What Drives Value

Join Bob Lewis of The Visionary Group for an inside look at the key factors that enhance—or diminish—an accounting firm's value. Bob will break down what buyers and potential merger partners look for in a candidate firm, offering practical insights to help you strengthen your firm's position in the market and maximize its worth.

Transcription: 
Transcripts are generated using a combination of speech recognition software and human transcribers, and may contain errors. Please check the corresponding audio for the authoritative record. 

Bob Lewis (00:09):
Before we start this off, I just want to show you one of the things we talk about regarding building value. By the way, I need to pose for the camera already because I walk. You good? Another one? Another action shot? Would that be good? Thank you. All right. So let's talk about AI really quick when it comes down to building firm value. This session is not going to be about AI, but when I see that giant head, that picture of me up there, that's an AI-generated photo. You can see how good it is because if you look at the real thing, it's massively improved. AI does have some immediate benefits coming up. We're going to talk about what's happening in the strategy background—the battlegrounds happening out here right now. The question is: can you maintain independence, or do you do a transaction with a partner?

(00:53):
That seems to be a common recurring theme we're running into over and over again with firms of all sizes, not just the small firms. We're getting approached by firms in the hundred-million-dollar range saying, "We're not sure if we can continue to manage this on our own." I also found that I can't read the slides from here, so the data here is really key. If you're going to make a decision, no matter what it is, make sure you make an informed decision and not one just based on emotion. We touched on that a little bit in the last session, but no matter what you do, you have to understand what you're getting into. Let's look at marketplace options. There are traditional firms.

(01:34):
That's a shrinking number, by the way. Think of the top 30 firms in the US right now. If you knock off the Big Four, BDO, and RSM, how many of the remaining 24 do you think have not taken capital already? What do you think the percentage of those who took capital is? 50%? 40%? It's actually coming in at about 75%. Very few firms are left. Okay, at least I nailed that one. What's happening is it's harder to find a traditional firm. Traditional firm deals are normally less cash; you're rolling into a deferred comp program and swapping your equity into their firm. The reason why this has become a problem is because private equity groups started about four years ago in the US.

(02:22):
They started buying individual firms. Some made large capital investments in groups like EisnerAmper. The problem we have right now is that in the last four years—and some of our friends from Ascend may be in the room, I'm using them as an example—Ascend is about a $500 million company right now. They didn't exist four years ago. There are a lot of them: Richie May, Crete, Soaring. Those are all firms hundreds of millions of dollars in size that were vapor four years ago. Now, I've got another option on the market: capital-backed firms. That started about two years ago. Take a firm like Aprio or Frazier & Deeter. Frazier & Deeter is a $200 million firm; Aprio was at 550 at the time.

(03:13):
They took outside capital. Now they have the same capital to compete with the private equity groups that have been there for the last four years. The market has radically changed. Then we've got people that did an ESOP model. Michael Horwitz is sitting in the front here; BDO went straight with an ESOP model. Is anybody not aware of the fact that we have only one publicly traded accounting firm in the United States: CBIZ? Number two is coming. Does anybody know who number two is? Andersen Tax filed for an IPO four or five months ago. Now the question becomes: are more firms going to go for an IPO? Are some of these private equity groups that are now at four or $500 million, instead of selling to New Mountain, Blackstone, or Guggenheim, going to go public or just keep it?

(04:08):
Options are all over the place. Let's look at starting a transaction process. I'll be honest with you, most people don't understand their value. We created a valuation model that takes about 10 minutes to roll through to get people closer to where they need to be. Understanding what the potential value is is number one. Also, who are the potential fits? If you're going to do a transaction, it's not just the private equity group that reaches out to you. You have to look at all the different options in this marketplace, but identifying the right partners is hard because you're getting so many calls. How many calls do you get a day or a week from a private equity group? 50? 10? We're still getting calls from private equity groups wanting to enter this marketplace.

(04:57):
This is going to be a math test, by the way. Also, never sit in the front when I'm speaking, because then I pick on you.

(05:06):
Regarding the top 500 firms: not everybody reports, but let's just go with the fact that there are 500 firms. If three-quarters have either taken money or are part of another group, there's not a lot left. If I've got more and more private equity groups coming in—and they're not all private equity; I've got RIAs and family offices coming to the table wanting to put in minority investments. There was a firm in Chicago, about an $8 million firm, that took a 30% minority investment. I've never seen that before. Most people who want to put a minority investment in place want to put in a minimum of $25 million.

