There are many types of professional practices. Examples include medical, architecture, engineering, accounting, advertising, design and law. From a business valuation perspective, it’s important to recognize the common denominators these businesses share.

Reliance on intangible assets

Professional practices provide services rather than sell products (at least primarily). In addition, education, licensing and continuing education requirements may limit the individuals who can own and operate a professional practice. So, they tend to rely heavily on intangible assets, such as:

• Business and owner reputations,
• Client lists,
• Trained, assembled workforces,
• Procedural manuals,
• Noncompete agreements, and
• Professional licenses.

Professional practices rarely report these intangibles on their balance sheets. Some valuation engagements — such as those related to a divorce or a business combination — may require valuators to identify and assign value to certain intangible assets. In other situations, it may be appropriate to lump unidentified intangibles into a catchall category called “goodwill.”

Use of non-GAAP accounting methods

Professional practices are rarely publicly traded, and many don’t follow U.S. Generally Accepted Accounting Principles (GAAP). The use of nontraditional accounting treatments may require financial statement adjustments during the valuation process.

For example, many practices use a blend of cash, tax and accrual accounting techniques. Some report revenue for work billed; others defer revenue recognition until cash is received. A few estimate work-in-progress for work completed but unbilled. Some record payables, prepaids and accruals, but many deduct expenses only upon writing checks.

Keys to accurate professional practice valuations include understanding the accounting methodologies the firm and any comparable firms use and adjusting financial statements to ensure reporting occurs consistently. Apples-to-oranges comparisons will skew valuation results.

Other factors

Although not entirely unique to professional practices, several other factors may be relevant when valuing them, including:

Earnings capacity. On a going-concern basis, earnings capacity — rather than hard asset values — drives the value of professional practices. So valuators commonly use the market or income approaches to value them, rather than the cost (or asset-based) approach.

Spending habits. Valuators must consider discretionary spending and replacement compensation. For example, sole practitioners commonly commingle firm and personal assets or deduct quasi-business expenses, such as country club dues or luxury auto lease payments. Similarly, professionals may over- or undercompensate themselves, depending on personal needs or firm cash flow. These items may require adjustments to the financials.

Key person risks. The value of a professional practice is often tied to its owners’ skills, reputation, contacts and experience, especially if the firm is small or unestablished. Uncertainties facing potential buyers of a professional practice include transferability of ownership and retention of client base. Thus, age, health and retirement plans of key owners and employees often affect a professional practice’s value. Valuators typically quantify the risk of losing owners or employees with key person discounts. Or they might factor key person risks into their discount (or capitalization) rates.

Differentiation strategies. Some professional practices stand out from competitors by offering specialized or expanded services. In doing so, they might charge higher fees for these services. But specialization also may bring additional risks.

Valuators also consider the composition of the revenue base. For example, a practice that relies on one client for more than 10% of its annual revenue may be riskier than one with a well-diversified client base.

Get it right

Professional practices present distinctive valuation challenges. Experienced business valuation experts understand how to convert the qualitative aspects of a professional practice — including its intangibles, owners’ habits and business strategies — into a quantifiable estimate of value.

(This is Blog Post #1409)