Finance for professional services firms

A manufacturer borrows and a lender takes the machines. A transport business borrows and a lender takes the trucks. An accounting practice borrows and a lender takes a general security agreement over a business whose entire value walks out the door at six o'clock and chooses whether to come back.

That is the whole difference, and it runs through everything: which earnings are adopted, what secures the facility, how long the term can be, and which covenant is the one that actually binds. This guide covers accounting, legal, financial planning, broking, consulting, architecture, engineering and IT services firms, and the self-employed consultants at the smaller end of the same spectrum.

What actually differs

There is a fifth thing, and for many firms it is the binding constraint rather than any of the above: the gap between doing the work and being paid for it.

Work in progress, and the money you have already earned

A professional firm pays its people every fortnight and gets paid by its clients considerably later. Between the two sits work in progress, which is work performed and not yet billed, and then debtors, which is work billed and not yet paid. Added together they are usually called lock-up, and lock-up is funded out of the firm's own pocket.

Most owners track debtor days. Far fewer track the whole cycle, and the whole cycle is what consumes the cash.

Two things follow from that table. The first is that fifteen days of improvement releases about $99,000, which is real money that costs nothing to borrow and requires no lender's approval. The second is that a firm growing quickly consumes lock-up faster than it earns, which is why profitable professional firms run out of cash in good years rather than bad ones.

Earnings, when the owner is also the fee earner

In a professional firm the principal is usually the largest fee earner as well as the owner, and they decide their own pay. That makes reported profit close to meaningless as a measure of what the business earns, in either direction.

A principal who takes $80,000 and bills $400,000 makes the firm look far more profitable than it is. A principal who takes $350,000 out of a firm that could hire the same capability for $200,000 makes it look worse. Neither figure is what a lender adopts.

What a credit team does is cost the roles. It asks what it would take to replace the work the principals do, at market, and puts that back in as an expense. Everything above that is the return on the business rather than the return on the labour, and only that part services debt.

This is also the number that governs what a departing principal's share is worth and what an incoming one can afford to borrow, which is why getting it right matters well beyond the facility.

Buying a fee parcel

Acquisition in professional services is usually the purchase of a parcel of recurring fees rather than a business with premises and equipment. That changes what a lender is being asked to fund: not an asset, but the expectation that clients stay.

The questions a credit team asks are about durability rather than about the asset.

• How concentrated is the fee base? A parcel where the top five clients are half the income is a different risk from one spread across two hundred.
• How recurring is it really? Compliance work that repeats every year is not the same as project work that happened to repeat.
• Is the outgoing principal staying through a handover, and for how long? Retention clauses and earn-outs exist because this is the risk.
• What is the historic attrition rate, and is it evidenced or asserted?
• Does the buyer have the capability and the registration to service the work from day one?

Fee parcels are commonly priced against recurring fees rather than against earnings, and there are conventional ranges in each profession. Price is not our territory and we do not advise on it. What we do is test whether the earnings behind the price service the debt being raised against them, which is a different question and the one a lender is asking.

Security, when there is nothing to repossess

A lender to a professional firm typically takes a general security agreement over the business, personal guarantees from the principals, and, where it exists, a mortgage over property. The general security agreement is the formal position; it is not what the credit decision rests on.

The reason is straightforward. If a firm stops trading, the client relationships that made it valuable are the first thing to go, and a general security agreement over a client list nobody is servicing does not realise much. So these facilities are cash flow lending in substance whatever the security documents say, and they are assessed accordingly.

What that does to the term

Terms tend to be shorter than for asset-backed lending, because the security does not last as long as a building does. Where a principal brings property into the security position, terms lengthen and pricing improves, sometimes substantially. That is a real option and it is also a real decision: it ties the family home to the firm's performance, and it is not one to make on the strength of a rate.

The covenant that binds

The usual package applies, but the weighting is different. For an asset-backed business, cover ratios do most of the work. For a professional firm, leverage tends to be watched harder, because if earnings fall there is nothing to sell.

• Debt to EBITDA is usually the tightest test. It asks how many years of earnings the debt represents, and for a business with no realisable assets that number is the whole risk.
• Debt service and interest cover run as normal, tested at an assessment rate above the offered one.
• A current ratio test can be awkward for a firm carrying heavy lock-up, because work in progress is not always counted as a current asset on the lender's definition. Check the definition, not just the threshold.
• Some agreements add a covenant specific to the sector: minimum fee retention after an acquisition, or a cap on principal drawings.

What the file needs

Everything a general commercial file needs, plus the things specific to a firm whose value is intangible.

• Two to three years of financial statements and tax returns, plus current management accounts.
• A work in progress and debtors ageing, which for this sector is the single most informative document in the pack.
• A fee analysis by client, showing concentration and how much of the income is genuinely recurring.
• Principal remuneration set out separately, so the earnings can be rebuilt on a costed-role basis.
• For an acquisition: the fee parcel schedule, the retention or earn-out terms, and the handover arrangements.
• Details of every existing facility, because the new debt is tested on top of what the firm already carries.

The acronyms, in one place

What we can and cannot tell you

Andorra Advisory Group does not arrange credit and is not a credit representative. We build the analysis and the documents. Where a client wants the finance arranged as well, that is a referral to The Lending Lab Pty Ltd, a separate broking business, disclosed in writing at engagement. Our fee is fixed and payable regardless of whether finance is approved or what the analysis concludes.

So no lender is named here and no policy is quoted. Every threshold is a level commonly seen, and every lender sets its own. We give no taxation advice, no legal advice and no financial product advice, and we do not price fee parcels. Tax positions belong with a registered tax agent and legal positions with your solicitor.

If you are an accounting or legal firm reading this, you already know most of the accounting. What is usually missing is not the arithmetic but the translation: what a credit team does with it, and which of your own numbers it will not accept at face value.

General information only. Not credit advice, not a credit assessment, and not an offer of finance. Lending decisions rest with the lender and depend on your circumstances and their criteria.