In our last newsletter, we explored the critical steps to listing your firm or business for sale and highlighted a sobering statistic:
According to the International Business Brokers Association, 80% of businesses listed for sale do not sell!
The primary culprit? – Improper pricing.
What is the proper price for your firm?
Like any investment asset – whether stocks, bonds, or real estate – a business’ value depends on two fundamental factors:
- The cash flow it generates, and
- The risk of that cash flow continuing into the future.
Think of it like this: When you buy shares of Apple or Microsoft, you’re buying their future earnings. The price-to-earnings (P/E) ratio tells you how much investors are willing to pay for each dollar of project earnings based on the collective perceived risk of the company’s business.
This applies to your firm as well.
The Cash Flow Component
Cash flow is measured differently in a small business than in a large public company. The two most common small firm cash flow measures are:
- Seller’s Discretionary Earnings (SDE), and
- Adjusted EBITDA
SDE is equivalent to the net income of the firm plus owner benefits and discretionary expenses. These include the owner’s salary, company 401K contribution, auto expenses, travel, family cell phones, and other perks that aren’t required to operate the firm. Because they’re expensed, the net income of the firm is reduced (and, most importantly, the owner’s taxes).
Adjusted EBITDA is used for larger firms (typically over $2 million in revenue). It starts with the SDE then deducts the fair market value salary and benefits to replace the owner.
Cash Flow to Price
A proper price for a firm is the cash flow multiplied an appropriate multiple. The multiple is the inverse of the return the buyer expects from the firm. A multiple of 4, for example, means that each year the buyer would receive ¼ of the purchase price back in cash flow, or a 25% return on the purchase price.
Multiples are industry specific and are adjusted upward or downward based on the characteristics of the firm being priced. If an industry or particular business is high risk, the multiple will generally be lower than another industry or business that is less risky.
For example, a law firm generating $350,000 in SDE might sell for $350,000 (1x multiple) if it’s highly dependent on the owner, or $800,000 (2.3x multiple) if it has strong systems, an experienced team, documented marketing systems, and solid growth potential. The return to the buyer would be 43.5% of the purchase price in the later case.
Assessing Risk
Risk factors of a firm that affect the multiple include:
- Consistency of Revenue and Cash Flow. Do revenues or cash flow vary widely from one year to the next? Are they growing consistently, flat, or decreasing? Is the ratio of cash flow to revenue consistent over time? Does the firm have clients on subscription or another form of recurring revenue?
- Financial Records. Are the firm’s financial records accurate and well kept?
- Marketing / Sales Concentration. Does one client represent more than 10 or 15% of revenue? Is one marketing method or referral source responsible for more than 10 or 15% of revenue? Is the owner primarily responsible for sales?
- Key Person Dependency. Is the firm too dependent on the owner or another employee? If the owner leaves, will they poach the clients? Are the systems and workflows written or in the heads of the employees?
- Market Position. Does the firm have a brand that is separate from the owner? Does it have a consistent repeatable marketing method that doesn’t rely primarily on the owner ‘doing marketing?’ Does it regularly communicate with present and former clients and referral sources?
- Legal. Does the firm have proper agreements in place among the owners, written engagement agreements with clients, and agreements employees? Is it properly and adequately insured?
Also, risk is not assessed from the owner’s point of view. The owner knows the firm and how to make it work. Rather, risk is determined from the buyer’s point of view.
And all things being equal, increasing value means reducing risk from the buyer’s perspective.
The ‘low hanging fruit’ for risk reduction in a typical firm includes:
- Getting financial and tax records in order,
- Documenting key systems (especially those that turn over often),
- Transferring client goodwill to the firm as a whole rather than an owner,
- Reducing client, marketing channel, and referral source concentration,
- Implementing a non-owner-based intake process, and
- Niching down.
By doing these, you’ll grow the value of your firm without having to increase cash flow.
Want to Learn More?
Download our free “Guide to Selling Your Florida Law Practice.” This insight will be invaluable to you in preparing your firm for an eventual sale.
Call us at 407-649-7777 to learn more about getting your firm ready for sale.
