Professional practices come in many types: dental and medical practices, law and accounting firms, architecture and engineering consulting companies, individual and business professional consulting firms.
While a professional practice may look like a service business, there are key differences to bear in mind that affect what a practice is worth.
Top reasons why a professional practice is valued
Remember that your choices of business valuation methods and, ultimately, the results you get will depend on the reasons for practice valuation. So, what are the typical situations calling for valuation of a professional practice? Here are the top ones:
Ownership transfers, such as the practice sale, partner buy-in or buy-out.
Legal disputes involving partner disagreements and divorce.
Less frequently, a professional practice may be valued for:
Estate planning and taxation purposes.
Bankruptcy and reorganization.
Practice acquisition and expansion financing.
Differences between a professional practice and other service businesses
Most professional practices share a few key traits that set them apart from other service-oriented businesses. Assessing the practice in light of these traits is important to your selection of key valuation inputs: the cash flow projections, valuation factors, discount and capitalization rates.
1. Price sensitivity
Typically, professional practice clients are less cost conscious than customers of other service businesses. They look for the right expertise to address a critical need even if it costs more. Professional practices are less susceptible to abrupt pricing pressures such as deep discounts or low cost substitutions. This affects the practice cash flow projections and, in turn, what the practice is worth.
2. Professional reputation and skill
The reputation of a professional practice and demonstrated skills of its practitioners are very important to its success. This means that a large part of the practice value resides in its professional practitioner and institutional goodwill, not its tangible assets.
3. Reliance on referrals
Most clients seeking professional services get referrals from people they know – relatives, friends and other professionals. Strong referral network represents a key factor which contributes to the practice value.
4. High intangible asset base
More so than most service businesses, professional practices show a high level of intangible assets. Many of these assets do not appear on the practice’s Balance Sheet, hence have no “book value”. However, they often represent the most important and valuable assets the practice has. Consider using the business valuation methods which measure business goodwill, such as the Capitalized Excess Earnings method.
5. Licenses and protected market
Many professionals are licensed practitioners. This has two significant effects on the practice value. First, it moderates competition by limiting the number of entrants in the market. Second, it limits the pool of potential buyers that are qualified to acquire and run the practice.
Now, the practice’s fair market value is established in the competitive market place. Hence, the level of competition among the practice buyers has a major effect on what it is worth.
6. Client relationships and practice sale
Here is an important question: if the practice is offered for sale, can it be successfully transferred to the buyer? The answer often depends upon the level of professional goodwill. Some professional practices are quite challenging to sell because of the close relationship of its clients to the individual practitioner.
7. Professional practice life expectancy and value
A professional practice may have a shorter expected life span than other service businesses. This affects how you do income projections for the practice. And the income projections form the basis of such business valuation methods as Discounted Cash Flow. Importantly, the assumption of perpetual income stream may not be appropriate when valuing a professional practice. This reduces the practice’s residual value.
“Cost-basis” accounting statements such as the company’s Income Statement and Balance Sheet require adjustments before you can use them in business valuation. Your goal here is to demonstrate the business earning power and economic value of its asset base.
Your focus for the Income statement adjustments is to identify discretionary expenses that contribute to the business’ available cash flow. These discretionary adjustments are often called addbacks. You can then use this adjusted cash flow as the earnings basis in valuing the business.
When adjusting the company’s Balance Sheet, you need to determine the market value of the assets. This value may differ considerably from the depreciated book value. In addition, most businesses have a number of “off-balance sheet” assets that are quite valuable. Examples are the internally developed products and services, customer lists, and vendor agreements concluded on favorable terms.
Last, but not least, the business may have considerable goodwill. Business goodwill is not recorded on the accounting Balance Sheet, unless the business was purchased previously.
Designed on the leading-edge Java-6 technology, ValuAdder business valuation software is packed with features to simplify and speed up your business valuation.
One of these powerful features is ValuAdder AutocalculateTM. With AutocalculateTM on, ValuAdder responds to your inputs by instantly calculating your business valuation results. Refining your business valuation assumptions is a snap especially when coupled with the quick incremental adjustments using the up and down arrows provided on each ValuAdder input.
Here is how you can activate AutocalculateTM:
Click on the Tools menu.
Toggle the AutocalculateTM on. A checkmark indicates that AutocalculateTM is active.
You will find AutocalculateTM a real time saver in many business valuation situations, including:
What-if scenario analysis.
When reviewing a number of business valuation situations with your partners or professional advisors.
When developing the terms of a business purchase offer.
During negotiations over the terms of a business purchase offer or counter-offer.
The key reason behind the accuracy of the Discounted Cash Flow business valuation method is that it lets you match the business cash flows and the risk, represented by the discount rate you use. This method works by translating these cash flows to today’s dollars by calculating the so-called present value.
Now, any seasoned business person would agree that you can make reliable cash flow forecasts only so far into the future. Typical forecasts are done for 3 to 5 years, sometimes up to 10 years. But a successful business may continue running well past the initial cash flow projection. Obviously, such a business continues to create value over and above what this projected cash flow is worth. So how do you measure it?
