In the first in a series of articles about practice management, Keith Underwood looks at how practices are being valued in a period of changing business models
This article was first published in the October 2016 UK edition of Accounting and Business magazine.
What is your practice worth? The answer for some time has been: between 80% and 120% of annual fees. The profession has long embraced valuations based on fees rather than profits, yet the formula is strange and ill-advised as a sole measure of value.
Purchasers raising funds for an acquisition would not base their application on top-line turnover, and most accountants would advise their clients of a more professional and commercially acceptable approach. With a £1m-fee practice, some potential buyers could be looking at a 40% return and others a 20% return. Such a disparity should be reflected in the valuation.
The following considerations are likely to affect the valuation of practices.
The demographics of smaller firms (one to four partners, many of whom do not have in-house succession) are likely to generate a significant number of sellers over the next five years. Having a succession plan in place is wise and continuity is valuable. A consistent succession policy gives a firm a distinct advantage whether preparing for sale or the introduction of a new partner.
The capacity of the market to absorb fees through acquisition or merger is currently limited for a number of reasons. If the 40 biggest accountancy firms outside the top 10 make on average two acquisitions a year, buying up practices with fees of, say, £1.5m a year, then there is a cumulative fee churn of £120m. If there are 2,500 firms with fees of between £500,000 and £2m a year, and 30% of them have no succession, with the partners looking for an exit, then there is a potential cumulative fee churn of £750m (with average fees assumed to be £1m a firm). Admittedly, the acquisition process may be spread over five or so years, but, then again, these figures could be conservative.
Can the market absorb such a high rate of churn? The answer may lead to acquirers offering lower buyout values. The potential excess fees that are being offered in the market may stimulate non-traditional purchasers to make further inroads in the accounting marketplace.
Often specialist service-driven businesses seeking to buy general practices want to sell on the client services that are of no relevance to their business model. This is an expensive and disruptive consolidation, but may also offer a way forward as the market moves towards service-line business units rather than the broad spectrum of services traditionally offered by mid-tier and smaller practices.
In the early stages of practice growth (£1m to £5m), firms are willing to take on a range of fees to build scale. From £10m onwards, acquirers are becoming more selective and turning down fee blocks of £500,000 with a general practice spread of clients. We are seeing more assignment briefs, which are sometimes very specific about the client portfolio being sought.
Cost of compliance services
The prices of compliance services are falling and will continue to fall as outsourcing to cheaper locations and intuitive IT developments reduce costs. One result is that the skill and handling requirements that have long determined firms’ recruitment and employment structures are radically changing. Meanwhile the costs of IT investment and regulatory oversight are rising.
Importance of services offered
Client spend is not necessarily an indication of value; the contribution generated is the key, and it may be the scale of a practice’s business units that dictates value rather than the individual client spend. The highest fee-paying clients are usually those that require management accounting services. A specialist management accounting business – ‘onshoring outsourcing’ – can be much more cost-effective than a service customised for a client using legacy IT. There is a trend for traditional general practices to enter this market on the back of cloud accounting and compete with some efficient specialist service providers with very different business models.
There is more attraction and less risk of client loss in acquiring a practice with clients that have been introduced to, for example, regular billing, cloud-based accounting, standard collection procedures and more than one contact point within the firm. A ‘paperless’ acquirer will face costs associated with buying a traditional hard-file practice.
Some locations require a discounting factor for valuation purposes. For instance, practices in market town locations, outside the south east and major urban areas, with fees of between £700,000 and £1.5m are not attracting a healthy number of buyers. These firms are becoming harder to sell and net valuation outcomes are more problematic.
Valuation is a function of the value that a third party sees in a stream of revenue normally measured at EBITDA (earnings before interest, taxes, depreciation and amortisation) levels. This stream has to be sustainably immune from the risks of change in legislation, competition and service delivery investment. The risk factors in the sector have risen significantly over the last five years, and this is increasingly reflected in valuations.
For a decade, the consolidators paid exceptional values. None of these consolidators has survived, and the model has been discredited. But there are still deals and prospects of exceptional value. In the past 12 months, exceptional values have been paid by four kinds of acquirer: purchasers outside the accounting sector, specialists with a focus on a client portfolio, specialist service providers and technology-driven services.
We may now be looking at valuing general practice firms on the basis of their business units if these are of any size or significance. Just as in the past an accountancy practice with a separate wealth management arm has been valued as two separate businesses, increasingly the following lines will be seen as business units warranting separate evaluation:
- management accounting services
- tax advisory services
- compliance tax
- compliance accounts
- concierge services.
In this way it is possible to recognise the higher values attributable to these services as distinct from the values that could be ascribed to a general practice. To be regarded as a viable business unit, a firm would need to show these service lines are standalone, have separate marketing policies, dedicated management and staff, and a pool of clients generated outside the general practice portfolio. Acquirers will be particularly interested in profitability if it is linked to scale and opportunities to optimise the return on investment and resources.
The new-entry acquirers have a range of objectives. They will certainly have a growing market presence and disrupt service provision in the sector. They have money, are run as corporates and have clear objectives.
A number of aspects of technology and consulting might also add value to a practice. Some firms have developed their own intranet to enhance the quality of client service and compete with some of the larger firms for advisory services.
The intranet becomes the central hub for sharing processes, systems and best practice among team members. It increases the efficiency of compliance work, which allows for more face time
Others use an online, cloud-based client system or dashboard that provides feedback on how a firm has performed and what services the clients might value.
Adoption of technology is becoming a factor in valuation. Highly valued is software that enables intuitive scanning, bank statement feeds and automated reconciliations, client/supplier electronic portal feeds and payroll applications enabling employees to be on-boarded directly into the client payroll system. Specialist businesses have invested in these tools, gaining a cost advantage and service enhancement in return, all of which should feed into enterprise valuations.
General practices tend to have lower capital values. Payroll, wealth management, corporate service businesses and management accounting businesses yield a higher value by turnover than a general practice. Practices are seeking to reprofile and maximise both profits and capital value. The parallel development of business units that do not depend for growth and scale on the core client portfolio are usually more focused, productive and profitable. The profitability has an added value if optimisation through scale is adopted.
It would be wrong to ignore the top 10 or so larger accountancy firms. They have a different business model and are in a position to offer a range of leading-edge services to larger quoted, unquoted entrepreneurial and SME clients, which have a high value-add in the advisory offering. Mid-tier and smaller firms often try to compete but, due to size of operations and their client buy-in, often fail to provide a rounded leading-edge service across the full range of offerings. Larger firms have a depth of skills and services that are not reliant on a single individual.
During the second half of this decade, valuations across general practices are likely to become more diverse and the comparison with specialist businesses more disparate. If the risk factors prevail and profiling is not addressed by management, the valuation of practices individually and as a sector will trend lower.
Keith Underwood is managing director at Foulger Underwood Associates
"We may now be looking at valuing general practice firms on the basis of their business units if these are of any size or significance"