Current economic conditions are changing the methods of valuing CPA firms. Owners that stick to the tried and true multiples of fee volume may go begging for a purchaser. Here's what more sophisticated buyers and sellers of CPA firms are doing.

One of the issues that continues to trouble owners of CPA firms is the value of their firm. Many owners view the increasing value of their firm as the primary source for their retirement benefits. But the moment of truth arrives when the time comes to "cash in" the value to provide the benefits.

In many cases buy-outs of owners are unfunded, and in some cases younger owners resist taking on the obligation of purchasing the shares of retiring owners. In smaller firms succession is often accomplished by the acquisition of the practice by another firm. Owners sometimes have trouble attracting buyers for what they consider the firm's value and often are forced to postpone their retirement while seeking the right price.

Owners of firms that are reasonably priced should encounter no great difficulty in finding an acceptable and willing buyer. What is easier said than done, however, is setting that "reasonable price." The traditional approach of many owners of small firms is to think in terms of a multiple of gross fees. Some owners become obsessed with one particular multiple--one times fees or 1.5 times fees--without giving any thought to the actual or potential profitability of the underlying practice. They feel if one firm can get that multiple, "Why can't I?"

Owners planning for succession or acquisition are advised to recognize the quality of the gross fees and resulting earnings are what prospective purchasers evaluate. In today's economic and professional environment, the profitability of firms is shrinking. There is a wide range of profitability among firms. Those which have been able to distinguish themselves through high-quality, often specialized services, have done better than those which have had to fight for scraps in the highly competitive areas of tax-return preparation and financial statement attest services.

Owners may wish to consider other methodologies to help establish a realistic value of the share being retired or the firm about to be acquired. It makes sense therefore to turn to a more sophisticated valuation technique, the kind of technique used in valuation of other kinds of businesses.

Earnings Capitalization

This very common method of valuing businesses is based on the idea that a true measure of a firm's worth is its ability to produce earnings. The two factors needed to make the calculation are a realistic calculation of the firm's historical normalized earnings and a capitalization rate. A value is determined by taking the earnings and dividing by the appropriate capitalization rate.

The formula is very simple, arriving at the earnings amount and the capitalization rate is very judgmental.

Earnings. The most challenging aspect in determining the normalized earnings of a small business is the very subjective nature of owners' compensation. To properly determine value, the earnings must be adjusted to a market or fair value for the services rendered by the owners. In addition, there may be other non-market transactions--leases, perks, and the like--that must be considered in arriving at the earnings for the calculation.

Capitalization Rate. Typically the rate is determined by considering the likelihood of earnings continuing at the historical level, general economic conditions, the demand for the type of business for sale, and the current interest environment. For professional firms, with their dependence on services as the principal source of revenue, a capitalization rate of 20% to 25% is not unusual. Businesses which are more product oriented would likely use capitalization rates of 15% to 20%.

The Value of the Firm

A major problem in determining value for professional practices is the difficulty in distinguishing between the value of the practice and the contribution of the individual professional. As discussed earlier, the value of the practice is generally calculated by capitalizing earnings that have been adjusted to reflect the fair value of the services rendered by owners.

The fair value for salaries of business owners can be estimated by reference to published surveys of non-owners operating in the same capacity. However, this data is not available for partners/owners of CPA firms. Published data available for this group usually include an element firm. Therefore, a better measure of fair compensation will improve the results of the capitalization calculation.

Ronald G. Weiner, in the April 1986 issue of The CPA Journal, noted owner's worth is established in the marketplace. Weiner felt the billing rates charged to clients reflected the fair value of the services performed. CPA firms are accustomed to expressing their billing rates in terms of cost multiples, which are normally determined by calculating a cost per hour and multiplying by a fixed multiple. Therefore Weiner concluded fair compensation of the owner can be derived by looking at the relationship between salary and billing rate of non-owner professional employees and applying that relationship to the billing rate of the owner.

Testing the Valuation Method

To test the soundness of the earnings capitalization approach when valuing accounting practices, information was gathered from responses of CPA firms to the AICPA Management of an Accounting Practice Survey conducted in 1991. The small and medium-sized. The average firm in the study had slightly less than $2,000,000 in gross fees.

The summarized information included earnings before owner compensation and staff billing rates and compensation levels. Values were calculated under various assumptions for all 130 firms using the capitalization of earnings method. These values were compared to the more traditional valuation method of multiples of gross fees.

Fair Compensation

For each firm, a market or fair value for owner's compensation was determined as follows:

* The owner's billing rate was divided by the billing rate of the highest level of non-owner staff, typically a senior manager.

* The annual compensation of the highest level non-owner staff was multiplied by the factor calculated in the first step. The amount excluded bonuses based on firm profitability and any overtime premium.

