Is One Times Annual Receipts a myth?

 

Often, I have heard sellers state that their firm is worth one times annual receipts. Sometimes this is true, but it’s not the best way to measure the value of a firm.

What surprises me is that this “rule of thumb” is floating around our industry. We, as accountants, should know that sales or receipts do not equal profit or positive cash flow.

Who determines value of the privately held firm? There are no stock market quotes on the value. The bank involved with financing any purchase may influence the value. The bottom line is what the prospective buyer will offer and pay.

Value is estimated in a number of ways

  • Cash flow – The cash flow of the firm must be enough to to cover the debt service related to the purchase of the practice and provide an acceptable return on investment.
  • Owner benefit – This calculation is based on owner salary, depreciation, amortization, interest expense and other expenses that are added to net income. If this was the only calculation, then you could take this percentage and compare it to other practices being sold to arrive at the average value of practices given their annual receipts. This percentage is often used by banks and prospective buyers as the starting point.
  • Experience of employees, age of client base, location of firm, industry of client base and related economic prospects  – These factors seem benign at face value, but can play a big part in the sale of a firm.
  • Technical infrastructure – Systems, policies and procedures, equipment, and software all play a part in the value.
  • Percentage of annual revenues dominated by a small number of clients  – Your value would be greatly affected if any dominate client were to leave.

The above list is not an exhaustive list and other factors can come into play.  Each of these factors should be considered when weighing what a buyer would pay or the bank would finance.

Is the firm’s value you are looking to purchase equal to one times annual receipt? What about your own firm?