Having previously given a general overview of consultancy financials and then having a closer look at revenue, our series now brings us to margins, which can make a big difference in how appealing your business is to a potential buyer.
There are different types of margins, but the two that consulting firm buyers focus most on are the gross margin and the EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) margin. It is very important to note that in the context of a sale process, both of these critical statistics can be “adjusted”, or modified from your normal accounting practice for managing the business, or paying tax. These adjustments are never intended to mislead a buyer, in fact the opposite is true. By moving some expenses to different categories, or eliminating some altogether, a seller is actually showing the buyer a financial statement that more accurately reflects how the buyer would view the financial performance of the business once integrated into their organization. The proper presentation can have a material positive impact upon value realized in a deal.
Gross margin is simply gross revenue minus the direct costs required to deliver services or engagements that generated the revenue. Direct costs always include the salaries and benefits of the consultants and independent contractors that delivered the work to the client; think of them as a fully loaded staff cost.
Direct costs should also include the time spent by partners in delivering client work, but not the time spent selling, developing intellectual property (IP), administering the business or writing blogs or other marketing activity. When we are preparing a client for sale, we will often analyze and adjust the direct costs for these items to ensure that the gross margin statistic accurately reflects the cost of delivering the company’s services, rather than also including the costs of running or growing the business.
This is important to a sale process because a buyer might make a judgement about a selling firm based on the gross margin percentage – if it is low they might think “perhaps there is a utilization issue!” However, if in reality there is significant partner compensation in direct expenses that should be in selling expenses, then the buyer is coming to a wrong conclusion based upon incorrect information. By way of example, let’s say a shareholder/partner makes $500,000 salary, and this normally appears in direct costs (thus reducing gross margin by $500,000). If, in fact, this partner only spends 40% of their time on client engagements, then 60% of their salary ($300,000) should be moved to the admin bucket (more on admin shortly). Therefore, gross margin is $300,000 higher.
EBITDA margin refers to the profit generated by the business after subtracting administrative expenses from the gross margin. Some administrative expenses are obvious, such as rent, the salary of administrative professionals and IT expenses.
A critical adjustment when calculating the real EBITDA statistic is related to allocating the shareholder bonus properly between compensation related to running the business and profit sharing (which would not be included in administrative expenses required to run the business). This can have a significant impact on a sale transaction: A seller might want to reduce his or her implied salary in order to present a higher EBITDA statistic to a potential buyer. However, in reality what they are saying in this case is that they are willing to work for that reduced salary after the transaction.
The final piece of the puzzle when calculating the correct EBITDA statistic in the context of a sale process is to remove any non-recurring charges that a buyer wouldn’t expect to incur under their ownership. For example, if you spent $25,000 last year on legal fees related to installing a share bonus plan for junior partners we would expect to remove that expense from the administrative bucket when showing a buyer what our “true” EBITDA is. As opposed to the adjustments discussed above, this actually increases margin by removing an expense from the income statement. A buyer will agree with the approach, however, as long as they would not have the same expense under their ownership.
Given the complexities of the various margin statistics, and the importance of getting it right first time when speaking to a buyer, it is critical that care and expert advice is taken to ensure the financials are correct.
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