By Bill Carlino
CPA firms looking toward an external succession via a merger want to know what they should expect to be paid for their firm. Conversely, those looking to acquire an accounting practice want an estimation of what they would pay in today’s M&A market. Unfortunately, there is no standard answer.
From either the buyer’s or seller’s standpoint, firm value hinges on several factors. For example, what type of practice it is (standard tax, audit, specialty niches, etc.), what the perceived profitability of the practice is, where it is located (metropolitan vs. rural market), what technologies are in use, and so on.
Changes in the Marketplace
As recently as 15 years ago, the CPA merger and acquisition market overwhelmingly favored the seller. During those years, it was not uncommon to see firms receive multiples as high as 1.5 or 1.75. In the late 1990s and well into the 2000s, big consolidators such as American Express Tax & Business Services, Centerprise, H&R Block, and CBIZ were rolling up CPA firms on a regular basis.
But that was then.
Now, staffing shortages and the COVID-19 epidemic have left many firms with less capacity than in the past, making them unlikely suitors for firms where all or most of the partners and staff need to be replaced. And firms owned by baby boomers are hitting the market in droves as sellers, and that will continue for the foreseeable future.
The supply of sellers is outpacing the demand from buyers, allowing the buyers to become more selective and thereby depressing values. Some pundits suggest that traditional services provided by accounting firms will be taken over by artificial intelligence and blockchain technology may depress the need for audit and accounting services. This has made some buyers leery of acquiring firms with traditional practices for fear that the fees generated by these services will decline if not be lost altogether down the road.
There are exceptions, however. Some geographic areas have a high density of small CPA firms, which tends to attract an adequate pool of buyers. Also, practices with strong consulting niches are more in demand than traditional A&A and tax firms. A firm with strong young talent may be a more attractive acquisition, too.
Determining a firm’s multiple needs to be viewed as “cause and effect.” It’s critical to note that the multiple is the “effect,” arrived at in large part by several distinct variables – or the “cause.”
Upfront cash investment – In the majority of deals we have consulted on, the down payment in a straight sale (as opposed to a merger) ranged from 0% to 20% of the selling price. What a buyer is willing to pay in a down payment can be heavily influenced by several operational issues. For example, closing on a practice that is heavily tax-oriented just prior to the onset of tax season is more likely to receive a down payment than a similar deal closing in June when most of revenue for the year has been collected. Remember, the buyer is often making a significant cash outlay in terms of legal and consulting fees, IT upgrades, etc. Firms that provide traditional CPA firm services are more likely to get little to no down payment, while niche firms are likely to receive one.
Duration of the retention period – We have seen virtually no deals that were not contingent, to some extent, on post-closing client retention. The majority of deals are structured as “earn out” or collection deals. For example, if the seller were to be paid one times revenue over five years in an earn-out deal, the buyer would pay 20% of collections from the acquired clients for five years. Thus, the entire payout period is equal to the retention period. The hundreds of deals we have consulted on used a limited retention period. For example, the price may lock based on retention after the second year, even though the payout period is much longer. The pandemic has caused buyers to be more focused on retention periods, pushing them to be longer than in the past.
Profitability – Profitability refers to the buyer’s expected profits from the deal, not the seller’s historical profit. In some cases, there will be a significant difference between the two. If the buyer can absorb the practice with no incremental increase in overhead, capitalize on cost synergies such as savings in labor and rent, create revenue synergy through cross-selling other services, leverage work the selling owner was doing to lower-level staff, and pay the seller in a manner that provides the buyer a current deduction as opposed to long-term goodwill amortization, this increases the buyer’s profitability. Hence, this could increase the multiple the seller can expect to receive. How the purchase is structured from a tax perspective can also have a strong impact on profitability of the deal for the buyer.
Duration of the payout period – For small firms, most payout periods are typically five to seven years. Larger firms tend to be paid with longer payout periods, sometimes more than 10 years. Does that make a difference? Buyers tend to evaluate the profitability of a purchase based on the cash flow that will be generated. The longer the payout period, the smaller the purchase payments, therefore, the greater the annual cash flow from the deal. A deal that will take three years to throw off any positive cash flow is hard to sell to the partners of a buying firm, especially given the upfront integration costs that the firm will incur, thus affecting the multiple. The pandemic and the influx of sellers has caused payout periods expand too.
Multiples – Once again, the multiple is the effect; the variables above are the cause. It isn’t always the case that the effect is reflected in the multiple, but it often is. Let’s look at an example. Say we have a small, $800,000 practice that a buyer can absorb with no incremental increases in overhead. Note the following valuation scenario: Seller requires no cash at closing and will accept 12.5% of collections for 10 years. Many buyer firms would gladly accept these terms even though it results in a higher-than-current average multiple of 1.25. If the same seller wanted a down payment, short retention period, and a payout period, they would be unlikely to receive 1X.
Value is often in the eye of the beholder: one person’s floor is often another’s ceiling. But a consensus on a package of terms is essential for any deal to be completed and, more importantly, to be successful.
Bill Carlino is managing director of national consulting services at Transition Advisors LLC, a full-service consulting firm dedicated to ownership transition and succession strategies for CPA firms. He can be reached at firstname.lastname@example.org.
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