The great mystery: how do billing rates and profitability affect a firm's worth?

Author:Sinkin, Joel
Position::PCPS BRIEF - Interview
 
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When you are buying a CPA firm, historical profit is almost irrelevant. Even less relevant are the partner billing rates.

What? How can that be? When establishing the value of any business isn't its profitability the most important metric to consider? Aren't partner billing rates the most important way to know if two firms are a good fit?

What You Really Need to Know in an Acquisition: Net Profit

Consider this example. This scenario is extreme and simple to best demonstrate the principle. Assume the seller owns a $400,000 accounting and tax practice. You could absorb this practice into your current infrastructure with no incremental increases in overhead because you have the excess capacity to take on the workload. Until 2010, the owner of this firm operated from his home. His spouse answered the phone, did some data inputting and basically acted as a high-end clerical/paraprofessional. The owner did the balance of the work. The seller's profit margin was 85%.

In 2010, the seller decided to move to an office, the spouse was replaced by an office manager and a part time paraprofessional, and the owner cut back on some of his hours. With the additional overhead, the sellers' net went down to 40%. Assume you are not required to take on any of the seller's overhead or hire any of the seller's personnel. Based on these two scenarios, at what point was the seller's practice worth more to you? When it had an 85% margin or a 40% margin? Obviously, it isn't the seller's margin that matters. It is what the incremental margin will be after you acquire the practice. However, we have seen far too many deals passed on because the potential buyer never could get past the seller's historical margin. This is especially the case when the historical margin is lower than expected.

After making the necessary normalization adjustments to recast profitability to determine what it really means to the buyer firm, the margin may still be too low to justify the terms. In this case, the deal clearly shouldn't be done. But the historical margin is only relevant to the extent that it contains costs that will be assumed by the acquiring firm. If the buyer firm must hire more staff (or the seller's staff), increase rent expense with more space or otherwise incur incremental costs, then profitability is determined based on those costs, not the seller's historical costs.

Further, the deal's profitability should be evaluated not only on the recast profit margins, but also the terms of the deal. If the terms call for payments of 16% of collections for six years and the incremental profit margin is likely to be 35%, that is clearly 19% to the good during the payment years and, of course, much greater in the later years. The 35% profit margin isn't the sole determination of the profitability.

What You Really Need to Know in a Merger: Partner Profitability

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