“When we look at that,” Maurer continues, “if there is an owner who is going to phase themselves out, we look at the compensation level for the owner and say, ‘If we were going to have to hire a very skilled professional to replace the owner, what would that professional require as compensation?’ So we would view that compensation as the correct compensation for [what the owner is taking] when we valued the firm.”
Another issue comes from the misunderstanding of owner-advisor compensation and profit, says Palaveev. “Advisors in smaller practices sometimes confuse income and compensation. Imagine that I have a practice with $1 million in revenue and $300,000 in expenses. In my eyes, I have $700,000 in income. So when someone talks about a valuation of 6 times EBITDA, I might be tempted to think my practice is worth six times $700,000 = $4.2 million = WOW!
“On the other hand, a buyer, especially an institutional buyer, may be looking at this and saying ‘Philip retires, we hire a successor and pay her $300,000 in compensation to run and grow the business. So we have $400,000 in EBITDA here ($700,000 in income less $300,000 in compensation).’ The value to the buyer is six times $400,000 = $2.4 million.
“This discrepancy between income and profit is a big issue in the marketplace for smaller practices. The income is fantastic but a large portion of it is not transferable.”