Mergers: Where Did This 1x Revenue Nonsense Come From?

Assume there are two small CPA firms.  Each has two partners, equal revenues, same kind of clients, same age of partners, same everything. Except partner earnings.  Firm A’s average income per partner is $200,000 and Firm B is at $400,000.  Which firm should fetch a higher sales price?  Clearly, Firm B is worth more.

In most businesses, when companies are sold, they are valued based on a multiple of their earnings.  But not CPA firms.  They are commonly valued on a multiple of revenues.  This has never made sense to me and I fear those who know the origins of this convention are no longer with us.

Knowledgeable CPA firm buyers and sellers understand this perplexity and vary the selling price, up or down, based on profitability together with a host of other factors such as the quality of the staff and clients, services provided, etc.  But not all merger parties are knowledgeable.  Sometimes buyers or sellers have this one times revenue notion in their head and until it’s removed, it can represent a huge obstacle in negotiations.

So, to better understand this, I sought help from a few highly regarded, experienced CPA firm merger consultants.  Their thoughts are quoted below.

Bob Martin, Martin Consulting

Earnings of professional service firms, like CPA firms, are much more subject to manipulation than in larger, traditional, brick-and-mortar businesses.

Joel Sinken, Transition Advisors

CPA firms can make profit look better or worse than it truly is.  Some firms’ profits are artificially high because they don’t invest in the future, their quality control process is not very robust and the labor costs are lower than they should be.  What needs to be determined is the profit not to the seller but to the buyer.  Profit considered by itself is not enough of a factor to jump straight to sales value, and  in reality, the profitability affects the revenue multiple anyway. If the buyer can absorb a seller with no incremental increase in expenses, in most cases, the firm has more value to the buyer.

Thus, when valuing a firm, I look at the whole package.  Then, we play with the revenue multiple to arrive at the final sales price.  As a result, I’m pretty happy these deals are based on multiple of revenues instead of profit because profit alone isn’t always a strong indicator of the firm’s value without bringing in many other variables.

Terry Putney, Transition Advisors

In a prior life, I worked on a lot of mergers and we did, in fact, value firms on a multiple of earnings instead of revenues.  It’s not used more today because determining what “earnings” are requires defining how much of the partners’ comp is owners’ ROI and how much is true compensation.  I believe that what really matters is what the earnings will be for the buyer, not what they were for the seller.

Rosenberg’s take:

I have worked with several large, extremely profitable sole practitioners (example: $1M of revenue and earnings of $700K) on the sale of their firms.  In all cases, these solos quite rightly felt that their premium practices were worth a premium sales price.  The refusal of buyers to pay the premium price was a major obstacle in completing the deals.

If you do the math, the case for these premium solos is solid.  If you base the selling price on a multiple of earnings vs. revenue, these solos would sell at 2 times revenue instead of the more common 1.0 to 1.4.  But, as I was told many years ago, “statistics are a splendid irrelevancy.”  No buyers in today’s market will pay anywhere near 2x revenue because no one else is doing it.

So, what does all this mean?

Although there is plenty of logic to justify selling a firm based on a multiple of earnings, as a practical matter, it won’t fly in today’s CPA firm merger market because “it’s not what we do.”

The merger market shows no sign of slowing down. Even if you’re not merger-minded today, the topic is bound to arise sooner or later. When it does, make sure you’re educated on today’s merger market: consult CPA Firm Mergers: Your Complete Guide.