What drives the value of professional practices

Business appraisers must switch gears when valuing professional practices, such as law, accounting, actuarial or engineering firms. Unlike most manufacturers or retailers, professional firms generate cash flow predominantly from intangible assets. Key value drivers for professional practices include:

Management quality - Although some small practices remain administratively lax, many modern firms operate like large corporations, complete with formal policy manuals, extensive internal controls, and marketing and human resource departments.

Strong administrative controls add value. From a buyer’s perspective, quality management promotes financial statement transparency, expedites acquisition due diligence and facilitates transfers to new management.

Key person issues - In a professional practice, value often is linked to key partners and employees. This makes ownership transfer rather challenging. Management can use key person life insurance policies, non-compete agreements, employment contracts or formal management succession plans to mitigate the risk of losing key people and to enhance the practice’s value.

Service specialization - A growing number of professional practices offer specialized services. But although specialization may allow a firm to differentiate and charge higher fees, it can also add risk. For instance, specialized firms typically serve a smaller client base and thus may suffer from customer concentration risks.

And specialized project-based jobs are less stable and predictable than traditional, recurring assignments. To illustrate, as accounting firms transition from traditional audit and tax services to consulting engagements, maintaining historic revenues requires significant ongoing marketing efforts.

Financial statement issues - Professional practices may employ an inconsistent blend of cash and accrual accounting techniques. For example, some firms record receivables upon mailing invoices but omit unbilled charge-hours and unreimbursed client expenses. Others defer revenue recognition until they receive actual payments from customers.

Measuring earnings capacity also can be more complicated. Professional practices customarily distribute profits to enable owners to fund their share of the firm’s tax obligation. Besides net income, more meaningful gauges of a professional practice’s earnings capacity include operating cash flow or revenues per partner.

Because of these accounting nuances, appraisers often adjust their financial statements to get a clearer picture of the relative performance — and value — of professional practices.