Founder Arpeggio Advisors
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How to Value Small to Midsized Accounting Firms

Mar 24th 2016
Founder Arpeggio Advisors
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The value of small and midsized accounting firms is currently poorly understood. Conventional business valuation techniques are, at best, awkward tools, and as a result, such firms are challenging to buy and sell, undermining the exit value to owners and making it more difficult for acquirers to expand by acquisition.

Larger firms are excluded from this analysis because once accounting firms become “large enough” (and I’m not offering an opinion as to what that means), many of these features either diminish greatly or disappear altogether, and conventional business valuation techniques come back into play as appropriate tools to produce a credible value conclusion.

Conventional Valuation Tools Work Poorly

Conventional valuation tools work poorly for small to midsized accounting firms because most conventional valuation models are dependent upon serial, persistent flows of financial benefits (cash, profits, revenues) that are produced by assets that are owned and controlled by the company.

Many, if not most, small to midsized accounting firms produce only persistent or semi-persistent flows of financial benefits produced by assets that are affiliated with the company (meaning, people).

A summary of the shortcomings with respect to conventional business valuation models is provided below:

  • Valuation Technique: Guideline public company method
    • Discussion: Relatively few pure accounting firms are publicly traded. The few pure accounting firms traded on US and Canadian markets are large to the point where the value issues facing smaller firms are mitigated or obviated.  Multiples assume that there is confidence in medium-term reliability/stability of earnings or revenue.
  • Valuation Technique: Merged and acquired company method
    • Discussion: Data is not available to capture idiosyncratic business value elements, such as personal goodwill, key person discounts, or competitive advantages of service delivery (if any). Multiples assume that there is confidence in medium-term reliability/stability of earnings or revenue.
  • Valuation Technique: Discounted cash flow method
    • Discussion: Few accounting firm market participants have even a moderate level of confidence in forecasts more than 12 months ahead of the effective date of the valuation.
  • Valuation Technique: Capitalization of earnings method
    • Discussion: Most accounting firms experience volatile earnings that make it difficult to determine an appropriate capitalized earnings basis.

Consider the alternatives available to an individual or company that wishes to own an accounting firm. That individual or company can a) buy one, or b) start and build one. In a scenario where buying an accounting firm is more expensive than starting one, the buyer would at least consider starting one – one, it is worth adding, that is likely to compete with the target company.

For many, if not most, small to midsized accounting firms, many of the firm’s “assets” are fundamentally connected to and embodied by the firm’s employees, some of whom are likely owners. How do you assign a rational value to a company whose primary asset is (or is embedded in) people?

The Novel Accounting Firm Valuation Model

Fortunately, fair value accounting offers a framework that, while perhaps not offering the definitive answer, seems to be a solid starting point. Valuations for financial reporting frequently require that a value be estimated for a workforce-in-place, as part of a broader exercise for allocating purchase price under Accounting Standards Codification Topic 805, Business Combinations (“ASC 805”).

Employee compensation lies at the heart of the model. Employee compensation ought to capture production-relevant employee expertise, experience, client relationships, business origination capabilities, and management skills. All of the costs associated with re-creating the workforce-in-place are, in some fashion, connected to employee compensation. Training and productivity ramp-up costs are expressed as a percent of fully-burdened employee compensation, and recruiting costs are expressed as a percent of base compensation. (Signing bonuses are absent from this example, although it may be appropriate to consider them in certain circumstances.)

Let’s say we have a 10-person firm, and there is a little bit of leverage on personnel, so there’s also a director, a manager, four analysts, and two administrative professionals. If the asking price for the business is $900,000, the buyer may consider simply opening up a competing business. If the asking price is $600,000, it may be a good deal for the buyer relative to re-creating the business.

Additional elements and refinement opportunities are worth highlighting, as they represent potential departures from the financial reporting cost-of-replacement procedures.

  1. The applicability of Section 197 tax amortization is debatable in a real-world context as it is unclear that an acquired workforce is truly a separable and salable asset.
  2. When this cost-of-replacement analysis is performed for financial reporting, a required rate of return on investment is often included in the analysis and is added to the base cost. This assumption in a real-world context is also debatable because the model would indicate that the value of the workforce is increased by using a higher cost of capital, which runs counter to fundamental financial principles, which indicate that as cost of capital increases, value ought to decrease.
  3. Not considered is the time it would take to re-create a firm. Whereas re-constituting a five- to 10-person firm may take a few months, larger firms may take a year or multiple years to re-create. Potential profits are lost as the theoretical replacement firm accumulates personnel and constitutes itself. A small discounted cash flow model might be used to capture this opportunity cost of operation.

Conclusion

The cost-of-replacement method should be considered when determining the value of small to midsized accounting firms. A variant of this method is already widely used in financial reporting valuations. The cost-of-replacement model more closely aligns the value analysis with the practical choice facing the potential buyer – the make-or-buy decision. More work is needed to develop this theoretical approach, and debate and discussion about this technique should be encouraged. Further refinement may position the business appraisal profession to be of better assistance to small to midlevel accounting firms.

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By Clinton Lee
Mar 28th 2016 19:44

Excellent article, Mike, thanks.

One key influence on price for service businesses, including accounting firms, is the extent of risk that's being shared by the vendor. Deferred payments, contingency / performance related compensation and other "concessions" in the deal structure can have a significant effect on price. What are your thoughts about those?

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