The Four-Number Practice Screen

What does the Four-Number Practice Screen measure?

The screen separates revenue, transferable earnings, near-term cash, and contingent proceeds. It is an original planning framework for organizing a conversation, rather than a valuation formula or an industry benchmark.

The first two numbers describe the practice. The last two describe the offer. Keeping those pairs separate stops an attractive headline price from substituting for an operating model. A firm can produce substantial revenue while leaving little profit after replacing the retiring owner. An offer can also look generous while postponing much of the payment.

Start with the same accounting period for every input. A trailing twelve-month revenue report paired with an old annual payroll budget creates a comparison that cannot be reconciled. Record the source, period, preparer, and unresolved adjustments next to each number. The uncertainty belongs in the screen rather than in a footnote nobody reads.

How do you establish collectible recurring revenue?

Reconcile fees to collections, then identify the clients and services likely to continue under the buyer. A list of invoices shows activity; it does not, by itself, establish future collections.

Group clients by service line, billing cycle, and relationship owner. Separate tax preparation from monthly bookkeeping, payroll, advisory, and unusual project work. Identify clients with overdue balances or a stated intention to leave. Do not remove every imperfect account automatically. Show the issue and decide how the purchase agreement will treat it.

Protect client information while building this analysis. The IRS explains that tax-return information disclosed in sale diligence remains subject to Section 7216 rules. An NDA should not be treated as a blanket substitute for analyzing a permitted disclosure.

For an initial screen, anonymous client codes can connect revenue and collections without placing a named taxpayer list in every bidder’s inbox. Keep the identifiable information in a separate controlled location. Document any exclusions so the buyer can distinguish a confidentiality measure from missing evidence.

Why do owner-replacement earnings matter?

Owner-replacement earnings estimate what remains after paying for the work the selling owner performs. They answer a different question from how much the owner currently takes home.

Build a role inventory before choosing a compensation adjustment. List production hours, technical review, client management, staff supervision, business development, and administration. Decide which duties the buyer will perform and which require employees or outside help. A buyer planning to work full time and an investor planning to hire a manager need different budgets.

Suppose, purely illustratively, a firm has $870,000 of recurring collections, $555,000 of operating costs before owner pay, and a $145,000 replacement budget. The calculation is $870,000 minus $555,000 minus $145,000, leaving $170,000 before acquisition debt and taxes. Those inputs are assumptions, not market compensation data.

If the replacement plan needs a reviewer during filing season, include that expense. If an existing manager can absorb duties, test available hours instead of assuming free capacity. The supporting analysis connects to the broader valuation hub and the guide on accepted and disputed add-backs.

What belongs in cash available at closing?

Closing cash means the seller’s cash from the transaction after the deductions shown in the agreed closing statement. It should not include a future seller-note balance simply because the note appears in the purchase price.

Record the cash purchase component, debt paid off at closing, transaction expenses, escrow, working-capital adjustments, and amounts needed to release liens. Distinguish enterprise value from the seller’s equity proceeds. If the agreement includes a separate consulting arrangement, identify it separately rather than counting both consulting pay and sale consideration in the same line.

The IRS overview of business-sale allocations explains why a business transaction is not necessarily the sale of a single asset. The screen therefore includes an allocation question for the seller’s tax advisor, but it does not assign a tax rate.

Ask the advisor to prepare timing-sensitive tax scenarios. A dollar held for taxes is still the seller’s money, but it is not available for an immediate retirement expense. Keep gross cash at close, estimated tax reserves, and spendable cash in separate rows.

How should contingent proceeds be displayed?

Show contingent proceeds as a range linked to the actual agreement. A maximum earnout, seller note, and rollover interest are different assets with different payment and risk characteristics.

For an earnout, identify the eligible revenue, measurement dates, collection rules, cap, offset rights, and dispute procedure. For a note, identify principal, interest, payment schedule, security, priority, and remedies. For equity, identify the ownership percentage, dilution provisions, distribution rights, governance, and liquidity restrictions. None of those items becomes cash merely because it has a stated amount.

Use three cases: contractual maximum, a stated operating scenario, and a downside case. Explain the assumptions in each. If a proposed formula has no floor, the downside can be materially below the headline. If a fixed obligation remains enforceable despite client loss, show that distinction without assuming collection is certain.

The quality-of-earnings guide helps test the operating assumptions behind these cases. The rollover equity guide addresses an equity interest that cannot be evaluated like a scheduled payment.

What does an illustrative offer comparison look like?

Consider two fictional offers for the same practice. The example compares timing and risk without claiming that either price is appropriate for a real firm.

Assume each offer requires $42,000 of debt payoff and $28,000 of closing expenses. Offer A produces $640,000 before tax reserves; Offer B produces $490,000. Their headline maximum prices are $840,000 and $890,000. The second offer has a higher maximum and $150,000 less near-term cash.

Now assume the contingent payment is earned at 70% in an explicitly hypothetical operating case. Offer A adds $91,000 and Offer B adds $231,000. Total proceeds in that case are $731,000 and $721,000 before taxes and any discount for payment timing. Reconcile the arithmetic before discussing a preferred offer.

How does a buyer add financing to the screen?

A buyer adds a separate debt-service and working-capital test. Positive owner-replacement earnings do not establish sufficient cash for every proposed purchase structure.

The SBA identifies changes of ownership and working capital as potential 7(a) uses. That program overview is not an approval for a particular deal. Ask the lender to identify the current policy, required documents, assumptions, and conditions applicable to the borrower.

In the fictional practice above, assume annual debt service of $112,000. Dividing $170,000 by $112,000 gives approximately 1.52 times coverage before other required adjustments. This is arithmetic, not a lender acceptance threshold. A $35,000 operating shortfall would reduce the numerator to $135,000 and the ratio to approximately 1.21.

Map monthly collections as well as annual totals. A seasonal practice can have positive annual coverage and insufficient winter cash. The screen should lead to a cash calendar, not a declaration that the purchase is financeable.

How do you turn the screen into a decision?

Use the numbers to identify the next unanswered question. Do not average them into a score that conceals the terms or the quality of the evidence.

1. Reconcile the source reports and isolate unsupported adjustments.
2. Build an owner-replacement plan with named roles and a stated budget.
3. Recreate each offer’s closing statement and contingent formula.
4. Stress-test client loss, delayed collections, and staffing costs.
5. Give the buyer, lender, attorney, and tax advisor the same assumptions.

The four numbers form a decision record. Save the original version, mark revisions, and record who approved each material change. When the offer changes, update the cash and contingent rows immediately rather than leaving the financial model attached to an outdated letter of intent.

An incomplete screen can still be useful. A blank owner-replacement figure tells you that operating diligence comes before negotiation. An unclear earnout range tells you that contract definitions need attention. The framework works when it exposes uncertainty early enough to resolve it.