Congratulations! You’ve decided to buy an accounting firm!
As you begin your early assessment of a firm to acquire, you should expect to be able to review an array of initial information so you can make an informed decision about whether to invest the time and effort to pursue the acquisition.
An Overview of a Report provided to a Prospective Buyer
In our process, once a potential buyer has signed a nondisclosure agreement, it is standard practice for the buyer to receive a detailed report on the firm they are considering. Some call this a Confidential Business Memorandum and some call this a Confidential Market Report. Regardless of what it’s called, this report gives the buyer some core information they need about the practice in an effort to address most of the initial questions
It should provide them a breakdown of revenue by tax, accounting, and other services the practice provides. It should provide a summary of revenue, average fees, number of returns by tax return form, etc. It should present a breakdown of accounting services, how much the firm achieves in client revenue, how many employees they staff, their roles, rates, annual compensation, billable hours, software used, and more.
In this report, historical financials should also be presented and recast to show the seller’s discretionary earnings (SDE). This provides the potential buyer an opportunity to assess the actual earning potential of the firm and more accurately assess their own potential profitability and income after adjusting for their projected expenses and debt.
In recent months, we’ve had an opportunity to help quite a few buyers review these reports from other firms and a common issue is presenting itself. Buyers aren’t receiving complete or accurate information.
Information Buyers Should See Added Back
The process of recasting financials is very well defined and established across the business brokerage industry. There is no reason or grounds to deviate from the acceptable standards established by the major associations in the industry. Again the goal is to accurately share with buyers the true earning potential of an acquisition if the buyer were to run it just as the seller has but with the seller removed from the equation. So, expenses specifically tied to the seller or owner discretionary expenses and non-recurring expenses that will go away with the sale are added back into the net income to provide a more accurate presentation of the SDE. Expenses that should be added back include things that are unrelated to ongoing business operations… discretionary expenses not tied to the operation of the business. These are expenses a new buyer wouldn’t necessarily expect to take on. Expenses that should be added back vary greatly from firm to firm but almost always include:
- Interest expense
- Owner compensation and payroll taxes (but only for a single owner or partner)
- Owner benefits (i.e. health, life, disability insurance)
- Owner discretionary expenses not company related (car lease, cell phone, home office, travel, meals and entertainment, etc.)
- Amortization or depreciation that disappears with the sale
Information Buyers Should NOT Expect to See Added Back
Expenses buyers should not typically see added back include expenses that the operation depends on and that are recurring in nature. These expenses include:
- Staff payroll
- Staff benefits
- Tax software
- Additional Owners’ compensation and benefits (may be normalized to market)
In most sales, all of these expenses are operational and can’t be added back.
Recently we’ve seen financials that are adding back far more than they should to the bottom line. This gives a false presentation of how profitable a practice is and can mislead buyers to believe their return on the acquisition will be greater than is likely.
With accurately recast financials the buyer can evaluate the economics of the transaction by removing any additional expenses that will go away due to redundancy or scale of economy with a buyer’s existing business and can also factor in the impact of any anticipated transaction debt to arrive at a reasonable estimate of their potential profitability from the acquisition. This would be the Buyer’s Discretionary Earnings (BDE) and may not be the same as the SDE. This analysis varies from buyer to buyer based on the buyer’s circumstances so the recast should avoid making assumptions about the buyer’s situation by adding back expenses that may transfer to the buyer.
Historical Data is Key
Another issue we’re increasingly seeing in the past few years are projected financials being recast and relied on as the basis for sale price. As a buyer, unless you are buying a small portion of a practice, you should expect to see and review the past three years of historical financials for any practice you evaluate. This is standard.
The only way to accurately assess the earning potential of a firm is to evaluate historical financials. It can be difficult to project future revenue and everyone’s inclination is to be optimistic, so projections we typically see present substantial increase in revenue and dismiss recurring expenses. At ProHorizons, we establish our opinion of price based on the prior year revenue and the past three years of revenue trend. We may sometimes present a projection if we are very late in the year, but, if we do, this is always coupled with and supported by the past three years of historical financials. Our advice would be to never accept or agree to a recast or price solely based on projected revenue and expenses.
When you work with ProHorizons, you’re never alone. We offer comprehensive solutions to assist you at key stages in your practice development. Whether you are entering the field of accounting services ownership, seeking to grow an existing practice or are transitioning to your next professional or personal life chapter, we deliver the right targeted service to get you there. Contact us and ask how we can help you.