While today’s post is not exactly Part II of last Tuesday’s post (Valuation, Sale and Succession Planning – The Right Timing Dilemma), there is an important overlap…One that is always talked about but at the same time it’s one of the least understood…Let me offer a clue through a question:

What is the second important thing that gets the most attention when it comes to a sale of a practice/business?

What do you normally hear or read when it comes to a sale or M&A transaction in our industry?

If you have started thinking by now, let me guess what you are thinking and give you another clue… Are you probably thinking first about the first important thing before you attack the second one? And chances are you might have correctly guessed the first one…It’s valuation or how much the firm was sold for…Am I right? Therefore, the second important thing cannot be valuation or the value of the firm…I guess I have given some very strong clues…Haven’t I?

Many (if not all) of you might have even guessed that the second important thing that gets the most attention is the multiple…What multiple did this firm get? And for most solo practitioners or even a two-partner firm, the most common metric that is discussed is the Revenue Multiple or Recurring Revenue Multiple (RRM). There are other variations of multiples such as EBITDA Multiples, Net Profit (or Cash Flow) Multiples, and the more common PE Ratio that is generally used to value publicly listed companies… However, recurring revenue multiples get a lot of attention in our industry (even globally). Why may you be wondering?

One reason is that sellers almost always rely on a rule of thumb based on a multiple they read in some trade press or heard in a study group/WhatsApp group/ industry convention. A special point to note is that a rule of thumb always relies on the past and not the future…Confused? Allow me to explain what I mean…

In simple words the rule of thumb (when it comes to multiples) implies that the business will continue to operate at least at the same performance level it has before. A key point to understand here is that value is always a function of the future, not of the past…But a reliable way to look at the future is to also look at what has happened in the near past, the last three to five years.

When one thinks about a revenue multiple, essentially one is valuing the business based on what it has done in the past rather than on what it is likely to do in the future. Most firm owners (prospective sellers) don’t really think of this point, but most sophisticated buyers understand this very well. Thus, they look at hundreds of variables across client demographics, client service model, value proposition, internal team/leadership, risks, firm’s growth engine, systems and processes, client acquisition capabilities, competition, cost structures necessary to take care of existing clients, and so on.

Prospective sellers rely on this rule of thumb as that’s the only data easily available about private market transactions. However, most firms have an earn-out or performance contract-built in…so the real value is never known until the earn-out phase is over…but more on this in another post explaining earn-outs and deal structures.

I now share an interesting visual I received from my colleague about some data shared by an RIA M&A Consulting Group in the US…Since I don’t have the source of this visual available, I am unable to attribute this to the right source…