Acquisition activity in recent years is up in just about every industry, and accounting firms are no exception. Indeed, the last 15 years have produced historically high levels of merger and acquisition activity within the accounting industry.
Not only is acquisition attractive as a growth story in an environment where 3 percent growth should be considered good for the mature firm, but acquisitions may also be the key to a viable succession strategy, both for the buyer and the seller.
Relatively little has been written on pricing accounting firms. It is tempting to take the position that price is unimportant in accounting firm mergers because it is rare that the majority of consideration paid takes the form of cash. However, it is important to note, even if you don’t pay any cash for an acquisition, you are still somehow pricing the acquisition, such as by the assumption of liabilities, enrolling new partners into the current partner compensation program, guaranteed minimum compensation levels, and so forth.
The absence of published thinking on the pricing of accounting firms is attributable to the fact that pricing accounting and most other professional services firms is complex, and does not lend itself well to conventional business valuation techniques. Income-based methodologies work well only if future cash flows are reasonably predictable after the acquisition. Market-based methods are hard to use because establishing comparability between the target firm and other acquired firms (few are publicly traded) is dubious.
The asset approach is typically used for holding companies or firms in a liquidation scenario and thus is often discarded — especially since accounting firms have relatively few tangible assets. While the foregoing statement is true, the asset approach appears to be a potentially valuable tool for determining the value of an accounting firm.
FIRST PRINCIPLES
Before proceeding, it is instructive to refresh on one of the fundamental laws of valuation, which is the substitution principle. The substitution principle indicates that the value of an asset should be equal to the price available to acquire an identical asset. In other words, the value of a business should generally not exceed the cost to recreate the business, if it can be replicated (many businesses, including large accounting firms, probably cannot).
Not all businesses can be practically replicated from scratch. For example, the economics and practicality of replicating a Big Four brand are likely prohibitive. However, many firms, especially smaller professional services firms, can be replicated. Accordingly, before assessing value by using the typical tools (income approach, market approach), ask yourself if the firm could be replicated. What does it take to replicate an individual accounting firm?
Replicating an accounting firm mainly means “replicating” the firm’s owners and staff, especially if the acquirer is a firm of any size. Any systems that the target firm has will likely be supplanted by the acquirer. Customer relationships are likely tied to the target firm’s people, unless that firm has an unusually strong brand. Perhaps the top 40 or so accounting firms have material brand value. You might be surprised to learn how many of your firm’s clients can’t even name your firm. The relationship is often about the relationship between the client and the client manager.
The question now falls to the cost of replicating the personnel of the target firm. The most practical path to replicating a firm’s personnel is hiring the personnel or hiring theoretically identical individuals. The cost of hiring includes:
- Recruiting costs (such as paying recruiters and hiring bonuses);
- Training and ramp-up costs;
- Costs to buy out (or wait out) any restrictive covenants; and,
- Costs to replicate (or assume liability for) any accrued or imminent deferred compensation.
(You may ask why customer relationships have been excluded from this valuation approach. They haven’t. Instead, they are included in a back-door way. Professionals’ compensation is typically set by how much business they represent and originate. Since recruiting fees typically are determined as a function of compensation, the value of acquiring those relationships is implicitly considered.)
Another dimension to acquiring the required employee base is time. Whereas in a straightforward firm acquisition, the employees and owners associated with the target are acquired at the time of the transaction, accumulating those employees (or similar ones) takes time. This boils down to a classic “make vs. buy” decision, with which every accountant is familiar.
Even with unlimited financial resources, it would be difficult to simply synthesize the workforce instantly. It may well take a number of years to acquire a workforce equivalent to that associated with the target firm, especially where restrictive covenants are concerned. Chances are that buying out restrictive covenants on an employee-by-employee basis will be prohibitively expensive, if it is possible at all.
More likely, those employees whose value is closely linked with their client relationships will be prohibited from exploiting their full value until the expiration of their respective restrictive covenants. The time required to replicate the workforce of the potential target is a real opportunity cost of choosing in this make vs. buy decision.
The way to address this timing problem is to perform a differential cash flow analysis that considers the present value of the expected cash flow of the target if the firm were acquired in its entirety today, compared with the present value of the expected cash flow when the employee base is acquired/replicated over time, including the time required to wait out restricted covenants. In addition to the differential cash flows, it may be conceivably appropriate to apply different discount rates to the respective forecasted cash flows as well.
I have offered a valuation methodology that is something of a hybrid of an asset approach (the value of the in-place labor force) and the income approach (present value of differential future cash flows in the replication (make) vs. acquire (buy) scenarios). This analysis, while somewhat more complex than the application of classic valuation techniques, should yield a more insightful and credible value thesis when pricing an accounting firm. The benefit should be well worth the additional effort.
Michael S. Blake, CFA, ASA, ABAR, BCA, is the founder of
