Understanding what your firm is financially worth will help you make informed decisions on succession/exit planning. This article provides valuation considerations for business owners looking to sell their professional service firm.
When considering the sale of a professional service firm, such as a law or accounting practice, many business owners are challenged with determining the right price and structure for the sale of the practice or partnership. In this case, a valuation performed by an external valuator can provide an independent view of the value and set the business owners’ expectations. Reasons for performing a valuation can also include the admission of new partners, income tax and succession planning, implementation of a partner buy-sell agreement, or litigation.
Intangible vs. tangible assets
A professional firm’s financial statement generally outlines tangible assets such as, cash, accounts receivable, work-in-progress, furniture, and equipment at their depreciated or amortized book value. Intangible assets in the form of goodwill can arise, in part, from personal goodwill (attaching to individual partners, in different proportions). However, personal goodwill is not transferable. Another type of goodwill relates to the practice and is commercially transferable. Firms with significant personal goodwill may want to find ways to institutionalize their practices and client relationships to enhance the commercially transferrable goodwill component. An example of this is ensuring that each client has more than one point of contact within the firm.
Valuation considerations and transaction structure
Certain valuation methods can be used, such as multiple of earnings, discounted cash flows, or rules of thumb, but they do have limitations. Such approaches might apply to large corporate practices with recurring relationships, which create commercially transferrable goodwill that can be transitioned to a new owner. Another approach to value professional services firms is the adjusted net asset approach. In this case, the valuator would work off the existing balance sheet and adjust to reflect any differences between fair market value and book value. Typically, the main asset would be the work in progress (“WIP”). This assumes that a purchaser will have access to the firm’s client files and be able to continue with the existing book of business.
To do this, the valuator would need to go through the existing client files to determine the expected outcome for total fees and timing. Any potential step up in value from book value to fair market value should theoretically reflect the excess margin available to the practice from existing commercial goodwill.
There would be two options for structuring the transaction that consider the valuation and sale of the WIP:
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Calculate the present value, with payment up front. This would then transfer all the risk, and possible additional upside/downside such as a higher or lower realized profit margin, of each file to the purchaser.
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Calculate the expected amount, then work on a payout plan as the billings on these files are collected. This approach transfers the risk to the seller, as they are no longer running the file and don’t control whether the client stays.
Note that under these scenarios the payout includes the “profit” per file, not the total fees, as there would be costs going into completing each file by the new owner. In this example, we also assume that there are no other material assets or liabilities on the books of the business and that the company would be sold on a cash and debt-free basis.
A sale/purchase of WIP would be structured as an asset deal (i.e., the transaction would be defined as the purchase of a certain asset versus the purchase of the shares in the business). Buyers typically prefer to purchase business assets over shares as they get to pick and choose the specific assets they are interested in, and they aren’t responsible for any liabilities associated with the existing business. In addition, a buyer can increase the tax cost of any depreciable property to its current market value. A share sale, on the other hand, is usually preferred by sellers as it generally results in a favorable capital gains treatment (i.e., the lifetime capital gains exemption). If there is meaningful value in a company’s brand and reputation and the buyer intends to carry on the same or similar business, a share purchase might also be an appealing option for the buyer.
Seek professional advice
If you are a business owner who is contemplating the sale of your professional service business, setting your goals, vision and your exit plan early is critical for success. Once you decide to proceed with the sale of your business, consider engaging a financial professional to assist with negotiations. Unlike purchasers, who may acquire several companies over time to fulfill a long-term corporate strategy, most business owners may have never sold a business and, consequently, may have difficulty separating the pragmatic decision-making role from the emotional aspects of the sale.
For more information, please speak with your BMO financial professional.
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