This depends on what your plans are for the business. If you plan to sell it once the projected cash flows have been received, then the additional value is in the proceeds you realize from the business sale.
But what if you plan to run the business indefinitely? You can continue with your business cash flow projections, but their accuracy tends to suffer the farther out they are. Can the business value be assessed without this infinite stream of cash flow projections?
Yes indeed. What you need to do is estimate how the business cash flows will change past the projection period. One simple assumption is that the cash flow will continue growing at a constant rate. You can refer to your cash flow forecast to estimate this growth rate. And the value of a constantly growing cash flow stream can be calculated by the process known as capitalization.
So, under this approach, there are two parts to what the business is worth. First, it’s the present value of the initial cash flow stream. Second, it is the long-term value of the constantly changing cash flow, known as the residual value or terminal value.
Here is the ground rule to bear in mind when using the Discounted Cash Flow business valuation method:
The shorter the cash flow projection period and the lower the discount rate, the larger the contribution of the residual value to the total business value.
So, if your business is relatively low risk and you expect to see a steadily growing cash flow, then a short-term cash flow forecast should suffice. However, if you anticipate significant changes in your business earnings, then consider doing longer-term cash flow projections in order to get an accurate estimate of business value.
Small business value is driven by its earning power
It will come as no surprise to you that the value of a small business depends on how much money it makes. More so than the market comparisons or the size of the business asset base, its ability to generate adequate income for its owners defines what it’s worth.
Given this, you may wonder – when it comes to business valuation, what is the best way to assess the business earning power?
Earnings basis – the key reference point for business valuation
Your first thought might be – look at the company’s historic Income Statments and choose the standard measure of profitability such as Net Income or EBITDA. That should serve as an excellent earnings basis, right? Wrong!
The fact is that the vast majority of small busnesses are managed to minimize taxable income. As a result, what appears on your company’s tax returns may be a far cry from its true economic potential. OK, if not the profit, what then should you use as your earnings basis for valuing the business?
Cash is king: why accounting profitability measures don’t work for valuing a company
The answer is cash flow. As a business owner you need to decide what amount of money you can remove from the business without harming its ability to run smoothly. Just because the business nets a certain amount does not mean you can put your entire profit in your pocket. You may well overlook such critical requirements as the funds needed to buy additional inventory or invest in new business equipment.
While Net Profit and EBITDA account for the business income and expenses, cash flow lets you see how the money moves through the business. This gives you the “big picture” of where the money comes and goes – including changes in working capital, cost recovery through depreciation, investment and financing activities as well as owners distributions. That’s why seasoned investors use cash flow to determine the business earning power.
For valuing a small business, the most common measures of cash flow you will see are:
In practical terms, you calculate SDCF by starting with the company’s pre-tax profit and developing a number of adjustments, commonly known as addbacks.
What are addbacks?
Addbacks are basically cash outlays that are made at the discretion of business ownership. As mentioned before, the starting point is business pre-tax earnings. This is because most small businesses are structured as the so-called pass-through entities for tax purposes such as sole proprietorships, partnerships, S corporations or LLCs. The owners pay taxes individually.
Addback No 1: single owner-operator entire compensation.
By convention, the entire compensation package for a single owner is added back to the pre-tax profit. If the business is offered for sale, this addback is pretty important – this amount transfers to the buyer after the sale closes.
Addback No 2: Manager replacement adjustment for other working owners.
If there are other owners who work in the business, their compensation is adjusted to market value. This is known as manager replacement. The idea is that the new buyer will replace the selling owner and take over the compensation. However, the buyer will have to replace other owners and will need to hire outside managers to perform their jobs. If these owners are paid above market, then the difference is additional earnings for the business buyer. If, on the other hand, the owners are underpaid, then the buyer will have to come up with additional cash to hire their replacements. This reduces the cash available.
Addback No 3: Non-cash charges such as depreciation and amortization.
The depreciation and amortization are “paper expenses” and do not impact the business cash flow directly. Business owners have considerable discretion in how to depreciate their assets. Hence, annual depreciation and amortization expenses are added back as well.
Addback No 4: interest expense.
The interest expense is added back because the new ownership can choose how to finance the business operations. For example, they may decide not to borrow any funds, pay no interest, and pocket the interest expense as additional income.
Addback No 5: non-recurring or one-time expenses.
Non-recurring expenses are another form of addbacks. These are incurred rarely and do not represent a normal business expense. Examples are moving expenses associated with business relocation to a new site.
Creative addbacks – what sticks and what doesn’t
When selling a business, some business owners are tempted to add back a number of other expenses to demonstrate superior earnings and, therefore, higher business value. Things like auto and cell phone expenses, trade show attendance and travel are common. These may well be discretionary and thus serve as justifiable addbacks. On the other hand, trade show attendance may lead to legitimate business expenses required to develop new vendor and client relationships. If you must visit and entertain clients to get business, then travel and entertainment expenses are essential and not discretionary.
You can expect that the most common addbacks will most likely be acceptable to a savvy business buyer or lender offering business sale financing. But they will certainly scrutinize an addback schedule which bristles with creative addbacks – whose amounts far exceed the norm for your industry or those rarely seen for your type of business.
