When I mention “the economics” of the transaction, I am most specifically referring to the anticipated cash flow of the acquirer. This is an important consideration for many reasons, but most importantly because insufficient cash flow is the number one reason for business failure. The economics should be evaluated and understood by the seller, prior to putting the practice up for sale, and by the buyer early in the process and certainly in advance of making an offer.
From the seller side of the equation, the economics will most directly dictate the ability of the seller to work for the buyer and the terms of any seller financing. In regard to working for the buyer, the seller needs to evaluate how much revenue they are generating and what discretionary earnings (net income plus compensation and non-operating perks paid to the seller) they are realizing. As a quick reference, in a practice grossing less than $150,000 annually there is likely little remaining to pay the seller after the buyer covers all the operating expenses, the buyer’s income, and debt service to the seller or a bank. However, this calculation also depends on the buyer and whether they have an existing practice, whether they already have substantial income from that practice, whether the buyer can realize some scales of economy in expenses like rent, software, and supplies, and whether the buyer would like or need more extensive assistance from the seller. Most buyers are going to be looking to improve their income or bottom line through an acquisition, so a practice with $150,000 annual gross or less may not fit the economics for the seller to work for the buyer.
In regard to seller financing, it is important to understand that in most transactions we work on the seller usually finances 20-30% of the transaction price over a three to five year term with most of the balance financed by a bank over a ten year term. The term of the seller financing can have significant impact on the buyer’s economics and can influence whether a bank will finance the acquisition. For example, we had a recent sale in which the seller’s discretionary earnings (SDE) was around $200,000. The buyer was securing a loan to pay most of the price and would have annual debt service of approximately $42,000 to the bank. The seller was to finance approximately $50,000 and the proposal was for a three-year term, which would result in another $18,000 of annual debt service paid to the seller. So, the buyer would have approximately $140,000 of optimal buyer’s discretionary earnings (BDE) prior to compensation and benefits, which easily fit the bank requirements for their debt service ratio. When the seller came back and requested their financing be paid off in 18 months, it increased the buyer’s debt service from $18,000 to $35,000 and reduced the optimal SDE to $123,000, which put the loan on the margin of the bank’s requirements. So the economics were not feasible for this reduction of the seller financing term.
As a more extreme example of unreasonable seller financing, I came across a practice for sale recently that had annual gross revenue in excess of $900,000 and SDE below $300,000. In my opinion, the asking was very high based on the SDE and the seller wanted about a third down and was willing to finance the balance of $740,000 for three years at 6% rate of interest. Under this proposal the annual debt service to the seller alone would be just under $250,000… leaving the buyer with less than $50,000 of optimal BDE after going out of pocket several hundred thousand dollars. I did consider that the seller knows this is unreasonable and has set up this proposal to encourage a buyer to seek bank financing. However, even if a bank financed 70% of the price at a 5.5% rate of interest and the seller only carried 30% for the three years, the annual debt service is still around $226,000…leaving the buyer with less than $74,000 of BDE for each of the first three years. Remember this BDE is prior to buyer compensation and benefits, so not much return although in this second scenario the buyer would at least preserve a few hundred thousand dollars of out-of-pocket cash by using bank financing instead. The economics in both these proposals simply does not leave the buyer with sufficient income or return and I suspect the seller will not sell unless they revisit their expectations.
From the buyer’s side the economics are a bit more straightforward but also of much greater consequence. At the outset of exploring any acquisition, a buyer should get a clear understanding of the target practice’s SDE and then recalculate these to their own expected BDE. In some cases, expenses like software, rent, supplies, and other redundancies, as well as any other net income the buyer will bring to the acquisition, can be added to the buyer’s anticipated BDE and in other cases, some of the operating expenses might have inappropriately been added back when calculating the practice’s SDE and will need to be taken out of the buyer’s BDE calculation if they do not already have an established practice and will be taking on the seller’s location or these operating expenses. The buyer then needs to develop a clear understanding of their anticipated debt service and remove this amount from their anticipated BDE calculation. If the remaining BDE is 120% or more of their target compensation or growth goal, then it is probably reasonable to proceed as cash flow should be healthy. If the amount is less than 120%, then some assumptions may need to be revisited. If the amount is below 100%, then either adjustments need to be made to income and growth expectations or the transaction likely is not one to pursue.
The sale or acquisition of a tax and accounting practice presents a unique opportunity and there are a lot of layers to the perceived value on each side of the table. The economics are not the only element to consider as location, reputation, types of service, billing rates, profitability, staff, and other elements all have their own value. However, the economics need to be considered and evaluated or income and cash flow could be an issue and overlooking this could lead to a failed transaction.
ProHorizons is a West Coast brokerage and consulting company focused on tax and accounting practice sales and acquisition services.
If you are planning to sell your practice and would like more information about our service, please visit our Sell Your Practice page and/or Request a Sales Information Page. If you are looking to acquire a practice, please visit our Buy an Accounting Practice page, see if there is a practice of interest in our Current Listings in the Pacific Region, and/or Register with us as a Buyer.