Numbers game: how to value and price accountancy firms

IN AN AGE of continued economic uncertainty and increased competition, where organic growth is difficult to achieve, there are considerable advantages to M&A for accountancy firms. Improving a firm’s market position, extending geographic, service and sector reach, acquiring new talent and additional clients are just some of the benefits. However, acquiring firms should be aware of risks that may crystallise after the deal is concluded and ensure that the target practice is not overpriced on day one of completion. There are three key elements to effectively handling these issues – day one valuation, post-completion price reconciliation and an earn-out element.

Day one valuation

Most accountancy firm M&A tends to be structured as the acquisition of the assets and undertaking of the target practice. This is due to numerous factors, including the fact that transferring LLP interests is unusual and because assets acquisitions allow most liabilities to be left behind. As a result, the consideration structure is often focused on the net asset value of the target practice on completion. There are three key valuation issues here to bear in mind:

An accurate assessment of completion net asset value will be difficult due to fluctuating factors such as bad debts and work in progress;

As client agreements are usually terminable at will, it is unlikely there will be certainty as to the proportion of clients that will transfer; and

Some clients – those that present conflicts or regulatory issues to the buyer, for example – may need to be excluded from the valuation.

Post-completion price reconciliation

The challenges presented by a day one valuation make a completion accounts adjustment after completion attractive. This would be based on a target level of net assets – where these have been exceeded then a further payment becomes due to the seller and where the target has been missed a refund may be due to the buyer. Crucial to consider here is how to value items such as bad debts and WIP and whether the price adjustment should be an upward adjustment only, or should a price reduction also be a possibility.

Particularly where the seller is essentially an empty shell after the sale, having distributed the proceeds of sale to the LLP members, there are two major issues to consider:

– Should there be a part payment of the completion price into escrow to cover the eventuality that actual net assets are less than target net assets – i.e. that the buyer has essentially overpaid?

– Should set off rights be written in to allow the buyer to set off any further consideration payable following the completion accounts exercise against any claims which may arise post completion against the seller?

Earn-out element

Where future revenues provide the basis for the purchase price, an earn-out offers an incentive to ensure the acquired firm delivers on anticipated revenue streams and profitability. This is particularly relevant where the motivation for the acquisition is to acquire a new service line that the buying firm does not possess – which is capable of being more easily measured.

What kind of earn-out? An earn-out mechanism would usually span between one and three years post acquisition. It may be either a true earn-out (where proceeds are paid to the seller), or a target-related bonus arrangement for the acquired partners and senior employees (tax and employment law issues will need to be considered).

Earn-out reductions? A buying firm may want to consider a reduction in any earn-out or bonus payment if any key partners or senior staff leave within a specified time period after completion (again, tax and employment law considerations will need to be considered), or if there are clients of the target practice that the acquiring firm is unable to take onto its books, due to regulatory or conflict reasons.

Existing clients? Consideration should be given to how any earn-out or bonus payment should be calculated with respect to any target firm clients that already use the services of the acquiring firm, or which are cross-sold by the acquiring firm to the target practice.

Set off? The acquiring firm may again want the right to set off any earn-out payment against any warranty or indemnity claims against the seller post completion.

Jonathan Snade is a partner in the corporate team of law firm Manches LLP