"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: Thank you for your informative article, "The many ways to bow out," which appeared in the May 2013 issue of Investment Executive. It caused me to wonder how financial advisors' books of business are evaluated for sale purposes.
For example, I have a $70-million book whose assets are allocated in approximately 40% individual stocks, 40% mutual funds and 20% exchange-traded funds. Half of my revenue is fee-based; and I expect to convert most of the mutual funds, which are front-end load, to fee-based by the end of the year.
My practice is of very high quality. We do full retirement planning and have precise notes and complete files on every client.
I have been told a practice is worth two times fees, a percentage of assets under management (AUM) or a combination of the two. Could you provide your opinion as to the value of my practice, based on your experience with other advisors?
Coach says: Two out of three conversations I have with advisors today have something to do with buying or selling a practice, so valuation is on a lot of advisors' minds. In fact, the most popular talk I have been presenting at conferences this year is entitled "Your Practice Isn't Worth What You Think It Is ... It Could be Worth More (or Less)."
The driver of interest in this subject is simple demographics. The leading edge of the baby boom is now starting to retire, and that includes many financial advisors.
The good news for advisors, vs for many other retiring entrepreneurs, is that advisors often have more control over when that day will arrive, which allows them some influence over what their businesses will be worth when they are finally ready to transfer it.
That said, here is my central conclusion after many conversations with advisors on this topic: both buyers and sellers typically have unrealistic expectations of a practice's value (up and down) because:
- Most advisors have little or no experience in buying or selling a practice.
- Where there is experience, it is too recent to assess the long-term outcome of the transaction.
- Advisors tend to rely too much on quantitative measures of value without sufficient attention to the qualitative aspects of a practice.
- Advisors have inadequate financial records to predict future earnings accurately.
- There is no database or organized practice exchange in Canada in which past transactions can be used as references for valuation.
Consequently, what has emerged as the most common methodology for valuing advisor practices are the "rules of thumb" that you described.
These rules include items such as: three to four times earnings before interest, taxes, depreciation and amortization (EBITDA); two to three times trailing 12-month revenue; three to five times recurring revenue; or 2%-4% of AUM.
Regular readers of this column will have seen my opinion of these shortcut evaluations a number of times. I do not like them because they presume that all practices are equal - which they are not! Each practice is a living entity with multiple nuances that affect its value.
Furthermore, all of these measures are backward-looking, when the only thing that should determine the value of a practice is future profitability. Like any other investment, an advisory practice is worth only the profits it can generate going forward, not what it did in the past.
If I am interested in buying your practice, I will use past results as a guide to how well your business has been managed, but I won't make you an offer to purchase based on your history alone.
How, then, do we determine the value of a practice? Before outlining the specific process, let me share the principles that guide the valuations we do for advisors who are buying or selling:
1. Cash flow is king! The best gauge for valuing a practice is "discretionary cash flow," which is the cash left over after all expenses, including compensation to the advisor, has been paid. Unfortunately, most practices do not have any discretionary cash flow because the advisor consumes all the cash left over after expenses. Theoretically, therefore, most practices would have no value at all.
In reality, however, that business could have value if the compensation can be allotted between what the advisor receives for performing the role of an advisor and what the advisor receives as the proprietor/owner of the business. It is the latter portion that is considered discretionary cash flow and used in the valuation calculation.
2. The risk/reward trade-off. Because valuations are based on expected future cash flow, the greater the certainty there is around that cash flow, the higher the valuation will be. Consequently, all other things being equal, fee-based practices generate higher valuation multiples than practices in which new commissions have to be earned each year. In addition, practices with low client turnover are worth more than those with revolving doors for clients, and so on.
3. Finding balance. There is both a science and an art involved in the careful valuation of an advisory practice. Proper valuation requires an objective assessment of the quantitative measures of a practice - revenue, profitability, AUM, etc. - as well as subjective consideration of the qualitative aspects, such as age of clients, marketing effectiveness, personal goodwill of the founder vs corporate goodwill of the practice, etc.
4. What is "right"? Approximately right is better than precisely wrong. Given the variability of revenue that many practices experience as a result of factors beyond the advisor's control, including market volatility, it is unreasonable to assume that projections of value will always work out as anticipated. Add to this the subjective valuation of the qualitative aspects of the practice and the best that can be expected is to come up with a range of values as the starting point for negotiation.
5. Value is subjective. Regardless of the valuation that comes from the formal process, the final price should be driven by the motivations of both the buyer and the seller. Vendors who are anxious to sell will accept lower prices; purchasers who are anxious to buy will pay more.
The best outcome would be one in which the seller receives more than he or she thinks the practice is worth, while the buyer feels he or she got a good deal based on what the buyer thinks can be done with the business going forward.
- Specifics for valuing a practice
The process is complex and should involve the following steps:
- Gather the required financial information.
- Perform an analysis of the key metrics that the information reveals.
- Calculate discretionary cash flow.
- Determine the risk premium that should be allocated specifically for the practice under review.
- Calculate the discount factor to be applied to expected cash flow to convert it to present value.
- Apply that discount factor to determine the practice's current valuation.
All of this sounds straightforward enough and, in fact, is the same process that an investment analyst would use to evaluate any equity-based investment. That means that anyone considering buying or selling a practice has to think in the same way: this is an equity investment, so what would someone be willing to pay for it, given its future potential?
By now, you also will have noticed that we have come to the end of our space in this column and we have not yet answered your question of "How much is my $70 million in AUM worth?"
While you may be disappointed that there is no definitive answer, hopefully, you have a better understanding of why a simple multiple of revenue or percentage of AUM is an inadequate methodology for valuing a financial advisory business. As noted earlier, each practice has its own characteristics, which either add to or detract from its potential value.
So, here's the deal: spend some time thinking about all the things that should make your business sell at a premium price; then, think about all the things that might warrant a discount.
My expectation is that with this information, you will have a far better idea of what your practice is worth to someone other than you.
This is the first instalment in a two-part series. Next month: the specific factors to consider in determining the pluses and minuses of a practice and the formula used to arrive at a final valuation.
George Hartman is managing partner with Accretive Advisor Inc. His latest book, Blunder, Wonder, Thunder: Powering Your Practice to New Heights (www.marketlogics.ca) was published in 2010. Send questions, comments and opinions on any aspect of practice management to email@example.com.
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