The result was an amount representing the fair value of the owner's services.

A test of this billing rate method was performed as follows: The highest level of non-owner compensation was estimated by applying the same procedure using the billing rate and compensation of the next lower level of non-owner staff.

The average predicted salary was within $370 of the actual salary, a difference of only one percent. As a result, this method of estimating the fair value of owner's compensation was considered to be valid. Table 1 presents the range of owner compensation as calculated under this method.

Normalized Earnings

For each firm, normalized earnings was calculated by subtracting the fair value compensation for all owners from earnings before owners compensation to arrive at what was considered to be normalized earnings. No attempt was made to normalize the fee revenue of the firms. However, in practice, adjust the revenues of the firm being scrutinized for non- recurring or unusual items that are not likely to continue.

The ultimate answer is whether the derived owner's compensation makes sense relative to the size and nature of the practice. It should be noted the higher the assumed owner's compensation, the lower the normalized earnings and ultimate value of the firm.

Value of Firm

The value of each firm was calculated by dividing the normalized earnings by a capitalization rate. A range of rates was used to give a range of values recognizing there is no one right answer for each firm.

Table 2 shows the valuation process for a firm having $1,900,000 in gross fees, $900,000 in earnings before owners compensation, and six owners all with a billing rate of $105. This firm has managers that earn $40,000 with hourly billing rates of $55. The implied salary per owner is $76,364, resulting in $458,184 in total owner salaries. Subtracting owner salaries from earnings before owners compensation results in normalized earnings of $441,816. The value of the firm is calculated by capitalizing these earnings. Table 2 shows the values that would result using various capitalization rates from 16% up to 24%. These values are compared to gross fees of $1,900,000, to determine the multiple of gross fees each value would represent. The multiples range from 1.0 for a capitalization rate of 24%, to 1.5 for a capitalization rate of 16%.

In this example, conventional wisdom is upheld--the values determined by the capitalization method justify a 1 to 1.5 multiple of gross fees. However, the same method when applied to all 130 firms yields some surprising results as shown in Table 3.

TABLE1

DISTRIBUTIONOFCALCULATEDOWNER'SCOMPENSATION

PercentageofFirmsCompensationLessThan

20%$55,577

4063,968

5067,857

6070,312

8081,600

100126,000

At a capitalization rate of only 14%, over 60% of the firms in the sample have gross-fee multiples of less than one, and at a capitalization rate of 20%, 40% of the firms have gross-fee multiples of less than .5.

Those that would challenge these low multiples have two choices: Justify either a decrease in the estimated fair value of owners' compensation or a reduction of the capitalization rate. It would be difficult to assume a compensation level lower than that shown in Table 1, considering compensation being paid to staff, or a capitalization rate below the lowest in Table 3 (14%) in light of the many uncertainties facing the profession.

If an individual owner is planning for retirement, the calculation can be done on the basis of the individual owner. The fair compensation of the individual can be estimated and normalized earnings can be capitalized at an appropriate rate to determine the retirement price.

TABLE2

CAPITALIZATIONOFNORMALIZEDEARNINGS

Grossfees$1,900,000

Netincomebeforeownercompensation$900,000

Calculationoffaircompensation

Managerbillingrate$55

Managercompensation40,000

Ownerbillingrate105

Ownercompensation76,364

Numberofowners6

Totalownercompensation458,184

Normalizedearnings$441,816

Multipleof

CapitalizationrateValueGrossfees

16%$2,761,3501.5

182,454,5331.3

202,209,0801.2

222,008,2551.1

241,840,9001.0

In practice, it is likely that more than one year's income will be averaged to arrive at an earnings amount to be used in the calculation. However, the current year's earnings illustrate both the high degree of variability of value between firms and the fact that the use of a firm's gross-fee multiple does not provide an accurate measure of a firm's value.

Impact of Overstaffing

Sometimes a firm is willing to acquire another firm at a price exceeding what calculations seem to warrant. One reason for this may be the acquiring firm anticipates staffing the firm at more efficient levels resulting in higher earnings. To illustrate this, one firm from the sample that appeared to be overstaffed for its size was examined to determine the likely impact of this overstaffing on normalized earnings and firm value.

Table 4 shows the calculations of capitalized earnings and the resultant gross-fee multiple for this firm based upon actual staffing. This calculation is the same as that shown in Table 2, except that instead of using a range of discount rates, only 18% is used. The results indicate a firm value of $1,842,489 or $153,541 per owner and a gross fee multiple of .37.

Using the staffing factors from a prior study, the firm has about three more owners, three fewer professionals, four more paraprofessionals, and one more support person than is appropriate for its size.