(05:56):
Obviously, $25 million going into $8 million doesn't work, so they're looking at $100 million-plus firms. There hasn't been a lot of that happening yet. The other part is: what's the fit? Let's assume all the money is equal. I talk to three people who give three ballpark equal offers. What's the best fit for the client? The client is asking: "What's the cultural fit? How does this work? What's the long-term vision and strategy?" To me, that's one of the things investment groups need to hone in on: selling the vision after a deal beyond the numbers, because younger professionals are trying to figure out how this works.

(06:45):
Here are our historical values.

(06:50):
It's hard to find this: no cash, paying over five years based on retention of clients. I can't find that deal anymore; it's almost impossible. Values today include stock-based deals, adjusted EBITDA, cash, and rolled equity. We're going to hit all of these pieces regarding how to build value. Once you understand the value of your firm, what can you do to make it better? It doesn't make a difference if you decide to go private equity or stay independent; you can use this material in your firm. Here's the valuation model and the basic math. To get down to doing a valuation, you have to get to the adjusted EBITDA.

(07:37):
It's compensation and add-backs. People get confused; they think the multiple is the most important thing. The most important thing is getting to the net adjusted EBITDA number correctly. How do I put the add-backs in? In one transaction we're in the middle of, they submitted all their data. I asked what else they had beyond basic add-backs like depreciation and interest. They scoured their records and came up with another $650,000 of expenses that weren't going to recur. At a multiple of 10, that added $6 million to the deal. You have to start thinking this way. The art is the multiple. Let's look back at this table here.

(08:26):
I have Michael sitting here in the middle of Houston. By the way, if you have a firm in Houston, you are automatically worth more. It's a hot market. Boston. Nashville. Go find an independent firm in Nashville; there are about three left. Depending on how badly I want to get into Houston, I may pay more for Michael's firm than for another firm in Cleveland. Sorry to the people in Cleveland. By the way, I'm from Chicago, so we make fun of certain areas like Wisconsin—the "Cheddar Curtain." Does anybody not know that?

(09:10):
When you cross the Illinois border into Wisconsin, they call it crossing the Cheddar Curtain because Wisconsin is all about the cheese. There are two critical elements to this: the "scrape"—which needs a new name because it sounds terrible—and the add-backs. Here is an example: I have a $20 million firm dropping 30% to the bottom line ($6 million). This is before any equity partner compensation. Partner comp in this case is $5.7 million. I'm going to reduce it by half, so I take $2.85 million.

(10:01):
That's my scrape. Could we do 40% or 60%? Sure, but it has a major impact on the outcome. We'll stick with 50%. I look at other add-backs: $700,000 for depreciation, interest, and payments to retired partners. This is a fictional but realistic example. My net adjusted EBITDA is about $3.9 million. If I look at a multiple of eight, nine, or 10, that's the value of my $20 million firm. Do those numbers look insane? They aren't; they're very realistic. In fact, if that firm is in Houston, I may be past a 10.

(10:50):
Now, let's talk about how you boost the price. I'm playing with math, so if there are private equity guys in the room, just hold tight. What if I took my realized revenue per hour of $200 and just added $5?

(11:16):
On 100,000 hours, I put a $500,000 boost into my EBITDA. A $5 increase on $200 is only 2%. If I look at non-billable hours—say 95,000 hours—and convert 5% of that at $205 an hour, that adds another $900,000. I just added $1.4 million to EBITDA. In a transaction with a 10x multiple, I just added a lot of value. If you're not going to do a transaction, why are we not doing this anyway? If you want to stay independent, this is how you create internal capital to make investments. This boost took my net adjusted EBITDA to $5.3 million, adding another $13 million or $14 million in value. This doesn't even include efficiency from technology or cross-selling advisory services. This is just baseline.

(13:16):
There are other value considerations, like earn-out targets. By the way, submit questions through the app. They don't want to set an unrealistic earn-out target that you won't achieve. In a transaction, I might buy 70% of the firm, pay 70% of that in cash, and hold the balance over the next two years. That's where the earn-out typically comes into play. Every deal has working capital. In an equity transaction, the seller typically keeps the cash, AR, and WIP, but they fund the working capital. You have to figure out if these pieces work for you. What's my ongoing compensation? Remember the scrape: Mike's salary went from $500,000 to $250,000. How does he get his comp back up?

(14:49):
Michael runs a large association for accounting firms. These people have resources that firms can sell. We have a giant client base, and what do we sell them? A tax return, an audit, accounting. What about HR services, tech services, wealth management, or other things these clients need? That is how we build value. I've never seen a transaction go just on money. I've seen a client leave $5 million on the table because they preferred a traditional firm over private equity. You have to find the best fit. A key factor is rolled equity.

