Valuing a Selling Owner’s Real Estate Firm

The foundation of the sales process is the valuation. Much like selling a home, pricing a brokerage firm to market value is critical as we prepare a firm for sale.

As trusted consultants in the residential real estate industry, we get the privilege of working with firms of all shapes and sizes. Whether branded by a major national franchise or independent, flat-fee or graduated commission plan, small or large, at REAL Trends we’re here to guide our clients through some of the most important and life-changing decisions they make as owners. When an owner decides it’s time to sell, it’s our job to prepare them for what’s usually an emotionally challenging journey.

A Tedious Process

Unlike pricing a home, valuing a brokerage firm is quite a tedious process. The financials are a crucial component that guides value, but numerous other factors must be considered. Some of these factors may manipulate the financials as we build our model for value. Expectation management is a huge part of this whole process.

When the primary asset of firms in this industry are independent contractors who can leave whenever they want, it’s essential to understand the inner workings of an organization. With smaller-sized firms, we must take a close look at the concentration of sales, particularly the owners’ contribution to company dollar if they list and sell—which in most smaller firms is the case.

It’s About More Than The Multiple

Interestingly, most owners understand the basic principle of value as a multiple of profits. Unfortunately, some don’t understand the qualifiers that go into profits. I’ve had many preliminary conversations with owners who use the bottom line of their Profit & Loss Statement as the number for their internal calculation of value only to find out that the actual number they should be using is radically different.

In the valuation world, we use what’s called Adjusted EBITDA (earnings before interest, tax, depreciation, and amortization.) The “Adjusted” part of the equation is often impactful for firms where the owners list and sell.

Owner’s Compensation

If owners draw their commissions like the rest of the agents, the impact may not be as significant. If they don’t, the bottom line of the Profit & Loss Statement can be quite distorted. For example, if an owner generates $500,000 in Gross Commission Income and, at that level, the standard company split is 85/15, then they should be drawing $425,000 off the top.

This would result in Company Dollar of $75,000. Many times, we see owners not taking a conventional split and merely letting their commissions flow through the company. When owners do this, they pay themselves on the back end via distributions after the company pays all its bills, they get what’s left.

The problem is that when owners do this, their perception of company profits is misguided. I’ve had owners tell me that they have profits of $750,000. But, after analysis, we realize that this number is overstated because the owner ran their commissions through the company.

Using the example above, if the owner drew their commission like any other agent, then the company profit would be $325,000 ($750,000 in stated profits less $425,000 that is the owners’ commissions). Think of it this way; if this owner were to sell, then the owner isn’t going to give the new owner all his commissions; he is going to keep 85 percent.

Ultimately, the income factor of a valuation is what a new owner can expect to make on a going-forward basis, all things being equal. If an owner is not drawing on the top end from their commissions earned, then an adjustment must be made to reflect a reasonable income factor accurately.

This adjustment can be quite substantial. Again, using the example above, at a 3.0 multiple of adjusted profits, the value would be $975,000 (3 times $325,000), not $2,250,000  (3 times $750,000).

Other Considerations

There are other things to consider when it comes to how selling owners are compensating themselves. Are they drawing a salary? Is that salary at a fair market rate for the operational duties they’re performing? Are the owners going to remain with the company after a sale?

Are they going to continue to sell? Is the Company Dollar that the owners are generating on an adjusted basis a material portion of the overall Company Dollar? These factors and more should be considered as we build our valuation model. Owner activity is the first thing buyers look at when going through their due diligence. The bottom line: Expectation management is hyper-critical when preparing for a sale!