"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.
This is the second instalment in a two-part series on practice valuation, a response to the financial advisor's question below. Part 1 in the series appeared in the June 2013 edition of Investment Executive.
Advisor: 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: In Part 1 of my response to your question, we addressed the principles of practice valuation. Now, let's look at the specific steps we follow at our firm when valuing practices.
I will use a $70-million book of business, like yours, as an example. However, I will have to make some assumptions along the way to illustrate the process.
Please do not, in any way, assume the resulting valuation is actually what your practice is worth. Arriving at a valuation for your business specifically would require considerably more information regarding the specifics of your business.
- Step 1: gather the required financial information
Surprisingly, most financial advisors do not keep very good financial records of their own businesses. Sure, they have financial statements prepared by their accountants for tax reporting, but these seldom reflect the reality of the business. Balance sheets, for example, are normally of little use because most practices have few assets beyond furniture and equipment and few liabilities other than normal operating payables.
Consequently, the income statement (the "profit and loss" statement) has to be relied upon. Even that can be suspect, due to "creative accounting" that might include such items as family members on the payroll and company-paid vehicles. These perks all have to be omitted from the income statement for valuation purposes.
Otherwise, the true value of the practice will be understated because of overstatement of expenses. Unusually large transactions, such as major purchases or that occasional gigantic commission on a new account also have to be "normalized" to reflect more consistent revenue and expenses.
- Step 2: analyze key metrics
With an adjusted income statement in hand, we then assess the practice against several benchmarks to determine how it compares with other practices. For example, we like to see:
- No more than 40% of total revenue going to advisor compensation. Note that this is for performing the role of an advisor - not reward for ownership. As indicated in the previous column, most advisors pay themselves whatever is left after expenses, without differentiating between their compensation as an advisor and their return on equity. For valuation purposes, we are interested in discretionary cash flow, which we often refer to as "earnings before owner compensation" to emphasize the point.
In our example, I am going to assume that your "turn rate" (return on AUM) is 1% - meaning: your $70-million book generates $700,000 in gross revenue. Our advisor compensation target would, therefore, be $700,000 x 40% = $280,000.
- No more than 35% of total revenue going to operating expenses. That includes costs such as salaries and benefits for non-revenue-producing staff, office overhead and marketing. In our example, operating overhead target would be $700,000 x 35% = $245,000.
- Step 3: calculate discretionary cash flow (profitability) and productivity
Discretionary cash flow is simply the amount left after all expenses, including advisor compensation, have been accounted for. In our example, the discretionary cash flow target would be 25%: $700,000 x 25% = $175,000.
Not to say that this leftover amount (a.k.a. profits) should not be paid to the founding advisor - just recognize it as owner compensation rather than advisor compensation.
With these numbers in hand, we then look at a variety of productivity and profitability ratios, including:
- AUM per advisor, per client and per staff member;
- number of clients per advisor and per staff member;
- revenue per advisor, per client and per staff member;
- discretionary cash flow per advisor, per client and per staff member.
- Step 4: determine the risk premium
As with any other equity investment, there are two levels of risk to be considered in valuing a practice: business risk and market risk.
Regarding business risk, every practice has unique characteristics that make it more risky or less risky than others. This is where both quantitative and qualitative aspects come together to affect value. In most instances, we consider 35 to 40 variables, among them are:
- The profile of the client base (demographics, average account size, etc.).
- The sources and consistency of revenue (product mix, percentage of recurring revenue, etc.).
- The pricing policy (fee-based vs commission, turn rate, etc.).
- Staff experience (qualifications,etc.).
- Capacity (systems, scalability, etc.).
For each variable, we assign a "plus," "neutral" or "minus" rating to indicate its impact on the valuation. These ratings will help to determine whether the practice overall warrants a "premium," "standard" or "discount" adjustment.
Business-risk premiums for Canadian practices typically range around 20%-30%. Practices with more premium than discount rankings earn a risk assessment in the lower end of the range (meaning they are less risky); practices with more discount rankings are assigned higher risk premiums (more risky).
Determining the appropriate business-risk premium is the most subjective part of the valuation, yet this premium can have the biggest impact on the final valuation. This is why I stress the importance of having the valuation performed by someone who understands the nuances of what differentiates financial advisory practices - which will provide the best chance of obtaining a fair price for both the buyer and seller.
- Step 4: calculate the discount factor
The discount factor will be applied to expected cash flow to convert the latter figure to present value. To determine the discount factor, we apply the following formula: discount factor = market risk + business risk.
Let's assume we have determined that your practice warrants a business-risk premium in the middle of the range - say, 14%-16%, and that the market-risk premium in today's environment is 11%. The discount rate for your practice then would be (14%-16%) + 11% = 25%-27%.
- Step 5: apply the discount factor to determine current practice valuation
The final adjustment is to reflect a reasonable rate of growth for the business. Many advisors will argue: "We have averaged 10%-15% growth year-over-year." But, in the long run - which is what the potential purchaser is assessing - the average sustainable rate of growth of a practice is more like 5% from market gains and new client addition, less attrition and withdrawals.
Consequently, in our example, the discount factor we would apply to this practice is 25% to 27% less 5% growth = 20% to 22%.
With $175,000 of discretionary cash flow, our sample practice's valuation range would be $175,000 ÷ (20% to 22%) = $795,000 to $875,000. This equates roughly to:
- 1.1%-1.3% times AUM
- 1.14-1.25 times revenue
- 4.5 to five times discretionary cash flow.
Again, any valuation should provide only a point of reference for the negotiations between buyer and seller. The final price will be determined by their joint willingness to make a deal. Hopefully, however, you will agree that a scientific approach to valuation is better than using simple "rules of thumb."
George Hartman is co-founder and managing partner with Accretive Advisor Inc. and president of Market Logics Inc. in Toronto. Send questions, comments and opinions on any aspect of practice management to firstname.lastname@example.org.
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