Fair market value when a professional practice is incorporated
With the adoption of An Act to amend the Professional Code and other legislative provisions as regards the carrying on of professional activities within a partnership or company, the government of Quebec has made it possible for members of a professional order to practice as a corporation. Careful planning is essential when activities carried out by a professional or a group of professionals acting as a general partnership) are transferred to a corporation. One of the main steps in the process is establishing the fair market value of the professional practice to be incorporated.
What are the factors that make professional practices so unique and that influence their fair market value?
– First and foremost, professional practices are service companies. They do not make or sell a tangible product. Human capital is their primary asset. A large part of the transferred assets are, by nature, intangible assets.
– Most professional practitioners hold one or more licenses issued by professional orders. Professional practices can normally only be sold to another practitioner who is a member of the same order. This limits the number of potential buyers to professionals who have the same training, expertise, and experience.
– The value of a professional practice depends on the skills, reputation, and individual efforts of its practitioners. This component of a practice’s value is not easily transferable to a potential buyer. It’s known as personal or professional goodwill and is based on the fact that clients patronize the business mainly to see a specific practitioner. It is understood that if the practitioner leaves to go to a different practice, their clients will follow.
– Commercial goodwill, on the other hand, is generated by the success of the professional practice’s operations and is linked to the entity. Commercial goodwill often accounts for a significant portion of a professional practice’s value.
It is based on the fact that clients are not tied solely to the specific skills of one person, but to the location of the practice, the staff working there, the telephone number, the condition of the facilities and equipment, the reputation of the business, etc. In such cases, clients will continue to patronize the business even if there is a change of ownership.
– Finally, more so than for any other type of business, the value of one practice compared to the next varies according to the nature of its clients. In most cases, the value of the practice is generated by existing clients, the potential to retain them, and the ability to attract more.
Overview of the most common valuation approaches and methods
It is often said that valuation is more an art than a science. The valuation of a professional practice is not an exact science, and there are no formulas applicable to all types of practices. Valuation approaches and methods vary according to each situation. Above all else, valuation is a matter of judgement and perspective.
In general, since the value of a professional practice often lies in its intangible assets (e.g., human capital, client list, and so on), these factors tend to be ignored under the premise of liquidation value. Therefore, a professional practice should be valued as a going concern (using an approach that includes, among other things, the method based on capitalization of net profits) as opposed to the liquidation method.
Other valuation methods are also commonly used. These are market-based methods or rules of thumb. The latter are based on transactions that have taken place in the industry. Rules of thumb, however, only provide an approximate value and should not be used as the only valuation method since the estimated value they produce often tends to be higher than it should. For example, a common rule of thumb for accounting firms is that the value of the practice is equivalent to about one year of income. However, when we look at the transactions in more depth, it is not uncommon to find that this “year of income” is paid to the seller over a period of time and often without interest. In addition, the calculation is often based only on income from clients who stayed with the business after the sale. In these cases, the equivalent cash value is considerably less than the rule of thumb.
These basic concepts will help you work actively with your financial advisor as you go through the steps of incorporating your professional practice. You should always keep in mind that the