The question we get asked most about accounting firm deals is, "What is the multiple?" While the multiple is a key factor in determining the purchase price in a transaction, it is not the most important element in optimizing the value of a firm. The critical factor is establishing the net adjusted EBITDA, or NAE.
Why? The NAE is what the multiple is applied to that calculates the purchase price. It seems simple, but getting to the NAE is a more complex calculation. It is a process that cannot be accomplished using an online tool, survey, or even using traditional valuation models.
The old methods of merging in or selling no longer work today. We have yet to see a firm in years who wants to merge into another firm and roll into that firm's unfunded deferred compensation program to be paid out at lower than market value over a ten-year period. While independence is still an option, it requires a firm to reengineer how they approach the market, price, reassess who should be a client, get partners in alignment, and enforce accountability. Creating an independence plan, not a business plan, is a more complicated process, but an independence strategy is not part of this article.
There are three reasons why firms want to understand their value. First, they are in the process of exploring being acquired. Second, they are not sure what their firm is worth and if they should start talking to acquirers. Third, firms are looking at changing their internal buyout calculations to close the value gap between an internal succession and an external purchase price. That last one is a tall order.
The details behind the multiple
This part is simple. The multiple is what the buyer is willing to apply to the NAE. Variations in multiples occur based on how much the acquirer wants the opportunity.
Core variables impacting an acquirer's decision are size of the firm, geography, profitability, niches, the size and type of clients, bench depth, and leadership's commitment to stay on. As an example, a buyer looking to break into the Chicago market may pay more to acquire a firm and bend their rules on what is an ideal or minimally acceptable opportunity as opposed to a firm with an office already in Chicago.
When it comes time to calculate, the NAE, this is where the math side of your brain kicks in with some support from the creative side. There are three steps to get to the NAE. Steps one and two are straight math. Step three is the creative side.
Keep in mind there are differences in accounting that also come into play. An example is accrual versus cash-based accounting. Inside either of those pathways there can be differences in how, for example, retired partner payments are paid. Are they a balance sheet item or paid as an expense that hits the income statement? Another factor is the impact on partner compensation due to delays in converting accounts receivable into collected cash and the impact of work-in-process.
Step one is to look at the gross profit before any equity partner compensation. Subtract the equity partner compensation and the balance of remaining profit is then added to 40% of the equity partner compensation. That is your first part of the NAE.
Step two is primary addbacks. These items are all added to the NAE from step one. They are payments to retired partners, payments to firms you acquired, interest paid, depreciation and amortization, and any unusual expenses. Again, depending on how a firm accounts for certain items you need to be sure you are not double counting an expense to add back to the NAE.
Step three are the secondary addbacks. There are two types of secondary addbacks, hard and soft. Hard addbacks are expenses that will go away if you are going into another firm. Typically, these include consultants you may be using, association fees, recruiting costs, etc. Soft secondary addbacks require more discussion. Generally, the two material ones are personnel that may be in overlapping positions the acquirer already has in place, and a percentage of technology costs. The extent of both hard and soft secondary addbacks can vary greatly firm by firm.
It is virtually impossible to use an online valuation tool to calculate the value of a firm. There are too many financial and operational questions, and since firms use different methods of accounting you need to unravel the pieces and directly talk to firm leadership.
A simple example is accrual accounting still relies on cash to pay partner income. Using a $10 million firm with a 30% gross profit of $3 million before any equity partner compensation, if that firm has large accounts receivable and/or work-in-progress balances, you could see partner compensation at $2 million because that is all the cash they had available. The next year that same firm could have the same $3 million in profit but pay the equity partners $4 million because they collected the cash in the lagging AR and WIP. These minor details can materially swing the purchase price.
Getting to the approximate market value requires a deeper look at the firm's complete financial picture. Experience is critical to understanding how to structure and value a firm because we see advisors who have never been involved in a transaction, or only in a limited number of transactions, providing opinions on pricing and terms. This leads to significant misinformation in accounting-related transactions and options.
These pieces that sit behind the multiple are deep. The NAE is the math that can be altered a bit based on the agreement on some addbacks, but the multiple will swing based on what each buyer will be willing to pay.
Think of the multiple as the art and the NAE as the math. Once you have established the NAE then layer in emotional elements or the need to enter a market and multiple variations can radically swing the purchase price.
