Developing & Realizing Business Value

AGN Global Business Voice: International Business Issues

Are you interested in a valuable proposal?

Almost every week, many accounting businesses are getting “those calls“ related to business value. In some respects, it’s really nothing new. Larger firms have absorbed smaller ones for many decades, and from time to time, we have seen externally funded consolidators active in the market. It’s certainly the experience in the US and Europe and parts of Asia that famous accountancy brands, regional or local, have been absorbed into larger internationally branded firms or even into technology businesses. (Read our June 2022 AGN Global Business Voice – The New Consolidators?)

But could it be different this time? Certainly, the pandemic has catalyzed a number of trends that have been brewing for a long time. And now it would appear that business valuations are at an all-time high. Tempted? Inevitably, every situation has “a number”, but it could equally be that the offer is not there, and neither is a clear path for the next generation. You need to realize the value you have generated in your firm for your own future. What to do?

In this Global Business Voice, we take a look at the present environment for valuations, unpicking some of the key features and trends, and then suggest some practical steps that AGN members can take to maximize their position – Develop and realize business value. The author draws experience mainly from the US and Europe, and it’s accepted that the situation may vary in different regions across the globe.

Establishing ‘Business Value’ has never been straightforward.

Compared to a business, for example, with a substantial asset base or a unique proprietary process, “value” in professional services is traditionally considered ephemeral. This is because it depends on the retention and motivation of talented individuals (who can only be secured to a limited extent), delivering to well-informed and demanding customers complex intellectual property that is hard to differentiate from competitors. Right now, like never before, the industry is subject to dynamic change, fuelled by revolutions in technology, the requirements of human talent and, most recently, flows of new capital.

Historically, activity in the sector was driven by those working in it rather than external professional investors. Both valuations and deals depended on somebody, usually a senior partner in a larger firm, looking at a target and deciding, “Is this opportunity going to give me and my partners a better living, and will it build our coverage and reputation?”.

Why a multiple of revenue?

As far as valuation itself was concerned, features like profitability rates and future cash flows were always obscured by the intimate and complex financial and other arrangements of the owners working in the business. That’s what drove the approach of valuation based on revenue and, in particular, revenue expected to recur annually.

A benchmark multiple of 1 x revenue was often considered a starting point, often with an adjustment for net assets. In reality, perhaps a multiple in the range of 0.6 and 1.3 describes the historic situation more accurately. But it was still merely a proxy to estimate future profit and cash flows. Where in the multiple range you landed could vary widely, depending on gross margin rates, growth prospects, the proportion of recurring to non-recurring fees, cost base and overheads, and a multitude of other factors. But all in all, you were probably ending up with a valuation of somewhere between 3 and 4 times annual net earnings (EBITDA).

At its heart, the traditional approach revolves around the conventions of a “profession” – a business dependent on complicated and risky technical judgments from highly experienced and skilled people who were themselves working in that business. It was primarily an internal view about “practising the craft” of accounting and making a good living as an equity partner. Arguably, it’s the direct opposite of the view of an external professional investor.

External professional investors – a different mindset in a sector that’s changed

Many AGN members can testify that there is a very different approach employed by the present crop of external professional investors. And often that can lead to a seemingly lucrative offer and a higher order of magnitude than we have seen historically.

External professional investors regard the sector as a highly profitable, cash-generative, and low-risk business. The questions in the mind of these investors do not concern their own careers and daily working lives in the business but are about maximizing value and minimizing timescales: “Can I hike rates of profitability in this model by using technology or increasing team leverage/gearing? Or better yet, both. Can I scale up the model by acquiring market share? Can I drive growth by cross-selling new services?”

The attitude is summarised by the reported comment of some investors that they “are not a pension fund for partners at the end of their careers”. It’s a substantially different mindset – and at the moment, it leads to higher valuations, and particularly if the target firm has a strong niche focus, technology that can be leveraged, or is on an attractive growth path. And, of course, none of this is wrong; it’s just a different approach.

So what’s changed to make “the professional craft” into just another business investment opportunity? Undoubtedly, the demographic wave of equity owners looking for retirement is a significant factor. There is also the perception of uncertainty about whether a new generation of professionals is prepared to invest and wait for advancement in the same way as the present crop of equity owners did. But perhaps the mega-trend here is technology, with ever-increasing capabilities and ever-lowering barriers of entry. The pandemic probably accelerated all these factors, and also provided “proof of concept” for new ways of working, and demonstrated that clients will accept them.

