"Coach's Forum" is a place in which you can ask your questions, tell your stories or give your opinions on any aspect of practice management. For each column, George selects the most interesting and relevant comments from readers and offers his advice. Our objective is to build a community of people with a common interest in making their financial advisory practices as effective as possible.
Advisor says: After years of marriage, my spouse and I are divorcing. The process has been relatively amicable. However, where we disagree most is in the valuation of my practice for the purposes of splitting our assets.
Not surprising, given that we have enjoyed a good lifestyle because of the cash flow from my business, my spouse's lawyer wants to place a much higher value on the practice than I think is reasonable. He is using the term "fair market value" (FMV).
I believe he's relying on my spouse's anecdotal stories of what other advisors have sold their books of business for to come up with his valuation. I want to be fair, however. Having read several of your columns on practice valuation, I wonder if there are any special considerations in the instance of divorce.
Coach says: Although divorce is seldom a pleasant experience, you can take some consolation in the fact you're not alone. According to Statistics Canada, about 40% of marriages end in divorce, when both first and second marriages are considered.
Therefore, it's not surprising that the financial advisor community would exhibit a similar pattern.
Consequently, valuation of financial advisory practices for purposes of determining net family property value under provincial family law is quite common. And, yes, there are differences between valuations for this purpose and standard valuations that should be taken into account.
The first difference is that valuation in a divorce situation often requires the valuator to look backward - to the date of separation - in order to place a value on the practice at that time.
As you may have experienced, the matrimonial settlement process can take a long time, even years. Market conditions, the economic environment and the marketplace for advisors' books of business can change over a couple of years. The valuation, therefore, has to determine fair value as of the date of separation, not as if the valuation were taking place today.
Second, because there's no actual buyer and seller, valuing an advisor's business for divorce or litigation purposes differs from valuing the same book of business in a real-life transaction. In the latter circumstance, other factors come into play, including:
- potential synergy between the buyer's business and the book being acquired
- capacity and capabilities of the acquiring advisor
- differences in perceived opportunity and risk.
Consequently, the valuation of an advisor's book of business for matrimonial settlement must be based on a proven methodology that - while not ignoring the emotional aspects of the situation - brings appropriate perspective and rationality to the discussions between the parties.
Relying on "stories on the Street" regarding the amounts of money that practices have been sold for, such as you suggest your spouse is referencing, also can be misleading because, in our experience, when all terms and conditions of a deal are considered, sellers often exaggerate what they received and buyers often understate what they paid.
The underlying principle specifically related to valuing an advisor's practice is that value is based on the profitability that the practice is expected to generate in the future - not how the advisor's business has done in the past.
Consequently, the point that bears repeating is that valuation for divorce settlement should consider the future potential as it existed at the time of separation, not the results that were achieved between that date and the date of any current valuation.
- Fair market value
Let's consider the option of FMV, which your spouse's lawyer has suggested as the basis for valuation.
As you know, FMV is a specific term relied upon in tax-related matters and frequently used in divorce proceedings to value, for example, shares of a publicly held company, a residence or a valuable piece of art.
In my view, however, the notion of FMV doesn't apply in general to advisors' books of business nor, more specifically, should FMV be used for purposes of matrimonial settlement.
My reasoning is that the broadly accepted definition of FMV is: the highest cash price achievable in an open and unrestricted market between a willing buyer and a willing seller, in which both buyer and seller are knowledgeable and informed and are acting freely and independently of each other.
In general, FMV does not apply to advisors' practices for three main reasons relative to the definition above:
First, the highest cash price achievable cannot be known because most deals are not transacted for 100% cash up front. Only the seller really knows the subjective, qualitative aspects that could make his or her practice worth more than another of comparable size - including client demographics, client loyalty, referral rates and process efficiency.
Furthermore, there's no database or organized "practice exchange" through which past transactions can be used as references to appropriate valuation.
Second, the market is not open and unrestricted. Only those qualified by certification and licensing and with dealer/firm sponsorship may practice as an advisor.
Advisors also are limited by regulation or dealer policy in the advice they may give, the products they can offer and the methods by which they promote their businesses.
In addition, advisors have a responsibility to put clients' interests first, which dictates a certain business operation.
Third, buyers and sellers of advisors' books of business are not knowledgeable and informed. Most have little or no practical experience in buying or selling a book of business. They tend to rely too much on quantitative measures without sufficient attention to the qualitative aspects of a book of business. And they have inadequate financial records to accurately predict future earnings.
More specifically, FMV does not apply to advisory practices for purposes of matrimonial settlement for two reasons:
The notion of a willing buyer and a willing seller does not exist because there's no actual buyer or seller, and valuation is being forced by the process of divorce.
Second, acting at arm's length doesn't accurately describe the situation in most instances. That's because either party or both parties may have control or influence over the other that might cause him or her to act in a manner that is not at arm's length.
- Fair value
In my view, "fair value" is more accurate than FMV for valuing most advisory practices.
This measure considers not only future revenue and profitability, but also the risks associated with that revenue and profitability continuing.
Consequently, in the valuations we do at our firm, we take into account percentage of recurring revenue, sources of revenue, pricing policy, expense ratios, product mix, client demographics, economic environment, the marketability of the advisor's books of business and myriad other factors. We are looking for nuances in a practice, compared with others, that might warrant a premium price or a discount.
Another benefit in favour of fair value vs FMV is that fair value enables us to differentiate between "lifestyle" practices and "enterprise" practices.
Many advisors have built great businesses that afford them a wonderful standard of living based on cash flow from clients because of factors such as the advisor's personal charisma, special skills, network and salesmanship. In many cases, however, those attractions disappear when the advisor sells, leaving little long-term value for a purchaser.
I have no bias against a lifestyle business; in fact, I have built one for myself. However, all other things being equal, lifestyle practices are worth less than those with enduring features that carry on after the founder sells the practice.
These points highlight the merit of the valuation being completed by someone who understands the advisory business and considers: what creates value in your practice; how it would be transferred from you to another advisor; the current market for practices; and the marketability of your specific practice.
Finally, as I have written often, any final agreement between the parties ultimately will be determined by considering not only the outcome of any valuation, but also the level of desire each party has to reach an agreement.
In a relatively amicable settlement, as you have described your situation, if both you and your spouse accept that "approximately right is better than precisely wrong" with respect to the valuation of your business, you are likely to achieve a resolution more quickly and with less discord.
I hope this helps you in your divorce negotiations.
George Hartman is CEO of Market Logics Inc. in Toronto. Send questions and comments regarding this column to firstname.lastname@example.org. George's practice-management videos can be viewed on www.investmentexecutive.com.
© 2017 Investment Executive. All rights reserved.