One of the greatest strengths of ValuAdder is its flexibility. You will notice that ValuAdder offers you a number of well-known business valuation and deal structuring tools. With all the tools and business valuation methods available to you, you can make the choices that best fit your particular business valuation, business sale or purchase situation.
We discuss the strengths and weaknesses of the various business valuation methods in our Business Valuation Guide. Once you have selected your methods, you can set up your ValuAdder to use them in a just a few key strokes. Here is how:
Create a new ValuAdder window by clicking on the File menu and choosing New.
Select the valuation methods you want from the Start Tab.
Create a Tab for each method you choose by clicking on the Create button.
You can rename your business valuation tools using the Tab menu to make your choices easy to remember. For example, if you are working on a business purchase offer and decide to use the Deal Check tool to structure your offer terms, you can rename the Tab to something like My Offer Terms.
Grouping all your tools in a separate ValuAdder window is an excellent way to organize your work. For example, you can keep all your method selections, your assumptions and valuation calculations together when valuing a specific business. And you can save all your work in one step and then restore it later by using the Save and Open commands in the ValuAdder File menu.
With all the business valuation methods available, you may wonder which ones work best for valuing a start-up business.
First, let’s consider the special challenges faced by a young business that affect what it is worth.
Conflicting requirements for start-up valuation
Unlike an established business, startup companies have little history of financial performance. Frequently a young company is just beginning to implement its business plan and needs critical resources to reach its objectives. The two key requirements any start-up has is access to funding and talented employees. These two requirements often create conflicting views of what the start-up business is worth.
Reasons for showing a high business value
Many start-up business owners look for outside equity or debt financing to meet the business financial needs beyond the prototype stage. When owners look for funding from early stage investors, such as angels and venture capitalists, their goal is to raise as much capital as possible without giving up a large portion of their business ownership. This strategy tends to favor high business values – the higher your pre-money valuation, the less business ownership you give up to raise the amount of capital required.
Key employee stock options call for low business value
On the other hand, you would like to attract and retain key employees with cheap stock options. Bear in mind that tax and securities authorities require that the stock option strike price be at the current fair market value. This means that you need a low start-up business value for realistic and defensible stock valuation!
Disguised compensation pitfall
As your young company prepares for an IPO, you may be tempted to issue cheap stock options to founders and key employees. However, government securities agencies such as the US Securities and Exchange Commission (SEC) keep a watchful eye on such late stage option grants and IPO stock prices.
If they believe that the IPO price is too high compared to the option strike price, they may assume that you underpriced the pre-IPO shares below their fair market value. In the interest of protecting all company shareholders, the SEC may take these option grants as a disguised form of compensation. Needless to say, this may have significant tax and legal consequences for the business and its founders.
We discuss the fundamental economic principles behind each of these approaches in ValuAdder Business Valuation Guide. The question you may have: what is the best choice of approaches and valuation methods to determine the value of a young company? Let’s consider how each valuation approach fits this situation.
The asset approach and its valuation methods generally work well for asset-rich businesses. A typical technology-based start-up has most of its value in a set of intangible assets known as Intellectual Property. Generally, it is quite hard to assign a value to such assets within a start-up. Their cost may vary considerably and there is no reliable history of income such assets can produce. As a result, the methods under the asset approach are rarely used to value a young start-up.
The market approach to valuing a business relies upon relevant comparisons to similar businesses that have actually sold. Since few young start-ups sell, there is little evidence of selling prices that offer a good comparison. This makes estimation of the start-up value difficult under the market approach.
This leaves us with the income approach and its valuation methods. These methods require income projections and assessment of the risk associated with receiving the income. Owners of a start-up need to prepare detailed business plans which include financial performance forecasts. In the absence of actual financial performance history, these forecasts can be used as inputs into the income-based business valuation methods.
Valuing a start-up: discount and hurdle rates
For a young company, it takes a leap of faith to assess how realistic its forecast is. Are the projected sales levels achievable? What will the competitors do in response and how will it affect the product or service prices? How well is the key intellectual property protected against cheap substitutions? These and many other questions need to be addressed when assessing the risk.
This risk is translated into the appropriate discount rate, another key input into the income-based valuation, such as the Discounted Cash Flow. It is not unusual to see discount rates in the 30 – 50 % range when valuing a start-up. A 50% annual return means that your original investment grows to over 11 times its initial value within 6 years.
Bear in mind that a venture capital firm may have a “numbers” strategy in its investment portfolio. For example, the VC can expect that only one out of every ten portfolio companies succeeds. If the remaining nine investments don’t do well, the returns realized from the successful company must compensate for the loss. This return may be built into the VC‘s hurdle rate – the required rate of return used to screen proposed investments.
If you know what the investor’s hurdle rate is, then you can check your financial projections to ensure that your business growth matches the VC’s investment profile. For example, if the VC expects 50% annual return and is prepared to wait for 6 years for a liquidity event (IPO or business sale), then your business plan must support an 11-fold increase in business value.