For most of their history, advisory firms were incredibly illiquid small businesses, and founders had to spend years or even a full decade training a successor in the hopes of having someone, anyone, to pay for the value of the equity that had been built. But over the past 15 years, a combination of low interest rates and an expansion of private markets and their access to capital has led to an explosion of mergers and acquisitions (M&A) amongst advisory firms, turning practices into remarkably liquid businesses, transacting at ever-higher multiples as a plethora of buyers bid up the prices for sellers. Yet as the media has increasingly reported on sometimes-eye-popping multiples, the reality is that because of how deals are actually negotiated and terms are written, the “headline” multiple is often not actually a fair reflection of what sellers are receiving in the end!
In this guest post, Rich Chen, founder of Brightstar Law Group, explores how real-world M&A deals are negotiated for advisory firms, and what, exactly, can lead to material divergences between the valuation multiple externally reported in a deal, and what the seller actually gets for the business, with the aim of helping sellers better prepare how to negotiate with buyers.
The starting point is to recognize that when a buyer offers a seller a multiple of revenue or profits (EBITDA), the buyer and seller still have to agree on how to actually calculate revenue or profits. And as it turns out, determining exactly what the revenue base or EBITDA base will be – against which the multiple is then applied – is not as straightforward as simply looking at the firm’s profit-and-loss statement for the trailing-12-month period.
When it comes to determining a revenue base, trailing-12-month revenue may be a common starting point, but buyers generally only want to pay for revenue they will receive after the purchase is closed – i.e., recurring revenue that will perpetuate in the future. As a result, any one-time receipts are often discounted or removed entirely from the valuation process. Similarly, any other revenue streams that come “off the top” of the advisory firm – revenue-sharing arrangements to referral sources, fees paid to a sub-advisor, etc. – are also commonly removed, as buyers want to pay for net revenue, not the gross that they won’t get to keep anyway. And to the extent that revenue is set, buyers will often apply a haircut to the revenue calculation for any clients who don’t actually consent to the acquirer’s advisory agreement (often with a 1-percent-not-retained-equals-2-percent-reduction-in-value penalty).
For firms that are valued as a multiple of EBITDA, the adjustments can be even more complex. If the advisory firm doesn’t pay its own founder a “fair market rate”, acquirers will typically impute a salary into the business to pay the founder and reduce earnings accordingly… which can materially curtail the valuation of the firm as a whole. (And ironically, in this context, acquirers often want to impute a very high salary for the founder, as they more than make it back in a reduced purchase price when the higher salary reduces earnings being multiplied.) On the plus side, any personal expenses routed through the business are often adjusted out (increasing EBITDA and the business valuation). The most controversial adjustments are expenses that are nominally “one-time” in the business, but that buyers may claim represent a recurring need for reinvestment – from paying for technology consultants, to office transitions, to non-cash compensation for key employees (that the acquirer fears will turn into cash compensation obligations in the future).
The end result of these adjustments is that the final dollars a seller receives on their adjusted EBITDA or revenue base could be substantially lower than what a headline number implies; a firm that thought it was getting 4X revenue that really gets 4X adjusted revenue might only get 3.1X its original revenue, and a firm that anticipated getting 10X EBITDA may only receive 8X after adjustments are done.
The key point is to recognize that buyers don’t simply buy an advisory firm blindly; with experienced buyers in particular, it is a meticulous exercise of scrutinizing the financial details of the firm, to ensure what they’re paying for will really drive a favorable outcome for their business as the acquirer. So beware putting too much weight into media headlines that showcase seemingly high multiples… as often the reality is that those multiples were calculated after adjustments specific to the business, and are not necessarily representative of the going rate for unadjusted top-line revenue or profits!
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