Table 4 also shows the restated normalized earnings assuming the firm were staffed according to industry norms. The revised earnings are $1,093,767.

Table 4 goes on to show the firm value and gross fee multiple that would be expected if the firm were staffed in accordance with standards. The firm value would be $2,502,428 or $287,635 per owner. The gross fee multiple would be .50. The $659,934 difference in firm value represents the potential increase in future income available from making an adjustment in staffing.

A firm interested in acquiring this firm and feeling that it can convert the staffing level to the more normative level may consider the figure of $2,502,427 as an upper limit on the value of this firm, recognizing that there are both costs and risks in making staffing adjustments.

TABLE3

PERCENTILESOFFIRMVALUEASAMULTIPLEOFGROSSFEES

CAPITALIZATIONRATES

%14%16%18%20%22%24%

200.40.40.30.30.30.2

400.70.60.50.50.40.4

500.80.70.60.60.50.5

600.90.80.70.70.60.6

801.41.21.11.00.90.8

1003.32.92.52.12.11.9

Note:Distributionofgrossfeemultiplesbaseduponnormalized

earningsatvariouscapitalizationrates

TABULAR DATA OMITTED

This example suggests that there are substantial benefits, both in terms of profitability and in terms of firm value, of properly staffing a firm. However, the improvements are only available for firms that are improperly staffed. Staffing the firm in a manner that maximizes profits can have a significant payoff after a change in ownership.

There may be other factors a purchaser may want to consider in computing estimated normalized earnings. These generally involve duplication or perhaps excess capacity that may be eliminated or absorbed when the firms merge. Examples include firm administration costs and excess office space.

Growth

Many owners feel the market compensation and their firm's value calculated under the approach just illustrated are lower than they should be. One possible factor that could reconcile their feeling with the facts presented is a history of or potential for growth. A history of growth in gross fees can create increases in the owners' wealth that go beyond the earning in one income statement.

For purposes of this discussion, growth is divided into four categories. Each of these categories affects the value of the firm in a different way. The four categories are:

* Inflation;

* Efforts of the owners;

* Name recognition and reputation; and

* Mergers and acquisitions.

Inflation

Growth in gross fees due to inflation does not represent real growth. If fees rise in conjunction with inflation, it means the firm has maintained it's real value.

Efforts of the Owners

To the extent owners create growth through devoting their time to acquiring new clients or providing additional services to existing clients, there is a real increment to the value of the firm. Past growth of this kind has brought the earnings to their current level. In addition, a consistent growth history in excess of inflation should be considered in choosing the capitalization rate. The higher the rate of growth, the lower the capitalization rate, and the higher the firm value. If future growth is not expected to continue--for example, the rain maker will no longer be with the firm--normalized earnings should be adjusted to exclude the costs of supporting the rain maker and the capitalization rate increased.

Mergers and Acquisitions

A history of growth from mergers and acquisitions may result in an increase or decrease in the value of a firm. To the extent the payment for past acquisitions--covenant not to compete, wage continuation arrangements, etc.--is affecting current earnings, the cost should be eliminated. Such an adjustment will increase normalized earnings and the value of the firm. However, the unpaid obligations represent a non- operating liability, and the present value of the future obligations, whether they are on or off balance sheet amounts should reduce the value of the firm.

Mergers present a different consideration. If there was an equitable agreement reached between the merging parties, the value of the firm may increase representing the increased potential of the greater firm to grow. The individual owner values would be expected to remain unchanged until the actual growth is achieved.

Name Recognition and Reputation--Firm Identity

A CPA practice is a personal service business, and growth in services rendered is normally due to the personal efforts of the individual owners of the firm. However, some firms experience growth through name recognition. To the extent that the firm possesses this trait, it is a factor that must be considered in the valuation. Since name recognition and/or firm reputation would be transferred to any new owners, this should be priced as part of the value of the firm by reducing the capitalization rate.

Most growth in CPA firms beyond inflation is due to the efforts of the individual owners. Therefore, any growth that is anticipated in the capitalization rate chosen is only valid where the owners who are responsible for the growth are continuing with the firm.

Use the Calculations Wisely

There are many subjective factors in deciding the value of a CPA firm including the types of services offered and the demographics of the clients. Retention of the client base is obviously important. The calculations that are presented here should not be blindly applied. They are a good beginning consideration of the many complex factors entering any valuation. What is quite clear is that selling prices based upon multiples of gross fees are too simplistic an answer.

Jeffrey W. Lippitt, PhD, is an associate professor at Union College, Schenectady, New York.

Nicholas J. Mastracchio, Jr., CPA, is a lecturer at the School of Business, State University of New York at Albany and former managing director of CL Marvin & Co., Schenectady and Albany, New York.