Valuation Insights: Six Ways to Optimize Your Organization’s Value

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Adapting Firm Structure and Strategy to a More Sophisticated Buyer Market

For firms considering a sale or merger, ending with the most favorable price means starting with advance planning. Knowing ahead of time what information buyers will need from you helps advance the process. And if you think you already know how acquirers determine the value of your business and structure the deal, it’s worth noting that every deal is unique. The financial factors firms like ours evaluate have changed as new capital sources have become available to our industry.

As the transaction market has evolved, deal value and pricing are now driven by a more institutional level of due diligence. Moving away from book value-based pricing, buyers now apply the private equity world’s more disciplined and rigorous approach, employing metrics more in line with broader institutional investment practices. Preparing for this heightened level of scrutiny is essential to achieving the valuation you seek.

New metrics are driving the M&A market.

The mantra is no longer “profit per equity unit” or “deferred compensation buyout multiplier.” Even transactions that may seem more traditional are subject to today’s metrics, pushing due diligence to an entirely new level. The following guidelines detail what information we will ask for to help you “think like a buyer” as you prepare.

• Profitability and cash flow metrics are paramount. EBITDA measures operational profitability independent of financing and tax strategies, while normalized working capital reveals how much cash the business genuinely requires to operate effectively.

• Revenue quality indicators help buyers assess pricing power and efficiency. Monthly or annual recurring revenue, upsell, downsell and client churn are coming into focus. While revenue realization rates show how effectively a business converts billable time into actual invoiced revenue, realized hourly billing rates demonstrate what clients ultimately pay, rather than theoretical rate card prices, a key indicator of market positioning as a value-added advisor.

• Risk and operational efficiency metrics are also key indicators. Client concentration analysis identifies potentially material dependencies on a handful of accounts that could affect future revenue stability as well as understanding growth driven by rate increases versus increases in hours or new clients. Employee utilization and partner leverage ratios reveal whether the company efficiently deploys talent across different levels, directly affecting profitability. Finally, offshore resource utilization reflects the seller’s cost structure and operational flexibility in an increasingly global marketplace.
  
  
• AI Adoption and process automation assessments help us determine whether these create genuine competitive advantage. We assess workflows, technology maturity, operational integration and the potential for strategic value creation. We examine data sourcing, training processes and legal compliance with privacy regulations. To project specific cost savings and productivity improvements we identify automation potential across service lines.

Together, these metrics provide buyers with a comprehensive view of not just current performance, but the sustainability and growth potential of the business once it is under new ownership.

Unlike most firms, we assess potential acquisitions using accrual accounting with normalized monthly results, not cash accounting. This provides a more accurate picture of a seller’s true financial health. Many smaller businesses and sole proprietors report on a cash basis, which doesn’t include unbilled time, account receivables or payables. This can mask underlying issues, particularly with work-in-process and accounts receivable that must be billable and collectible to have real value. By converting to accrual accounting before a sale, sellers can demonstrate stronger financials and often command better valuations. Modern accounting software makes the conversion straightforward, and the effort is usually well worth it.

Firms exploring a sale are well advised to adjust reported compensation to reflect what would be typical or standard in the market, rather than what current partners are taking as distributions (what is affectionately known as the “scrape” or the “slice.”) This is especially important for smaller firms whose partners often pay themselves irregularly or based on tax planning considerations. Normalizing partner compensation reveals the true profitability of the business and allows us to gain a more accurate view of its value.

Many firms structure partner retirements in the form of deferred buyouts. Owners, partners and other senior leaders typically vest retirement benefits throughout their careers in expectation of receiving a sizeable sum post-retirement. In some cases, as this payout may not be recorded anywhere, it may be overlooked until revealed in the due diligence phase of the transaction. It is then viewed as debt or a debt-like item, which can affect cash proceeds available for active partners. Identifying these promised payouts ahead of time enhances transparency and enables the buyer to illustrate how the obligations can be settled from the proceeds of the transaction.

As potential buyers, we seek the opportunities that emerge when firms join forces. Normalizing results eliminates any unique circumstances that might appear to reduce a business’s sustainable profitability. For example, one-time or non-recurring expenses such as large equipment or technology investments may not be repeated annually, so removing them from the P&L statement demonstrates increased, sustainable earnings. For some businesses, retired partner payments or practice payments may be included as expenses and should also be removed as the expectation is that the remaining obligation will be settled as part of the transaction. Or owners may compensate themselves at non-market levels or run certain discretionary expenses through the business; adjusting for these expenses demonstrates a higher profit and may lead to a higher valuation and purchase price

In the M&A arena, businesses are typically valued on earnings, not assets, which is the reason that buyers want to determine the level of working capital needed to operate the business smoothly. It must be independent of the owner’s management style, which can artificially inflate or deflate the working capital target. That estimate – current assets (excluding cash) minus current liabilities (excluding debt and debt-like items) – can be affected by high unbilled time or receivables, inadequate reserves and other factors. If a business maintains excess working capital, the buyer may require that amount of working capital to be contributed as part of the acquisition. If a business maintains insufficient working capital, the buyer may adjust pricing to secure the funds needed to run the business after the transaction is complete. For this reason, it is advisable for the seller to normalize working capital prior to entertaining an acquisition. The normalization may require changes in billing and collection practices to effectively reduce the amount of unbilled time and accounts receivable each month.

Gaining an in-depth understanding of the data, analyses and statements firms like ours expect to see can equip you to plan ahead for streamlined, effective due diligence. This promotes greater confidence among potential buyers and can help optimize business valuation, enhance the likelihood of a successful transaction and smooth post-merger integration.

Best Practice: The Quality of Earnings Report

Many of the guidelines presented above can be fulfilled by conducting a Quality of Earnings (QofE) analysis before going to market. The QofE facilitates an accurate understanding of the financial metrics impacting a business’s value and the quality of its earnings. The report analyzes a company’s financial position and performance. It examines past revenue, cash flows and earnings to ascertain a normalized EBITDA, adjusting it for non-recurring one-time items to avoid misleading anomalies. It identifies working capital on a cash-free, debt-free basis and can quantify the potential working capital target a buyer will expect to be delivered with the business. The QofE can prove to be highly valuable to buyers, sellers, investors, stakeholders, lenders and company management.

Contact Us

With extensive experience in financial accounting, M&A due diligence, investment banking and tax structuring, our team is pleased to address any questions and to assist in preparing you to take the next steps in your firm’s future. Please contact us directly.

Jonathan Moore
Managing Partner, Client Services
jmoore@pkfod.com | 201.639.5746