One Times Gross: Is that the Law?
Accounting practices are worth one times annual gross revenue. This is a belief that has been around our profession for decades and, in fact, still drives the marketplace. No one can really explain why one times gross is such an accepted formula. (The best theory is that it assumes a backdoor cash flow. Buyers believe they can achieve a certain income level despite what the previous owner has done.) But whatever the reason for the wide-spread thought it is so persistent that many accountants do consider it some immutable law. They routinely talk of anything above a one times gross price as a premium and anything less as a discount! At Accounting Practice Sales we accept this mindset, using it to our advantage when possible and working to overcome it on other occasions.
This ubiquitous mantra implies that accountants value practices with reference to annual gross revenues. That actually is a bit strange. Almost all other small businesses are valued based on a multiple of net cash flow to the owner (including salary, payroll taxes, benefits, profits, etc.). This is commonly called discretionary cash flow. For all small businesses in North America that multiple is about 2.4 times cash flow to owner. The multiple for service businesses is less, more like 1.5 to 2 times. Therefore, if accountants were like everyone else, they would value their businesses at 1.5 to 2 times this discretionary cash flow. But they are different. Sometimes, where the cash flow is high for example, this mindset hurts the value of a business. At other times, like when cash flow is low, it helps the value.
Be aware that, despite our beliefs, not all practices sell at one times gross. One can no more say that than to say that houses sell for $X a square foot. Some do and some don't. There are a whole host of factors that will make a practice sell for more or less than another one. They include location, cash flow, type, size, etc. See Key Factors in Practice Value. One times gross is the starting point because that is what everyone thinks. But it is probably better to think in terms of a range like 80-120% of gross as being more realistic. Sellers and buyers need to move out of the mindset that every practice is the same and is valued the same. No one believes that each accounting or tax firm is a cookie cutter image of the one down the street. Of course, knowledge of those factors is a major reason for sellers and buyers to consider using an experienced broker who specializes in tax and accounting practices.
It is also important to note the distinction between what some mean by practice multiple. There is 100% and there is 100%. No buyer or seller thinks that 100% cash at closing is the same as 20% down and 20% a year for four years. Rarely will the latter result in the same amount in the pocket of the seller as would have happened with the first. And yet, parties often talk about 100% of gross or one times gross without knowing what the other has in mind. Deals have failed at the signing table when it was discovered that the buyer meant one thing and the seller the other. It is imperative that terms are understood early in the process. See Show Me the Money: How are Accounting and Tax Practices Sold for a discussion of terms.
Another problem is deciding what is included in the gross revenue calculation. First of all, what is being considered-billings or collections? It is a given that accountants should understand the difference in accrual and cash basis accounting better than anyone but when it comes to buying or selling a practice that is often ignored. Cash basis is often used but accrual can sometimes be a better indicator. At any rate, buyer and seller need to understand what is being presented. Second of all, what period of time is considered in the calculation? There certainly does not seem to be a consensus. Is the last calendar year the determinant? Or do the parties use the most recent 12 month period? Does one look at a kind of average of the last three or so years? Or does the year after the sale become the period under consideration? All of those measurements are used by one party or the other and often without prior discussion. That can lead to problems. One can not begin to discuss 100% of gross as a value without knowing what gross is.
To peg value at a multiple of gross it is necessary to know what exactly is considered as a part of the sale. Are furniture and equipment included or are these added to the one times gross ? What about accounts receivable, accounts payable or work in process? The assets sold in the sale of an accounting practice are those necessary for the new owner to continue operating the business. Generally, this is the goodwill of the practice including client files, client lists and non-compete agreements as well as property assets like furniture, equipment and software. The truth of the matter is that used furniture and equipment are not considered to have much value; in fact, some buyers do not even want them. They rarely affect the overall value. Usually the seller retains cash and accounts receivable while work in process is often prorated. The seller usually is responsible for all existing debt at the time of the sell. Leases are another item that needs to be discussed up front.
While one times gross is not a law it is certainly still very prevalent in the thinking of both sellers and buyers and cannot be dismissed. It is a general guideline and nothing more. It is best to realize, however, that prices do vary up and down from this simplistic standard. It is also best to remember simple economics. One, value is set by the buyer; sellers and brokers can determine an asking price but not the final value. If there are NO buyers the practice is worth nothing. Two, in an efficient market quality will command a higher price. Dogs are hard to sell no matter what the gross. Three, the larger the pool of buyers there is the greater the demand and, consequently, the greater the value. Buyers and sellers will most likely get the best and fairest deals if they consider these principles. Sellers should realize that they need a good broker like Accounting Practice Sales who understands these principles, can use them to maximum value and can create the best results.