An external professional investor’s approach to business value

Historic external professional investment forays into the sector have frequently been unsuccessful. Some suggest that (in the UK at least) the present mindset and new momentum can be traced back to 2016 and Azets, who originated as the accounting division of the Visma Group, a Norwegian-based technology and services company. Backed by private equity and driven by a vision to establish itself as a pan-European mid-market accounting powerhouse, in 2016, they acquired the UK firm of Baker Tilly and went on to acquire and integrate some 90 accounting firms across Europe. They now have around 7,600 professionals servicing more than 93,000 clients, generating approximately £700 million in revenues.

By leveraging advanced digital tools and automation, Azets planned to deliver efficient and streamlined accounting services, enhancing client satisfaction and operational effectiveness while maximizing the profit opportunity. Is it for real?

Well, in June 2023, the original private equity backers of Azets (Hg) took in a co-lead investor (PAI Partners) – the deal terms were not made public, but earlier in the year, there was city speculation of an overall valuation of between $1 billion and $1.5 billion1. So, just for old-time’s sake, that’s probably somewhere around 1.5 times current gross revenues (or around two times, based on the last reported numbers).

But in this, and most transactions in the sector now, multiples of revenue are not so much used, and earnings before interest, taxation, depreciation and amortization (EBITDA) are the focus. And if historically the sector was achieving 3 or 4 times EBITDA, the talk now is of a rising trend of anywhere between 5 and 10. Indeed, we are aware of one deal where the gross revenue multiplier would probably be around 2.5 times, which pretty much equates to the top of that EBITDA range. And perhaps there could be further to go. In the technology sector, multiples of EBITDA have reached levels of 12 or 14 times. There can be little doubt that the race to embrace technology has significantly driven these attractive valuations and gives some indication of how markets value the future prospects of that sector—yet another reason for firms to invest in technology and get up to speed with digital transformation.

Prices can’t keep rising – can they?

Market valuations are historically high and may perhaps have further to rise. But it is worth making note of some cautionary observations:

• The legal sector has five players in the Magic Circle. Right now, the top tier of accountancy has the Big 4 (or 6?), management consultancy 10, probably 4 to 6 global actuaries. So for the mid-tier/SME, focused accounting and advisory business, at what point do we reach market saturation? Whether you view markets locally, nationally or globally, it seems clear that demand will not support an unlimited number of successful players. And, of course, external professional investors know it – approaching a perceived point of market saturation will have a knock-on negative effect on values.
  
  
• There is a huge assumption here that technology developments deliver economies, efficiencies (and new services), and support the strategy to aggregate firms. But, on the contrary, might technology also drive fragmentation? Artificial intelligence technologies became useful and ubiquitous very quickly (ChatGPT – 4 months). We’ve also seen powerful innovations tend to come from start-ups, individuals, and small businesses. For example, in the UK, surely technology has helped drive the 40% increase in small independent practices and bookkeepers, increasing from around 55,000 to 77,000 since 2018. Doesn’t this chime with Generation Z’s propensity to reject conventional career patterns, the work-from-home movement, and the current dearth of qualified talent?
  
  
• Whatever generational label you care to apply, is it right to assume that upcoming young professionals will accept roles with less annual compensation and less autonomy than the present crop of equity owners, all in exchange for employee shares/options which they hope will one day be worth a lot of money? We comment above on a perception that this new generation of professionals is not prepared to invest and wait for advancement. But does that underestimate the entrepreneurial spirit and desire for relative autonomy, which has always been so attractive to professionals working in smaller firms? Much like technology, there are some big assumptions being made here.

Right now, we could perhaps be living through a golden era for the valuable small and medium-sized firms to cash out. Of course, that cannot and should not be ignored. But so far, at least, accounting and advisory business, at what point do we reach market saturation? Whether you view markets locally, nationally or globally, it seems clear that demand will not support an unlimited number of successful players. And, of course, external professional investors know it – approaching a perceived point of market saturation will have a knock-on negative effect on values.

SOURCES:
https://news.sky.com/story/accountancy-firm-azets-owner-runs-numbers-on-1-5bn-sale-12665320
IRIS Industry analysis Feb 2023

External finance? It’s not for everyone.

