Are businesses selling on Profit or Recurring Revenue Multiples?

Welcome to Blog 4 of our 5-part series on whats your business worth. One of the top 3 questions we get asked every other week is whether practices are selling on multiples of profit or recurring revenue.

The answer is both!

When you purchase a business, you are fundamentally hoping to make a profit from the business. Every buyer we speak to, or client we have worked for on an acquisition, wants to know what profit they will “make” as a result of the acquisition. Some like to measure other metrics: many are only interested in free cash flow if they are using debt to fund the purchase; for some it’s return on investment; others payback period; for many it’s what they take home that matters.

Most of the transactions that are completed in the marketplace are the sale of a practice, or book of clients, by the owner to an acquirer who has an existing practice. Most often the acquirer already has premises, staff, business systems and infrastructure, so consequently when purchasing another business or client book, most often the acquired business is relocated to the acquirer’s office – the “bolt on transaction”. For many of these transactions, only part of the purchase price is paid upfront (usually 60-80%) with the balance paid a year or two later and subject to performance clauses.

This is where the complexity begins. When you buy someone else’s business and relocate it with yours, and the performance clauses for the balance of purchase price are based on profit targets, it can be difficult to reach an agreement on how the expenses are allocated to the purchased asset during the ‘earn out’ clauses. The vendor also takes a risk on how the purchaser manages costs within the business during the earn out period, and in many instances where the vendor has exited the business, that is simply not an acceptable risk.

The Answer

So the vendor is not impacted by any expense decisions the purchaser makes it is common for performance clauses to look at revenue, recurring revenue and client retention, leaving all expense decisions impacting the purchaser (whether they hire additional staff, whether they move premises etc.). The purchaser and vendor both want to retain clients and revenue in the transaction, aligning their focus. There are several different ways to structure a performance clause of this nature.

Whilst the purchaser decides how much profit, and therefore free cash flow they will make from an acquisition, offers are regularly made with a recurring revenue methodology for the reasons outligned above. This is despite larger practices being ‘valued’ on an Earnings or profit Multiples. The purchaser translates this Earnings Multiple back to a Recurring Revenue methodology in their offer, so a simple earn out can apply on the revenue.

This is where the point of scale of the buyer’s businesses comes into the valuation equation. If your business is sub scale, and acquired by another business that isn’t at scale, the recurring revenue multiple offer you receive will likely not be at the top end of the range. This is because the client base is unlikely to be as profitable to that buyers practice. The more profitable your business, the more a purchaser is likely to offer for it – even though the offer might be positioned as a recurring revenue multiple.

On the flipside of this, during 2020 we have completed business valuations on practices that have acquired other practices in the last year or two and what we saw was practices pricing on a recurring revenue model and not factoring in expenses that were transferring with the client base acquisition, such as maintaining a satellite office, keeping an adviser on permanently, or additional software licencing costs. What we find is that the acquirer can overpay for the practice, and negatively impact their own practice valuation by transacting. We suggest performing an evaluation on the transaction with both recurring revenue and incremental EBIT to check if the transaction delivers the required Return on Investment (ROI) and is viable, or if allower multiple should be applied to revenue.

In our next blog, we look at the EBIT and Recurring revenue multiples that have been prevalent in the market place over the last 12 months. If you can’t wait for that blog, then click here to download our guide.

Centurion Market Makers is a wealth management industry expert providing business broking services to owners of financial planning businesses, and specialist business advisory services to large practices and licensees. If you’re planning on selling your firm in 2021, we’d love you to call us at 1300 766 156 for a confidential discussion or continue browsing our website for more tips, tools, and info on the steps to take when buying or selling your financial planning firm.