The Valuation Of The Goodwill Of Commercial Businesses
The concept and accounting treatment of goodwill has been the subject of considerable discussion and consideration over many years in the context of commercial valuations for corporate entities, which are not professional practices.Non-professional businesses tend to be valued, for the purposes of purchase, sale or merger transactions, on the basis of their underlying profitability. The capital value of a business is generally expressed as a multiple of perceived sustainable profits, so that an annual stream of net income is thereby converted into an equivalent capital sum.On average, private companies are sold for between four to six times sustainable profit before tax. Higher multiples will apply where the existing business is regarded as very secure and/or there are realistic growth prospects. Lower multiples will apply where current profitability and profit prospects are less secure. Similarly, multiples will tend to increase as interest rates, and alternative yields, decline, and will tend to decrease as interest rates rise.
Goodwill represents the difference between the overall business valuation, arrived at on the foregoing basis, and the aggregate book value of the individual net assets carried in the balance sheet. To obtain a detailed analysis of the differences between the valuation of the goodwill in commercial businesses and accounting firms, you may purchase a copy of our Practice Valuation thesis from the APMA website.
The Valuation Of The Goodwill Of Accounting Partnerships
In the case of professional partnerships in general and accounting practices in particular, a different valuation convention can be generally adopted. A methodology involving a multiple of turnover is normally adopted which, insofar as it is not expressed as a multiple of profit, appears initially to be quite distinct from that used for commercial businesses as set out above.Before considering such methodology it may be helpful if I identify those characteristics of professional accounting partnerships which result in the development of an apparently distinct valuation process.The first clear difference is that the legal constitution of most accounting practices is that of a partnership. The accounts of the partnership do not include a charge for the labour of the partners and, to this extent, overstate the true economic profit of the enterprise. The second feature relies upon the fact that the mathematics driving practices is very simple. For the purchaser of an accounting practice, whether in an on going or partnership dissolution situation, the overheads of the practice are generally irrelevant as they may be substantially varied by the transaction. Turnover and gross profit is therefore more important for the future than net profit.
As a consequence of the foregoing special characteristics, it has become a widely accepted convention that the value of underlying goodwill in smaller accounting practices is not determined by applying a multiple to sustainable profit, but rather by applying a multiple to sustainable turnover. Sustainable turnover comprises the turnover agreed to be normal for the practice. This would comprise gross recurring fees from annual compliance type work and non recurring special fees, to the extent that these can be demonstrated to be normal. This apparently distinct valuation methodology therefore simply represents a practical attempt to apply normal valuation principles in a manner which accounts for the special characteristics of the accounting partnership circumstances.
It is a general convention of accounting practices that a one third profit, after overheads can be earned on fees from clients, although this can vary.
In APMA’s experience of live situations over a thirty year period, the multiple applied to fees to negotiate and determine total practice value has been in the range of approximately 1 to 1.5 with the emphasis in recent years tending to be increasingly based around the lower end of the range. By 2002, I was finding ranges of around 0.8 to 1.2 being regarded as normal. I believe that the reduction in multiples in the last decade reflects a perception that clients are more mobile than they used to be. Also bank financing of practices, particularly larger practices, became more difficult.
If, for the purposes of illustration we assume a multiple of 1.0 times fees and a post-overhead profit margin of one third, this is equivalent to 3.0 times profit for a trading enterprise. This is somewhat less than a valuation of four, five or six times profit based on a normal commercial enterprise model, but we believe this discount reflects the fact that accounting practice profit is defined before charging for partners’ labour, (or notional salary). Such a basis therefore appears to be broadly consistent with the normal business valuation model.
The Change In Value During The Past Few Years
A variety of other influences have affected the value of accounting practices in recent years:
- Since the recession of the 1990’s clients have become more cost conscious, thereby placing pressure on fees. The recession also lost many firms a large number of clients who failed.
- At the same time costs have risen, both as a result of inflation and increasing professional regulation.
- Whilst this has put pressure on profitability, it has also increased the desirability of acquiring additional fee volume to maximise the use of fixed overheads. This has encouraged the purchase of blocks of fees.
- As a counterbalancing pressure it has become more difficult to obtain bank finance to purchase larger blocks of fees and this has tended to make the sale of such practices at high multiples of fees more difficult.
Factors Impacting Upon The Value Of Goodwill In An Accounting Practice
There are many factors impacting on the value of the goodwill of a practice or block of fees, each of which relies on the principle of willing buyer, willing seller at a given time. The value of the goodwill will not be the same if, for instance, it is being purchased as an integral part of a practice being sold on the open market as a going concern, compared with just the fees being sold unencumbered by any overheads such as staff, leases, etc. Additionally, investment in computer systems, key staff, must be taken into account.The answers to the following questions will impact on the value of goodwill:
- Is the goodwill of the partnership business to be valued:
- as on the outright sale of just the fees, or the goodwill of the business as a going concern, to a willing buyer,
- or as if there were a continuation of the partnership business, with the remaining partners acquiring the goodwill:
- or by an incoming partner who would be acquiring a minority share?
- Can the fees be serviced from locations over a wide area, without the probable loss of clients?
- Is there a higher density of established practices in the immediate area, tending to increase demand?
- Is there a prohibitively high contingent liability in the office lease?
- Is the existing payroll cost high, with a heavy contingent liability in staff contracts?
- Are key members of staff under non-competition contracts?
- What is the size of the client profile?
- Are value added services, such as Financial Services, currently offered, giving scope for further development?
- What are the charge our rates like, compared with the norm for the area?
- Does the summary of the time records show significant under recoveries?
- Have there been any PI claims or late filing penalties?
- Have there been any recent QAD visits?
- What was the outcome?
- What payment period is the vendor looking for?
- Will there be a ‘claw back’ clause in the agreement, over how many years?
- Will a heavy investment be required in computerisation and upgrading systems?
Basis Of Valuation
Generally, accountancy practices in the UK are currently valued in the range of £1.00 to £1.00 per £1 recurring annual fees, this figure having been fairly stable over the past few years. Sometimes practices sell for below £1.00 particularly if there is a forced sale due to death or insolvency where a claw back facility is inappropriate. Larger practices tend not to sell at the higher end of the ‘multiple’ range owing to the fact that up to 80% of all potential purchasing firms are sole practitioners or two partner firms. These smaller firms have neither the financial nor management resource to be able to acquire larger practices or blocks of fees and the larger firms tend to be located, and prefer to expand, within major conurbations. Also they will frequently not be prepared to pay a capital sum for goodwill.
We have attempted to relate the valuation of goodwill in an accounting practice to more general commercial valuation principles. We believe that goodwill as a recognised asset in most corporate sale transactions, also arises in a professional accounting practice environment, as a result of the same fundamental valuation principles.We have shown that a large number of factors impact on the value of any practice or block of fees, and therefore it is only by applying a great deal of experience to the valuation process that the correct weighting can be given to these factors.However, the main value of any accounting firm lies in its client base and the opportunity that this provides for earning profit.
APMA believes that it is essential during the course of any significant change in a partnership, and particularly upon a dissolution, that goodwill is recognised as an important asset and that it should be re-valued and charged and credited to the partners in respect of the transaction in contemplation.