 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.

Consider the following example. 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 one times the 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 much time would it take for 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 from three to seven times, with an average of five. Characteristics such as revenues per client, longevity of clients, the current owners’ willingness to stay on for the transition, and whether or not the firm provides other services such as financial planning can determine where in this range of multiples a firm will fall. This last variable is critical since 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 example and using an average multiple of five times free cash flow, Firm A would be worth $250,000. It has already been established 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 concerning yourself 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.