Differential compensation is a forecast of upper bound values in cases where the optimal buyer for smaller firms with goodwill is a current employee or an employee of another firm is. These buyers will want some idea of how much better off they will be if they buy the firm. For such buyers, the next best alternative to acquiring the firm is to remain an employee. The best measure of comparative advantage for these buyers is derived by taking the present value of the expected discretionary earnings (DE) from acquiring the firm and subtracting the present value of the buyer’s future compensation if they remain an employee. The difference between the present values is termed the differential compensation of ownership. The comparison should cover not just the first few years of ownership but rather a time horizon that would include the remainder of the buyer’s career. Usually this will not be much less than twenty five years. The value of the differential compensation represents the size of the pie to be divided and not a reasonable bid for the equity. The example below will illustrate the differential compensation forecast.
Example. Peter Pennypinch, CPA, has operated a sole tax practice for several years. High blood pressure and years of tax season related stress has convinced him it is time to retire. Let’s begin with a simplified overview of Peter’s practice.
Peter has employed a senior level accountant, Leona Littlecents, who may be willing to buy his practice for the right price under the right terms. She currently earns $75,000 and her employment contract does not include a covenant not to compete. This means if she were to leave the firm she could take some of the clients she now closely works with if she decided to work for another accountant or start her own practice. Because Leona is familiar with many of Peter’s clients attrition will be much less than with any other buyer. Therefore, she is deemed to be the optimal buyer.
As a preliminary step to measuring differential compensation we have to perform a forecast of the discretionary earnings (DE) that would be available if Leona purchased the firm from Peter. In developing this forecast the key drivers of DE need to be identified. These include:
It should be stressed that for purposes of the DE forecast the key is to project the total amount of expected clients that Leona will service over the forecast period. This will take into account the clients that are transferred in as well as the number of clients gained. This is in contrast to the maximum competitive advantage (MCA) forecast which just looks at the transferred clients and the rate of attrition. The purpose of the MCA forecast is to determine the very most DE that can be realized from the transferred client base. The purpose of the DE forecast as a component of the differential compensation forecast is to indicate to Leona just how much better off in total that she would be if she bought the practice as opposed to remaining an employee.
For purposes of this example it is assumed that Leona will realize a 48% of gross revenue DE rate. This means that 48 cents of every dollar of gross revenue collected from clients. It will be assumed that initially 85% of Peter’s clients will transfer in. Due to dissatisfaction after the first year it is forecast that Leona will lose an additional 10% of these clients in year 2. After the first two years it is assumed that Leona will experience an annual attrition rate of 5%. It is assumed that the average of $400 of gross revenue per client that Peter currently realized will, adjusted for inflation, be realizable by Leona. Finally, there will be new clients gained each year offsetting the expected attrition losses. The expected net forecast DE available to Leona based on these assumptions is shown on the table below as part of the overall differential compensation forecast.
The point of the differential compensation forecast is to compare the DE Leona likely will realize buying the firm compared to the salary she could realize if she remained an employee. For purposes of the differential compensation forecast, we will assume that Leona could switch to another CPA firm and immediately command a higher wage because she would bring some new clients to the new employer. So we will assume that her immediate first year wage would be $90,000 as opposed to her current wage of $75,000. The starting DE and salary figures have been adjusted for inflation at 2% annually. A 4% discount rate was used in computing the net present values. As shown in the table below Leona’s differential compensation has a present value of about $994,000.
Care should be taken interpreting the meaning of the differential compensation forecast. First, like the MCA forecast, the total differential compensation is not what Leona would be expected to bid on the equity of the practice. Like the MCA forecast, the differential compensation forecast is an upper bound beyond which no rational employee buyer would bid. Second, the differential compensation measures the maximum potential additional compensation available in exchange for assuming the additional responsibilities of owning the practice. The present value of the differential compensation measures the maximum value of the responsibility premium available to Leona. If it turns out that Leona believes that an additional compensation with a present value of about $1,000,000 is not sufficient to compensate for the additional responsibilities of ownership then she will not bid on the firm since the present value of the compensation differential will go no higher.
It should be stressed that the DE forecast is not reduced by the amount that Leona would have to pay in order to acquire the firm. In effect the equity price has to come out of the differential compensation. This is the size of the pie that the employee buyer and the seller have to decide how to divide when negotiating the equity price.
Copyright 2018 Michael Sack Elmaleh