When Jerry Butler, president of Queenston Consulting Inc. in Winnipeg, helps financial advisors sell their books of business, he refuses to do all-cash deals with full payment up front. In such cases, the vendor usually walks away, with no further contact with the buyer or the clients. Butler, however, wants to ensure that vendors do what they have promised, such as introduce the successor to the clients and remain in the picture for a certain period.
“The longer [the vendor] stays involved, the less the transitional risk,” Butler says.
The transition period – when the buyer takes over the practice and meets the clients – is crucial to the success of the transaction. The payment structure affects the transition period and the valuation of the business, according to Butler.
As a general rule, the more money that is provided up front, the less the total payment will be. For example, instead of a deal for $1 million with half of the total paid up front and the balance paid over two years, Butler would negotiate a $1.2-million price tag with the same down payment but the balance to be paid over five or six years.
Dangling a financial carrot in front of the vendor provides an incentive to follow through with promises of introducing the buyer to all the clients and even helping find new ones. This sale strategy also helps to reduce the transition risk – the risk of clients leaving during the transition period.
The first thing advisors who are considering selling their books should do is heed some of their own advice and develop an exit strategy. “It’s no different from doing financial planning for a client,” Butler says. “But it’s amazing how few financial advisors do it for themselves.”
The older an advisor gets, Butler says, the less his or her book is worth. That’s because the average client age goes up as the advisor ages. And the single most important characteristic of a client base is the average age; the value of your book declines as the average client age increases. If your average client is 60 years old, your clients will no longer be accumulating assets and, in the not too distant future, they will start taking money out of their RRSPs.
Once the average age hits 70, the value of a book of business declines by 7% per year, Butler says: “At age 80, it’s worth nothing. At 70, you’re still dealing with clients, but it’s more of a service book. You’re not going to grow with [the clients] because they’re not accumulating any more.”
Having a good set of files – electronic, paper or both – is crucial in order for the buyer of your book to become familiar with your clients without having met them. If the new advisor can demonstrate that he or she is familiar with a client’s account and situation, he says, that client is going to be more comfortable.
Butler adds that having a continuation plan that stipulates what will happen to your business if you die, become disabled or lose your licence, also is crucial. (About 8% of transitions are due to these factors.) “If you have to sell for those reasons, your business is [immediately] worth half,” he says. “Once you’re not able to work, then your clients will start looking for other advisors.”
What determines whether a business sells for an above- or below-average value is its transition risk, cash-flow quality (the probability of maintaining revenue) and the market itself (supply and demand), Butler says: “People say to me, ‘How can you say this business is worth X dollars?’ I’m not saying it’s worth X dollars; I’m saying that’s the price. It’s a seller’s market right now.”
Placing a value on a book of business is complicated and can’t be worked out on the back of an envelope. In many cases, a book of business represents a career’s worth of work and needs to be given the proper attention so the vendor does not feel short-changed when the deal is done.
George Hartman, CEO of Market Logics Inc. in Toronto, says that when valuing a book of business quantitatively, no more than 35% of total revenue should be allocated to things such as staffing, rent and marketing; a maximum of 40% should go to advisor compensation. That leaves 25% for the owner’s compensation or discretionary cash flow.
“The problem is most advisors don’t distinguish between their advisor compensation and their owner compensation,” Hartman says. “They tend to spend all of the money without knowing the real cost of providing the advisor duties. The [the 25%] is the reward for running a business.”
The value of a practice, Hartman adds, is how it’s going to do in the future, not how it did in the past. “Advisors are usually surprised to hear it’s not worth as much as they think it is,” he says.
Hartman agrees with Butler that today’s market is a seller’s market. Hartman gets 50 phone calls from potential buyers of books for every call he gets from would-be sellers. This discrepancy is based on the growing realization that a book can be built more quickly through acquisition than organically. Further, Hartman adds, the increasing costs of doing business, such as compliance and regulations, make larger practices with their higher margins more attractive.
– Buyback clause
Dave Watson learned the value of negotiating a gradual transition when he sold his book a few years ago.
Watson, founding partner of the Wealth Planning Group Inc. in Winnipeg, had visions of spending his retirement travelling, fishing, riding his Harley-Davidson and spending time at his cottage on Lake of the Woods when he sold his book.
Watson didn’t want to go “cold turkey” into retirement, so he signed an employment contract with the group that bought his business, and kept in contact with his main clients a couple of days a week.
Then, a serious snowmobile accident left Watson unable to pursue his hobbies, so he hoped to return to work, but on a part-time basis. As a result of the employment contract, Watson was able to buy back his long-term A-list clients and resumed working four days a week. While the arrangement is not his ideal semi-retirement situation, it gave Watson first-hand experience with both sides of a book-selling transaction in rather short order.
Watson says there are pitfalls for both sellers and buyers of books of financial advisory businesses. But one important point for advisors who sell their book is that once you cash the cheque, the business is yours no longer – unless you negotiate a buyback, as Watson did.
An agreement to purchase a book of business should include a vendor take-back clause, which ensures that both the buyer and the seller have a vested interest in the business for a specified period.
“If [vendors] still have some promises to keep over a few years, but have no skin in the game, they forget what they’re supposed to provide after the sale,” Watson says. “The more you understand and put the expectations on paper, the better it will be. If anything is loosey-goosey, [the transition] is not going to work.”
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