“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: I really enjoyed the presentation you gave on succession planning at a recent conference. I was particularly interested because I am in discussions with a younger advisor in my office about taking over my practice in five years’ time. By then, I will have been in the business for 35 years and, noting that emotional readiness was one of the key points in your presentation, I will be more than emotionally ready to make the transition.
One big point of contention between my intended successor and me is the value of my business – both today and five years from now. My firm has a suggested valuation formula based on assets under management (AUM), but it produced a number that I thought was too low. Coincidently, I received an unsolicited approach last year from a bank-owned firm and they proposed a formula based on previous years’ average revenue. Luckily for me, I had just come off my best year ever, so their valuation was significantly higher. Not surprising, the gap between the lower and higher valuations set off quite an internal debate about the price of my business.
You only referenced valuation at a high level during your presentation. Can you add depth to the subject?
Coach says: Covering the many aspects of succession planning is impossible to do in a 60-minute conference presentation. The objective of that talk was to motivate the audience to begin thinking about their succession plans. A survey at the presentation revealed that most attendees hadn’t begun constructing their plan, but admitted that they should.
Practice valuation may be the most critical aspect of succession planning because it has a major impact on both an emotional and a financial level. Giving up your life’s work is a psychological challenge because this act means giving up your identity – as an advisor, as a confidante, as a successful businessperson. Those feelings can be assuaged somewhat, however, if you feel you have received fair value for your years of hard work and that you will be able to enjoy the retirement lifestyle you anticipated.
Here are five basic principles of valuation and how they apply in the real world:
1. Future profitability. The price a buyer should be willing to pay for a financial advisory practice is based on what he or she expects it will earn in the future, not what it did in the past. Too many advisors who are transferring their business only look backwards and claim something like: “I earned X dollars last year, therefore my practice should be worth three to four times X.”
We do numerous formal valuations every year. Of course, we are interested in past revenue because it tells us about the momentum of the business. However, our focus is on profitability, which is what’s left over after all the expenses of operating the business have been paid.
In simple terms, then, the value of your business will be some multiple of its expected future profitability, not past revenue.
2. Cash flow is king. Advisory practices don’t have many tangible assets, so the real value is in the cash flow generated through clients or, more specifically, as previously noted, the cash flow over and above the cost of running the business. Counting elements such as salaries as operating expenses is easy to do; however, we often forget that in order to do business, someone has to take on the job of advisor – and be paid for it.
Most advisors do not make a distinction between what they get paid to perform their advisory duties and what they earn as business owners. They simply take home whatever is left after covering their operating costs. In fact, however, part of that total compensation is for carrying out the advisory role and part is for taking risks and building a business.
If you had to hire someone to perform just the advisory duties in your business, would you pay them as much as you currently pay yourself? Of course not. So, anything over and above what you would pay someone you would hire is your owner compensation; it represents the true profitability of your practice.
Furthermore, because you have discretion over how much you think the advisor’s job is worth, we describe your owner compensation as discretionary cash flow (DCF). The value of your practice will be a multiple of its DCF.
3. Risk vs reward. We know there is a trade-off between the expected risk and the reward associated with any investment. The same rationale applies to valuing a book of business: the more risk I assume as a buyer, the less I should be willing to pay to maximize my return potential. Of course, the converse is: less risk should warrant a higher price.
Because practice value is a multiple of DCF, the greater certainty there is around that future cash flow, the higher the valuation. Consequently, the larger the percentage of your revenue that comes from recurring cash flow, the more a buyer should be willing to pay. Sustainability of recurring revenue also is important. Fees generated from an asset-management agreement with clients generally are considered more sustainable than imbedded fees, such as trailer fees, which run the risk of being disallowed by regulators.
4. A science and an art. Calculating DCF is relatively straightforward, provided reliable information regarding revenue and expenses is available. That’s the “science” – an objective assessment of quantitative measures.
Equally important is the subjective consideration of the qualitative aspects of a practice. This is the “art” of practice valuation because this factor requires an understanding of what makes one book of business worth more than another, even though both have the same revenue or AUM.
Other factors to be evaluated include client roster profile, retention rate, product mix, service model and staff tenure. As well, the practice’s productivity is compared with established industry benchmarks for such measures as turn rate, average account size, revenue per client, number of clients and revenue per advisor and staff. In addition, we look at components of the succession deal itself: terms of payment, guarantees, clawbacks and the seller’s involvement in the transition. All of this is considered within the context of the general economic environment, local market conditions and the competitive landscape.
This subjective, artful evaluation often is the most significant factor in determining the discount rate to be applied to future expected cash flow in order to calculate the present value of a practice.
5. Value is subjective. Although we do our best to determine a realistic valuation of a practice, the number we put in our report is just a guide. The final price will be determined by agreement between the buyer and the seller and will depend on the motivation of both the buyer and the seller to complete the deal.
The best outcome occurs when the founding advisor feels he or she has received fair value for his or her life’s work and the successor feels he or she has paid a fair price for the potential of the business.
I do not have enough space here to dig deeper into the very practical aspects of practice valuation. With these principles in mind, however, the stage has been set for further discussion of this essential topic in a future column.
George Hartman is CEO of Market Logics Inc. in Toronto. Send questions and comments regarding this column to george@marketlogics.ca. George’s practice-management videos can be viewed on www.investmentexecutive.com.
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