In the end, perhaps the realization of ‘value’ of an accounting firm comes down to vision and direction (and their close cousin ‘culture’) – what do the participants in a particular business regard as “valuable”? What type of professionals are you and your firm? Thus, what approach is most likely to deliver your objectives? Below we describe two scenarios, perhaps a little exaggerated for the sake of emphasis. The first may well suit an external investment scenario of the types discussed above. The second, perhaps less so.

Common vectors of business value – The AGN Value Key

(See Appendix 1 for practical application of the AGN Value Key)

The good news is that the underlying ingredients or vectors of value are the same, regardless of a firm’s vision or culture.

The AGN Value Key is a model that exhibits the enterprise “value elements” that need to be progressed to build enduring value in accounting and advisory businesses. The two scenarios above describe different combinations of the keys to value, with different value elements playing at different volumes or emphases, but they are all encompassed by the AGN Value Key. By identifying, investing in, and developing the correct elements, it is possible to assure the firm for the longer term as a valuable business.

The AGN model identifies and develops the required elements, which we describe below with some suggested key challenges of relevance to many AGN members.

In Conclusion – a bubble of opportunity?

Some lucrative opportunities exist to crystallize value because external investors are taking a different perspective of the sector. Unlike many historic investors, there is no consideration of their own careers working within the business. Instead, they perceive a low-risk, high-profit, cash-generative opportunity purely from an investment perspective. They believe that market share can be accumulated in a fragmented competitive landscape with an ownership demographic looking for an exit. Their view is that profitability and growth can be supercharged by leveraging technology, economies of scale, cross-selling new services, and returns on investment can be focused on a narrower pool of equity participation.

A fundamentally different view of the business is being taken, which is being used to justify valuations at two or three times historical levels. Presumably, this will either prove justified or unravel in the coming years, but either way, we could presently be in a golden age for the valuation of small and medium-sized
accounting advisory businesses. How long any “valuation bubble” will sustain is, of course, impossible to say. And indeed, perhaps it has further to inflate, especially when the FinTech sector is considered. In the meantime, high-performance and top valuations are, in our experience, being driven by businesses with an evolved plan for technology and the opportunities around ESG. This needs to be supported by a skill/talent plan, which not only meets these needs but drives resilience and succession.

But inevitably, markets for SME-focused accounting and advisory firms must surely have a point of saturation when the demand to acquire practices will decrease or dry up, and the valuations available will recede accordingly. It is, of course, up to the motivations of the existing business owners as to whether to seek participation in the present trend or to maintain a focus on businesses owned and managed by talented professionals who work in them. Either way, the implications for those working in those businesses are likely profound.

Is it over for the independent firm? Big players in the industry have traditionally always spun out entrepreneurial professionals who see the opportunity to own their own businesses and do it “their way”. Some observers believe that present trends will sustain (or increase) this talent spinoff phenomenon. Meanwhile, the costs and other barriers to accessing technology and other business facilitators progressively decrease, increasing the potential for start-ups and smaller businesses.

The landscape may be shifting as the second division reorganizes itself. There will likely be a high point in valuations and disposal opportunities, and that could potentially be close. But it may well be a mistake to assume that the days are gone of the independent firm owned and managed by the talented professionals working within it.

Epilogue – The Prelude Corporation

In AGN high potential talent training programs, we sometimes refer to the Harvard Business Review classic 1970s case study The Prelude Corporation. It tells the story of where “Big Business” tried to modernize, systemize and defragment the lobster fishing industry in New England USA.

Whilst the case clearly has some age, it remains a relevant and cautionary tale. Big Business failed in its objectives, and the business became unviable. Why? At the end of the case study, we share the following elucidatory quotation:

The point is that performance in the lobster fishing industry depends on the skills and experience of engaged and motivated professionals. They regarded themselves as hunters, not factory operatives – a “craft” if you will? They did not care to be supervised and systemized but craved autonomy to approach the task as they saw fit and their experience demanded.

It is not hard to draw parallels between our own industry and the present trends and changes that we have discussed above. Of course, much has changed in 50 years. But have the fundamental motivations of people? Or have other things changed sufficiently so that these pitfalls can be avoided? Perhaps so, but possibly not. We will see.

Appendix 1: The value key challenge – what might an investor look for?

The Value Key is an indicator of where management might most effectively apply their energy and resources, but it is also a lens through which to consider the business from the perspective of a prospective investor or buyer. Click here to download Appendix 1.

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