Practice Continuation Agreements: Placing a Value on Your Practice

Included in This Chapter:

• Valuation Overview
  
• Valuation of Tangible Assets
  
• Valuation of Intangible Assets
  
• Valuation Methods
  
• Valuation Allocation

Valuation Overview

You should place a value on your practice before you begin discussions with a potential successor. This will ensure that you know the worth of your firm and of your individual clients. You need this information to conduct meaningful negotiations on various aspects of the practice continuation agreement. However, this valuation should not be confused with the process of valuing a practice at the time it is sold. Your goal now is to establish a value to use as a basis for negotiations with a potential successor.

The following sections consider each of the factors involved in assessing the value of a practice when making a sale or purchase.

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Valuation of Tangible Assets

Fixed Assets
Equipment and other tangible assets can either be negotiated as part of the practice continuation agreement or valued separately. A separate valuation may be appropriate in group agreements or state society plans, but agreement to a flat offer for all hard assets such as computers, furniture, practice software and related licenses, and supplies can facilitate negotiations and simplify the valuation process. You may want to offer these assets in exchange for the down payment on the practice. The objective is to keep the valuation as simple as possible. Haggling over minor assets that may hold no value for your successor could sabotage an agreement. When land and buildings are involved, a formal real estate appraisal can be obtained to determine an equitable value.

Be aware that with group agreements it is unlikely any group member will want to relocate to your office or purchase any of your tangible assets. Hence, these assets can pass from the estate to your heirs. If a group agreement does not provide for their specific sale, the tangible assets should be sold for the best available price based on current fair-market values.

Accounts Receivable
When the practice remains intact after it is sold, accounts receivable are often purchased to maintain the appearance of continuity for clients. In this case, you need to guarantee the value of accounts receivable or use a discount factor based on past collection experience. Current clients may be discounted 10 to 15 percent for the cost of collection. The discount should be greater for doubtful accounts. In the event of death, the discount factor may be further increased as much as 60 percent. A separate accounts receivable subsidiary ledger is maintained to facilitate an audit of the accounts purchased if a repurchase is required.

When the estate retains and collects the accounts receivable, it employs the successor firm as a collection vehicle and pays that firm for its efforts. This is common in the event of death. In such cases, collection costs are usually set at 10 to 15 percent of the amount collected, and the successor is not responsible for uncollected items. To protect your estate, you may want to state in the agreement that no bill will be collected for less than its full value without prior approval by the estate. Again, a separate accounts receivable ledger is maintained for separate administration.

Work in Process
Work in process should be completed and billed by the successor, but placing a value on it can be difficult. Amounts charged for prior engagements should be compared to the expected charge for current engagements of a similar kind. The value of services and client collection records should be carefully assessed. If the successor purchases any work in process, you may be asked to guarantee its value. Of course, billing all current accounts is the best way to minimize this problem. The best policy is to keep work in process to a minimum by rendering progress billings and billing for services upon completion.

The practice continuation agreement should address the division of fees between your successor and your estate. However, payments for the practice and payments for work in process should be kept separate. To avoid the appearance of bad faith, the agreement can state that, if there is a great deal of work in process or if it is unusually complex, allocation of fees shall be subject to the approval of the probate court or a third party.

In most sales of CPA practices, work in process does not receive a value because it cannot be determined or identified. Even if the status of a work in process is identified, the successor who has purchased it usually must either restart the client service project or finish what was begun. Successors are therefore reluctant to purchase work in process.

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Valuation of Intangible Assets

The most critical and elusive element in the valuation of a practice is the value of each client. It is basically the client list that provides for the future income stream, but clients are an intangible asset. In many cases, client value is the only factor that needs to be considered, for example, when the fixed assets of a practice are of little or no value to the buyer.

Remember, you have a better chance of getting the price you desire (especially if the price is based on retained fees) if the prospects for client retention are high. If your client base is not secure, the value of your firm diminishes in the buyer's eyes.

Nevertheless, client attrition is inevitable. It is unrealistic to expect all clients to be retained when a practice is transferred from one CPA to another. Upon learning of the death or disability of their CPA, many clients may feel that they have been released from any business or personal obligation to the practitioner and will take their business elsewhere. But many others are inclined to remain with the successor rather than shop around for a new firm. It is therefore essential to inform your clients of an agreement with a hand-picked successor firm as soon as it is signed.

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Valuation Methods

There is no single, prescribed method or formula for assessing the value of a practice. Each firm is different  and must be evaluated individually. The four methods described below should be modified to fit your needs. Above all, avoid elaborate formulas or benchmark figures, and be prepared to be flexible when determining the value of your practice.

When preparing for the negotiations, it may be helpful to employ several methods to establish the range within which you plan to negotiate. The examples that follow are based on the sample firm described here.  In examples involving projected income, a discount rate of 15 percent was used to determine present value. The actual discount rates used in negotiations will vary with risk factors, such as the cost of available financing and the tax treatment of the purchase. The table below summarizes the sample valuation calculations. It shows negotiation values for the sample firm ranging from a low of $327,780 to a high of $959,220.

1. Multiple of Gross Fees. Historically, the value of an accounting practice has been determined as a multiple of gross fees. Some consider this a "pie in the sky" valuation because it does not take into account the firm's expenses and its ability to generate profits. The multiple can be quite arbitrary, and the gross fees generated in one year may be unusual and therefore not reliable. Nonetheless, almost all practitioners are familiar with this method, and it should therefore find some acceptance in any negotiation.

The negotiator should select the multiple carefully, using a description of the firm and its operating environment to justify the selection. For example, metropolitan practices may command a higher multiple than rural practices. Multiples usually range from one-half to more than twice the gross fees.

2. Earning Power. Another method assumes that the most important asset in the practice is goodwill. Goodwill means that the buyer will generate earnings faster and at a higher level by buying a practice than by starting one from scratch. The method compares the buyer's potential earnings from the purchased practice with the potential earnings from a new practice. The seller is paid for the effort and risk associated with the startup period. This is often called the earning power inherent in the firm.

The advantage of this method is that it forces the buyer to realistically determine the costs and risks of a start-up business versus the benefits of buying an existing practice. The buyer can use this method to persuade the seller to describe the permanent and reliable components of the practice. The method considers the net profitability of the firm.

The disadvantages of the earning power method arise from the difficulty a buyer may have in assessing the projected net income. Moreover, the parties can easily disagree over the selection of the discount factor to be used in calculating the present or future value of the firm.

3. Present Value of Future Net Income. This method attempts to assess the value of the net earnings that will be generated in the future by existing clients. The exchange value of the practice is determined by the clients who will remain and by the services they will require. The method can be very objective and may include agreements with specific clients on services to be rendered, long-term contract periods, and fee levels. It affords the negotiators the ability to agree on the costs of future services and, therefore, on their profitability.

The principal disadvantage of the method is the difficulty in reaching an agreement on the selection of a discount factor for calculating the value of the practice.