Pricing your service business for sale

Valuation of closely-held businesses requires estimating future cash flows and then discounting those cash flows at an appropriate rate. Historical financial information is only important in so far as it suggests what to expect in the future. Historical information is never by itself sufficient—business conditions are constantly changing. Estimating future cash flows requires an in-depth understanding of the strengths and weaknesses of the firm being valued and trends in the industry and larger economy. According to IRS Revenue Ruling 59-60, “Valuation of securities is, in essence, a prophecy as to the future and must be based on facts available at the required date of appraisal.”

Accounting, actuarial, architecture, dental, engineering, financial planning/asset management, marketing, and specialized consulting firms are very similar from a valuation perspective. [Law firms are a special case which we addressed in a separate article in the July 2015 edition. Medical practices are also a special case because they are subject to a high degree of government regulation and price controls.] The following is a discussion of some of the major issues that need to be investigated to understand the future cash flow of professional service firms.

Recurring revenue

A high level of recurring revenue is one of the most valuable components of any business. If a buyer has high confidence that there is a strong future revenue flow, she will pay a premium. Some firms, such as accounting and financial planning/asset management, have a high percentage of recurring revenue because their customer base needs their service every year. Asset management firms currently sell at a higher multiple than most other professional service firms because they have a built-in revenue escalator clause—since they typically charge a fee based on a percentage of assets under management, as stock prices rise, fees automatically rise. Other firms, such as architecture and engineering firms (and my consulting firm) are more project based and have to sell new projects every year.

Operations

Professional service firms don’t have a “cost of goods sold” in the usual accounting sense. However, they do have a “cost of services provided” which is the cost of the person directly providing the professional service. Higher revenue per employee is in effect the same as a higher gross profit margin for manufacturing companies. It means that the firm is able to charge a premium price for its services. Also, how efficient are firm operations? What is the utilization rate of professional employees—are they busy year-round doing billable work? Is the firm efficient in billing and collecting receivables? Benchmark data is available to assess all of these aspects of professional service firms.

Business development

Does the firm have a system in place designed to produce new leads and are those leads pursued in a systematic way?

Professional development and company governance

Firms can only grow if their professionals develop high level skills and also learn how to translate these skills into excellent service. The best firms have systems in place to teach this. Also, professionals develop a special relationship with their clients. They understand their clients’ businesses and become “trusted advisors.” This is a highly positive development but the firm must protect itself from the danger that professionals will leave the firm and take with them the firm’s chief asset—its clients. Furthermore, professional firms must have a robust succession planning program in place so that when professionals leave the firm by retirement or for other reasons, the firm can continue to service the departing professional’s clients. Firms need to have in place a legal structure including non-compete agreements and partner agreements to protect the interests of the firm.

Professional/personal goodwill vs. practice goodwill

Professional service firms have little in the way of hard assets—their value resides primarily in intangible value or goodwill. Goodwill is defined as “the tendency of customers to return to a place of business.” The question for professional service firms is, why do customers return, is it because of the characteristics of the firm (practice goodwill) or because of the reputation of the individuals in the firm (professional/personal goodwill)?

Here is a simple example: A dentist opens an office in a busy strip mall and develops a profitable, high volume practice. To the extent that the profitability of the practice is a result of its location, it is practice goodwill. To the extent the success depends on the professional reputation of the dentist, it is personal/professional goodwill.

The whole point of “good company governance” is to transfer the goodwill of individual professionals to the firm to the extent possible. However, this can’t always be done—exceptional professionals will always retain their personal reputation and poorly governed firms will tend to “leak” goodwill and value.

This distinction between practice and professional goodwill might seem academic, but it has become very highly developed because of a quirk in family law—in Pennsylvania and most other states, professional/personal goodwill is not a marital asset in divorce proceedings, whereas practice goodwill is a marital asset. So in divorce litigation, the professional spouse will always argue that the goodwill (and hence the value) of the professional practice is personal whereas the non-professional spouse will argue that the goodwill belongs to the practice. This has resulted in a large body of case law on the subject and is one of the most frequently litigated issues in the divorce of professionals.

A good business valuation becomes a roadmap for identifying the strengths and weaknesses of a business. This is as true in the professional services context as for any other business. Let a good business valuator draw that map for your business—you might be surprised by what you discover.

Published in Business2Business magazine, September 2015