What’s the best way to find out how much your firm is worth? It is easily one of the first questions from prospective sellers. As a seller, if you understand how other firms value your business, you’ll know what to expect and won’t be surprised by the outcome.
Most sophisticated buyers begin by placing a multiple on net income or cash flow known as EBITDA. While there is a lot of talk around gross revenue multiples, very few firms use that metric. The obvious problem with gross revenue multiples, is that it tells a prospective buyer nothing about the underlying profitability of a practice.
You can have two firms that are each producing $1,000,000 of revenue. One is making $500,000 of net income (EBITDA), and the other $300,000. But there’s no way those two firms worth the same. Therefore, throw gross revenue multiples out the window. So, what’s the formula to evaluate a firm? Start with gross revenue and determine how much income is recurring versus non-recurring. Recurring revenue gets one multiple, while non-recurring revenue gets about half that multiple.
EBITDA and EBOC
Next, we calculate the gross profit by subtracting operating expenses from the gross revenue of your practice. But what are operating expenses? Operating expenses are all costs associated with the practice except for the owner’s compensation, (salaries, distributions, and profit-sharing contributions). This leaves things like rent, staff, technology, vendor costs etc., In our basic mathematical formula, gross revenue less operating expenses (opex) leaves gross profits. It’s also called earnings before owners’ compensation, and E.B.O.C. is the acronym.
For example, let’s say a firm has $1,000,000 of recurring revenue and 40% OPEX or $400,000 to support that revenue. That leaves $600,000 of gross profits or E.B.O.C. Next, the owner needs to retain some of the E.B.O.C. to support their lifestyle, if they determine $300,000 is needed to meet their living expenses that leaves $300,000 of EBITDA. EBITDA is where the multiple will be applied, to determine the value of the practice.
The Recast Step
But there’s one important step to the buying process that most sellers don’t know about: the recast step. It is the process of mapping the seller’s profit & loss statement (P&L) over to the buyer’s P&L. This is where sellers need to understand how a buyer is viewing their P&L post transacting.
What expenses are they removing from your P&L, what are they adding to your P&L? The buyers often have economies of scale that come along with the transaction. Who gets the savings is an important question.
Some firms will retain the savings they anticipate other firms will give you the savings back, this impacts your valuation greatly -the point is you need to know what they are doing with the recast adds/subtracts.
Transparency Is Key
Indeed, transparency is a big key in going through this process. If a firm didn’t show you the recast step, while not necessarily an indication of anything bad, I would question it. You want to see line item by line item, what impact of joining their organization has in your valuation. Any buyer not willing to share their financials or valuation reports, shareholder or share price history should be avoided.
There are many nuances to valuation, and while every firm is different if you understand this basic math, your well on your way to knowing what’s happening at the negotiation table.
Allen Darby is CEO of Alaris Acquisitions, a mergers and acquisitions consulting company for the wealth management industry. Contact him at allen.darby@alarisacquisitions or by telephone: 704-756-7160. Book time on Allen's calendar here.