(16:17):
Does anybody remember Sears? Was Sears a great investment? Netflix, Blockbuster, Enron. When you're looking at rolled equity from two different firms, what is the value inside each? The numbers might look the same on the surface, but what is the vision and appreciation? When people talk about 15% annual appreciation for the next five years, it inflates the potential price. You have to break those pieces down. Value drivers: how do you get sustainable EBITDA growth? Does anybody get involved in ERC or solar energy credits?

(17:07):
That's not sustainable EBITDA growth; it's short-term profit. ERC credits go away. How do you get the revenue per professional head up? Take a $10 million firm with 50 full-time equivalent accounting professionals. That's $200,000 revenue per head. The largest revenue per professional head we've seen in the US—outside of the Big Four—was about $525,000. I just surpassed that with a firm at $600,000. Do you know how they got there? Everything is value-billed. Their average realized rate was $600 per hour.

(18:51):
Everybody gets hung up on realization percentages, like being at 98% in the tax department. However, how does that convert to realized dollars per hour? If you have 100% realization and your rate is $200, that's okay. But if I have 80% realization and my rate is $270, I'm killing it. I just ran into a firm where the realized dollar per hour is extremely high, but other metrics are messed up.

(19:44):
Let's look at write-ups and write-downs. Mike is with QX, by the way—if you want to buy offshoring, go to Mike. Mike has a $20 million firm. What do you think his net write-downs were? Try $9 million written down and $3 million written up—a $6 million net write-down on a firm under $20 million. Their capital and profitability are sitting in the write-downs. This is a partner accountability issue; they don't know how to price correctly. It gets worse with upward client scaling. They are dealing with a ton of clients they shouldn't be, burning capacity.

(21:14):
What does a $100 million firm want? They do not want $1,500 clients. I dealt with a very profitable firm where all their clients were $1,500; we had a hard time finding them a home. We see firms where 80% of revenue comes from 20% of clients. Staff doesn't want to work on "D" and "C" clients. Why are we still doing that? I've seen firms put on their websites that they are not accepting new clients. Why would you do that? You should be grabbing clients from the "waterfall" as larger firms drop them. Has anybody tried firing a client recently?

(22:13):
They're like glue. You raise fees and they don't leave. Why are we underpricing clients when we have a massive supply-and-demand imbalance? We need to price this up. This gets back to independence; you have to find a way to get that internal capital back. Most profitable firms we see have deep niches, coincidentally in real estate. Identify and eliminate capacity-burning clients. We use an ABCD model. Take it one step further: D1, D2, D3, D4. Take the D4s and raise their fees first. You'll find very little resistance because they have nowhere else to go. Monitor the 80/20 rule three quarters of the year, not just during tax season.

(24:18):
How do we add advisory services? This is a huge hole in the market. I have a staff of 12, including M&A consultants. We talk to firms all day. It isn't great when a firm says, "We do 3,000 1040s at $600 each and make a ton of money." Nobody wants that firm. High volume, low minimums, and fees not tied to a business client are deal-killers. Second is high billable hours per partner. What's the highest number we've seen? 2,400? No, 4,500 billable hours. Ignore billing fraud; just imagine working from 6:00 AM to 9:00 PM six days a week plus half-days on Sundays for four years.

(26:25):
Partners should be billing 600 to 900 hours and leveraging the rest. "Eat what you kill" models are dead. It's impossible to unravel three firms operating under one umbrella. Not tracking hours is another issue. Let's assume you do value billing and don't track hours. It's impossible to understand the profitability of an audit or tax client during a transaction. We've had deals collapse because firms didn't track hours and couldn't agree on a price. Lack of bench depth is also a problem. If I have four older gentlemen and nobody beneath them, who is going to run the firm? On the advisory side, most firms have less than 10% in advisory because they have no time or experience.

(27:59):
Don't make the investment yourself; create a revenue share. You have clients who are selling; why not have an investment banking niche? Partner with someone to sell your client's business, take the assets, and roll them into your wealth management or family office. Every business client has HR, technology, and insurance needs. They love you, but we aren't selling those services to them.

(28:20):
Here is the simple math. I have 1,000 clients. Assume half will never buy anything else. That leaves 500. A 10% penetration gives 50 consulting opportunities. At $10,000 each, that's $500,000 in pure profit if you're doing a revenue share. Realistically, some engagements will be $25,000, adding $1.25 million. That increases firm value significantly. If you have the wrong clients, they dictate everything you do and cause grief. You must constantly grind through your client base. Legacy clients and small-town politics make it hard to raise fees, but you have to do it.

(29:43):
I got that down to the one-second mark, Dan. If you have questions, send them through the app. Phil Whitman is coming up next. Thank you for your time.