Late last year Spruson & Ferguson, an IP professional services firm, listed on the Australian Stock Exchange at a valuation of 13.9 times its profit on revenue of $82.8m. From what I can glean from the prospectus $160m was raised for the 19 partners, with none of this capital remaining in the business.
The expression “I can do that too” is still ringing around the market. So just how much is my firm worth?
I led my first transaction in 1990 when I sold my aerospace engineering business to a UK public company. Since then I have represented scores of buyers and sellers in transactions, and it is not unusual to be faced with misguided optimism on either side of a transaction. Typically vendors latch onto a multiple applied to some other firm and apply it to themselves – without ‘getting under the hood’ to understand why there is a difference. In fact Beaton Capital had a case last month where a sub-scale firm that had not invested in succession expected our client to pay a ridiculous multiple based on the advice of a ‘family friend’ – now how often do we hear that!
So, firstly some facts of life. Professional services firms (PSFs), be they management consulting firms, law firms, accountants, IT firms, consulting engineers, architects or IP firms, tend to suffer from the same condition, a dependence on mobile human capital, where core expertise resides in a human host – not in a fixed asset. This creates an inherent risk and makes valuing a collective of human hosts problematic. But de-risk it – and you start to create realisable value.
Recognising a firm of value
I am not going to try and justify an IPO multiple here, I’ll leave that to the brokers, this article looks at the trade sale market. But Spruson & Ferguson tick many of the boxes in the following analysis.
Consider these two scenarios on the PSF maturity continuum. At one end a firm of 100 fee earning professionals that has grown steadily over the past three years; has built a lead generating ‘machine’ independent of any individual; has locked key staff into the future of the firm through profit-sharing and equity; demonstrates long-term relationships with blue-chip clients that pay on-time, often with annuity or retainer income streams; has sub-segmented its business and uses technology to create scale and leverage wherever possible; has a management structure with breadth and depth of firm leadership and management as well as the capability to enable founders to exit at the right time; and also generates profits of at least 20% on revenue with a solid track record over the last three years. At the other end of the scale we have a loose group of professionals, however large, either working together on short-term projects, or worse working in isolation, where all the profits are distributed and little is invested in creating structure, fabric and culture. The first example will have considerable equity value, latter will be minimal – and it all comes down to one thing – predictability.
Despite what most vendors may believe, acquisition is a gamble. But despite this significant risk, the professional services M&A market is vibrant, with significant prices paid for quality firms. So understanding what drives value in the eyes of an acquirer is critical for an owner seeking to answer the question – what is my firm worth?
Valuation and the ‘multiple’
In simple terms your business is worth the cash profit that can be generated by it over the next few years. How far ahead just depends, that is a judgment call.
In acquiring a professional services firm most sophisticated buyers apply a multiple to the last 12 months’ profits, after taking account of the actual past trends and with an eye on the forecasts, so as to approximate a purchase valuation. Then there is some haggling to finally reach a purchase price – divide this price by the profit and you derive the profit multiple. But in this equation the ‘profit’ you use (historic, current or future) will impact the calculation of the multiple. So beware of blindly applying other people’s multiples.
The most useful measure of profit is EBIT, which is Earnings (or net profit) Before Interest and Tax. Some valuers add back depreciation and amortisation because they are non-cash items (giving what is called EBITDA), but that can be misleading since they represent a valid operational impost. The problem with using a derived EBIT multiple as a market guide to valuation is that you never really know how EBIT is calculated – since the incentive for a firm is to minimise profit (through legal means) to minimise tax, or a partnership may ‘normalise’ its results by adding a salary proxy and treat the balance of distributions as an unfranked dividend. There may also be a mismatching of the price paid relative to a historic EBIT figure, which for a growing firm may result in the EBIT multiple being overstated.
So a secondary comparator is often used to run a ‘sanity’ check on an EBIT multiple based valuation, this is the Revenue Multiple, because it is far less subject to distortion.
What firms sell for today
Based on information currently in the public domain, profitable privately owned professional services firms sell on average for EBIT multiples of 4 to 6 (and a revenue multiple of around 1). Of course there will always be outliers to this, and some firms command double-digit EBIT multiples. So what can drive up the multiple?
Driving up the multiple
From the average you can increase the multiple for the following factors (the degree of the delta will depend on how well you are pre-prepared and how well you negotiate). Remember it is totally subjective, and boils down to either reinforcing predictability or undermining it.
Factors that increase the multiple:
- Leading expertise, and when those skills are in short supply in a growing market. Including barriers to entry, be they technical, resourcing, sticky clients with long term agreements etc.
- Successful and stable business model, management and systems. Well-run and profitable firms just stand out from the crowd; they retain their clients and staff, and will attract a premium – because they are rare.
- A history of profit sustainability and steady growth – proof that strong profitability is embedded and predictable over the next few years reduces buyer risk and will increase the multiple. Fast growing young firms are riskier than well-established firms – but it just depends on the sector and other the factors listed here as to whether it will make a difference to the valuation. For example, young marginally profitable digital and analytics companies remain hot at present.
- Scalability – a business model that allows growth through technology – without any proportional increase in headcount, is an absolute positive. But hard to find in most professional services firms. Some are using technology to scale up commoditised services like legal decision support, patent filing, insurance claims, personal injury claims, IT services (SaaS), accounting and tax compliance etc. Others have innovative recruitment and employment strategies to ensure they can meet client demand at relatively short notice.
- A brand that grants the acquirer permission to enter new markets – a brand that has established a position of unprompted and front of mind awareness delivers significant value relative to its competitors.
- Geographic footprint – right time-right place. Premiums are being paid that allow acquirers to enter new markets, provided your footprint is established and proven – the PRC is a good example. But beware, overcommitting an organisation by having too many offices relative to size is seen as a negative – the Middle East boom backfired on many and still makes acquirers wary.
- Locked in client contracts – long term supply agreements that allow an acquirer to reduce future revenue risk increase the multiple.
Client quality has a significant bearing on the multiple. This is not about blue chips but about win-win relationships, as we know some major blue chips treat suppliers as commodities and are inherently unstable clients.
- Size – there is no doubt that size does matter, there is enough evidence to support size does have a direct bearing on the multiple. Subscale businesses are marked down or don’t even get considered.
- Management succession – investing in bringing up the next generation of leaders and management de-risks the purchase and so increases the multiple.
Don’t leave it too late
Lastly, don’t leave it too late to be sale ready. Ordinarily it takes years to build a firm that will generate the sort of exit value vendors crave. But all too often vendors do leave it too late to address continuity and prove predictability.
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