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Selling a Professional Service Practice – Part II

October 25, 2017

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In Part I of this series, Selling a Professional Service Practice: A Cautionary Tale, we explored common mistakes business owners make when selling their professional service business. In short, problems generally arise when there is little control over the process and a lack of communication on what the relationship will look like after the sale.

While professional service firms will generally have a variety of real and intangible assets that range from office equipment to proprietary software, the real value lies in the customer relationships. More specifically, the ability to maintain those relationships along with the related cash flow post sale.

In our experience at Smythe Advisory, if managed well, a transition of a professional business from one owner to another should result in minimal loss of clients. When we are preparing our analysis and financing proposals, we will stress test the viability of the investment by assuming our client might lose up to 35% of the purchased business. We find that, on average, the new owners lose less than 10% and often can add business through the introduction of innovative ideas and plain old enthusiasm. Having said this, it has always been hard to translate the benefits of future cash flows into high sale prices. In order to understand the issues at play, we do not have to look far. Some of the more common issues we encounter are as follows:

  • Professionals tend to value the technical work undertaken on behalf of the client. “Why should I have to pay for something when I will be doing all the work” is often assumed;
  • Most professionals are not entrepreneurial. Meaning they focus on the risks of making a bad deal rather than the benefits of a good one;
  • There is a misguided belief that they can quickly obtain clients for free rather than having to pay for them; and
  • There is a tendency to focus on price rather than return on investment.

Rather than focus on the problems, let us look at some possible strategies to ensure a smooth transition at a fair price.

First things first, you need an exit strategy. While there are many exceptions, it really helps if you have a plan for when you want to exit. If you do not want an exit, then do not worry about it. Keep working and let the business evolve and eventually wind down. The money you make while working will typically be more than made up from the capital you will get by selling. If you want to retire then you must start planning well in advance. I have always felt that professionals start to lose the energy and mental acuity necessary to be on top of their game by their mid-sixties. If you plan to leave the practice at sixty-three years of age, then it would be helpful to have a general plan in place four years in advance, at fifty-nine.

In preparation for your exit, you should create a road map for the purchaser showing them the financial and professional benefits of buying your practice at the price you believe is fair. Keep in mind, you will be up against plenty of traditional thinking on pricing. Engineering firms might sell for 3.5X earnings before interest, tax, depreciation and amortization (EBITDA), accounting firms typically start at $0.70 to $1.00 for every dollar of revenue and dentists at $1 for every dollar of revenue. Law firms, on the other hand, are problematic to sell and sometimes sell at a fixed price based on the number of clients or even the number of corporate record clients. We suggest you produce a financial information package that provides a detailed analysis of the revenue less expenses for the past three years.

In addition, have your model show what the potential return and cash flow might be post purchase. While you would expect purchasers to do this, you might be surprised how many do not. While most mergers and acquisitions (M&A) advisors would recommend against setting a price, rule of thumb pricing is increasingly prevalent in the sale of professional firms. Depending on your situation, we may or may not recommend you set the price. It is my view that a price that earns the purchaser an internal rate of return (IRR) of 25% and a pay-back of three to four years is a good place to start.

We also recommend that you run some form of auction. There are many good reasons to use an independent M&A advisor such as Smythe Advisory. Having said that, with a little help you can also run it yourself. A well-managed auction tends to result in the best price and terms. Purchasers will tend to put their best offer forward if they know they are competing to buy your business.

One area of constant frustration for the purchasers of professional service firms is that the owner or owners want to sell their business, but insist on having the benefits of ownership in terms of compensation and control. If handled correctly, a retiring partner can guarantee the eventual buyout and extend his career by a couple of years in a new and interesting environment. For this to work, everyone has to know what it will look like both professionally and personally.

Our last point of consideration is developing a transition plan with younger associates. I believe we are going to see more of these arrangements in the future. High performing millennial professionals tend to get serious about their careers in their mid to late thirties. They also do not have the patience to put in 15 years as an associate before being offered an ownership interest. While it is important not to promise what you cannot deliver, you can create a structure where the associate can see a path to ownership, along with higher income levels. Although a detailed discussion is beyond the scope of this piece, the structure should have the following components:

  • A clearly laid out exit from ownership by the principal
  • A financial plan that makes sense for both the associate and the principal
  • A timeline for when the transition will happen
  • Some form of shared risk on the quantum and timing of payments to buy-out the principal
  • An up-front financial commitment by the associate.

We have seen a number of very successful transitions, where the younger partners enjoy the benefits of ownership, the principal has a clear plan to exit and, as an added benefit, the former owner can extend their career in an environment where their knowledge and experience is needed and valued while avoiding financial tension. This type of ownership transition requires lots of patience and often a change in attitude by the original owner or owners. It can be difficult, but the rewards will make it worthwhile

It is inevitable you will stop working one day so you might as well plan for it.

In the meantime, if you have any questions regarding a professional service firm divestiture, please reach out to myself or one of the members of our Advisory Team.

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