We are all risk averse to some degree. However, from individual to individual risk tolerance and aversion can vary greatly… from those who will analyze and assess the risk of buying or selling a tax and accounting practice and address the risk factors accordingly to those who desire to take on zero risk regardless of the transaction.
Understanding Risk Aversion:
Being overly risk averse in regard to the sale or acquisition of an accounting practice may not be the safest path and could undermine your transaction if you are not careful. I have seen this play out for both buyers and sellers over and over again during the past 15 years. For the buyers, this risk aversion is typically in the form of a very minimal down payment and/or multiple years of revenue measurement to set the price. For the seller, this risk aversion is typically in the desire for all cash at closing.
A few years ago, I represented the sale of a practice in the Coachella Valley area. This was a very well-run and profitable practice with annual gross revenue of just under $850,000 with the seller’s discretionary earnings (SDE) around $455,000 or 55%. Average fees by tax return form were between $916 (on 1040 returns) and $2,500 (on 1120/S). Asking price was a bit above one times annual gross with the expectation that the buyer, as we always expect, would maximize their cash flow and offer by securing third party financing, with at least 70-80% of price paid down at closing. One year of revenue measurement under the buyer’s ownership to set price was acceptable with around 20% being subject to adjustment.
As the sale developed, we were contacted by a practice owner who just happened to own a practice in our client’s immediate vicinity. We connected the parties and over the course of a week or so got into discussion about structuring an offer. The buyer was only willing to pay one times annual gross with 10% down at closing and a five-year measurement of revenue to set price. This was a zero risk proposal for the buyer and 100% risk proposal for the seller. Not acceptable. So, I ran an return on investment (ROI) analysis for the buyer showing a projected cash flow increase not only of the SDE, but with removal of duplicate operating expenses like rent, janitor, software, telephone, utilities and to some degree supplies and other scale of economy savings. This set against debt service (in our 70-80% cash down model) and a built in cushion for margin of error and unexpected loss showed significant bottom line contribution ($359,000-$416,000) and a break even on invested capital of less than six months. None of it mattered to the buyer. He would not budge at all from his initial offer, which he based on some articles from an east coast firm he had read. We moved on to other buyers and eventually sold the business to an out-of-area accounting group looking to expand into the Coachella Valley market who was very reasonable in regard to price and terms. The practice gross revenue actually increased to $925,000 in the year after the sale (yep, bottom line contribution and break even were far better than my ROI analysis). And the risk averse buyer? Not only does he not have a tremendous amount of growth within his operation, he has a new and very successful competitor in his immediate vicinity. His extreme risk aversion undermined the possibility of a transaction and resulted in a tougher competitive market.
The same can be said of sellers that insist a buyer pay 100% cash down at closing. I completely understand this when there are so many unknowns early in the decision making process when selling your practice. But when the process evolves and buyers are introduced, explored and assessed, I am usually surprised when this makes no difference to the seller. The problem is that for a lot of buyers 100% cash down at closing is a non-starter, and in most cases, not possible. They perceive, and I cannot fault them, that the seller is not confident enough in either the practice being sold or in the success of the buyer for the seller to be willing take on a little bit of risk. The other problem is when 100% cash is the main criteria for assessing buyers, other critical factors like business acumen, interpersonal skills, management skills, energy level, and technical ability to perform the work are usually not given the consideration needed to insure the buyer is a good fit for the practice, clients, and staff. So, either the transaction falls apart because of this requirement or the buyer agrees and the risk of heightened buyer remorse and/or legal action come into play the minute anything does not go as expected after the sale closes… and things often do not go completely as expected, particularly if the buyer is not a good fit. In the end, sellers requiring all cash often find themselves in the same position as the buyer in our example above, either with a failed transaction and/or with a new series of problems and challenges.
Risk is a significant part of any transaction and should be considered in price and terms and mitigated to a reasonable degree. However, when risk aversion is too high and the risk adjustment is so imbalanced that one party is assuming virtually all the risk, the transaction will either not close or there is a heightened chance the parties will run into serious issues at some point after closing.