Jeremy Kitchin of APMA assesses the position of those asked to buy into an accountancy practice and outlines the key questions you should ask before you sign on the dotted line.
When buying a practice we are talking about the transfer of goodwill, but what is meant by goodwill‚ in the context of an accountancy practice? Many would argue that the goodwill lies in the ownership of the client files, i.e. in the opportunity to provide services to the clients and bill them for those services. However, does anyone have a legal right to those files, or indeed to the clients? One simplistic definition of goodwill is that it is the opportunity to bill fees.
At the time of writing, with the credit crunch well advanced, the going rate (multiple), slipped slightly, ranging from 0.9 – 1.2 x the annual recurring turnover. This is called the consideration. More often than not in 2018 however, we are now seeing a minimum selling price of 1.0x but this does vary.
We prefer to use the term turnover rather than gross recurring fees (GRF) as we find that GRF is an ill defined and much misunderstood term. It will be appreciated that the profit is generated not only from the recurring fee income but from the total turnover.
If there is a certain level of income generated from special work (one-off jobs), as long as that level can be seen to have occurred regularly in the recent past there is no reason to believe that it will not recur and it can therefore be added to and sold in the same way as recurring fee income. This may be likened to the fees generated by firms of solicitors which, in the main, may be recurring in value but not in the source from which it is derived.
The value of an accounting firm’s goodwill is a function of its sustainable level of turnover and it is the multiple applied to this turnover which determines the value. However ‘the willing buyer – willing seller’ at a given point in time formula still applies.
Valuation of a practice
What services does any practice offer? In seeking to place a value on the goodwill of an accounting firm it is useful to look not just at its historic and projected performance, but also at its potential. Some key questions to consider are:
- Does it provide more than just a compliance service to its clients?
- Could it supply value added services?
- Could it get involved in the needs of its clients for investment, pensions, life insurance, mortgages, the inheritance tax planning sector, probate, litigation support and management accounting services, and of course business advice?
- Rather than simply trying to protect its clients against paying too much tax, are they advised on how to make money?
- Is the business profitable?
- Looking inwards, what is the firm‚s gross payroll cost? Is it more than one third of the turnover?
- Are the employees remunerated in line with the local competition?
- Do the key fee-earners have suitable restrictive covenants in their contracts of employment?
- Are the premises owned freehold or rented? (If the answer is the latter, is there a heavy contingent liability in the lease?)
- What is the firm’s working capital requirement?
- Is the business managing its debt efficiently? The amount of working capital tied up in debtors is critical to most practices. It has a direct impact on cash flow and the overall level of funding required. Many firms are extremely lax and the level of debt within the average practice is far too high.
All the aforementioned points and many more will give an insight into the firm and its value. A competent broker will, for a price, provide you with a written valuation.
Becoming a principal in an accounting firm
There are many different ways of becoming a principal in an accountancy practice:
Starting from scratch
Many accountants who started from scratch, or even with a handful of small clients, will tell you never again. The rush to achieve a critical mass sufficient to enable the sole practitioner to earn a living wage often results in him low-balling, i.e. pinching clients from other practitioners by offering to charge them lower fees.
One problem with this approach is that you need more clients to achieve the necessary fee income but as each client is contributing only a marginal profit this approach usually results in the new practitioner working extremely long hours. Even so, the profit generated will often be insufficient to fund the employment of junior fee-earning members of staff, with a view to sharing some of his load. Thus, the new practitioner finds that he quickly reaches the pain barrier‚ where he has insufficient time to take on and service more clients and insufficient profit to employ help.
Buying all the goodwill of a practice
It is a seller’s market. Currently it is quite normal for a small practice or block of clients generating a turnover of up to £100 000 gross fees located in a major conurbation, for example, to attract initial interest from between 50 and 110 would-be buyers.
It is the norm for the consideration to be paid in tranches with a portion paid on completion and the balance paid on the first, second and even third anniversaries, depending on the value of fees purchased.
The claw back clause in the sale agreement usually applies to the second tranche only. Therefore, the vendor warrants via the claw back that at the end of his first year’s trading, the new owner will have billed, or will be likely to bill (where work for clients has been delayed) the gross fees (turnover) which was sold and bought. If the new owner advises the vendor that he intends making a claim under the claw back clause, the vendor should be given the right of discovery. In other words, the vendor should be given access to the client files relating to the purchaser’s claimed shortfall.
Buying part of the goodwill of a practice
Where a principal is planning his eventual retirement, in the case of a sole trader or a partner is leaving the practice or the practice is expanding, the principal(s) may decide to appoint an additional partner, either internally or from outside.
It is difficult to place a value on the equity taken up by the new partner as numerous issues must be taken into account. Clearly, a minority stake is worth disproportionately less than majority ownership. Also, the terms of the engagement are important i.e. what share of the profits will that equity earn?
The profit share need bear little resemblance to the proportion of equity held. For this and other reasons the partnership agreement must be carefully reviewed and, where necessary, tailored to suit.
Business analysts estimate that over half of all small and medium sized accounting firms lack adequate partnership agreements setting the groundwork for subsequent legal problems. Owing to a wide range of variables it is usual to value the goodwill of the whole practice using the willing buyer, willing seller formula. It is then up to the incoming partner to negotiate what is, in effect, a commercial arrangement.
Buying into a limited company practice
The majority of the points made in the preceding paragraph apply here. One area the incoming purchaser should be particularly aware of is the baggage, which the limited practice may bring with it. It is often unwise for the new director and shareholder to join the company without having sought suitable warranties from the existing company, its directors and shareholders.
If the incoming director is to own a minority shareholding he could look to personal guarantees. In any event an incoming director should look closely at the memorandum and articles of association of the company and seek legal advice.
As with any acquisition, a thorough due diligence examination of the practice, its client files, statutory documents, PI insurance track record, staff contracts and administrative systems should be carried out and if necessary professional due diligence help should be sought.
The potential shareholder should remember that a company’s accounts only reflect the situation at a point in time and are in any case often out of date by the time that they are published. Nevertheless danger signals can often be spotted there. High borrowings, relative to the share capital and reserves, negative cash flow, debtors rising faster than turnover and net current liabilities where the company has short term debts greater than its readily realisable assets.
Remember that generally speaking, shareholders’ chances of retrieving anything from liquidation are very small. Shareholders rank last of the creditors to be satisfied. The value lies primarily in the clients and you may expect a haemorrhaging of the goodwill once the clients find out that their accountants are in financial difficulty.