What’s your business worth?

Evaluating Your Practice

Advisor: I have been enjoying the series you are doing on IE:TV on the topic of buying and selling a practice. For one thing, it has made me think a lot more seriously about my own succession plan. In fact, I have started a conversation with another advisor about buying my business when I retire, and I guess that has also made me a little impatient for more information — most of which I am sure will come in the remaining episodes.

In the meantime, it is clear from the discussions with my potential purchaser that we are quite a bit apart on our thoughts as to what my practice is worth today and what it might be worth when we actually conclude a deal. I know from your comments in the video segments that you are not a big believer in “rules of thumb” — simple formulas for determining price. Could you, then, provide some more thoughts on valuation?

 

Coach says: For a host of reasons — from an aging advisor population to consolidation of practices for economies of scale and resources sharing — interest in the whole subject of buying and selling financial advisory practices is escalating. In fact, I would estimate that more than half of the consulting I do with advisors and dealer firms today has succession planning or growth through acquisition as a major issue.

The IE:TV series (seen on www.investmentexecutive.com) is being intentionally sequenced to coincide with a strategic approach to shifting a practice from one advisor to another for a very good reason. Most advisors want to short-circuit the process to get right to the bottom line: “What’s the price?”

Your impatience is fairly common. Clearly, valuation is an important item. However, in my view, price should really move to the forefront of your negotiations only after careful consideration of the strategic issues by both parties.

The starting point for your negotiations will almost always reveal a gap between what you and an outsider think your business is worth. That’s because you, as the seller, are thinking about “fair market value” of your practice while the buyer is looking for a “fair price.”

FMV is a familiar term for most financial advisors, particularly if they are assisting clients with tax or estate planning strategies. Unfortunately, in the context of selling their own businesses, too many advisors calculate the FMV of their practice through unreliable comparisons, such as: “When Bill retired, he got 3% of AUM. My business has to be worth at least 4% because [fill in the blank].”

However, let’s define FMV more traditionally as “the highest price, in cash, that would be paid for a practice in an open and unrestricted market by an advisor willing to buy to an advisor willing to sell, when both are equally knowledgeable, informed and prudent.” Then, we can begin to see why a discrepancy might exist between what a seller thinks his or her practice is worth and what someone else is willing to pay for it.

Simply put, that traditional definition of FMV does not fit the financial advi-sory business. First of all, we do not operate in an “open and unrestricted market.” An open market would be one in which departing advisors would be willing to sell their practices to whomever was willing to pay the highest price, without regard for what would happen to their clients, staffs or lifelong reputations afterward.

Similarly, acquiring advisors would be willing to buy any practice based solely on price, without looking at the nature of the client base or the fit between the two practices. I am happy to say that I have never met an advisor who would be willing to sell his or her practice to just anyone, or an advisor who would be willing to buy just any practice.

Also, we would have some sort of exchange, on which practices trade frequently and potential buyers and sellers could see the bid/ask prices and final sales results. While there are efforts to establish such an exchange, one does not yet exist that could be relied upon to compare value accurately.

Nor do we operate in an “unrestricted market.” There are practical issues around dealer firm relationships, restrictive covenants, advisor qualifications, government regulations and simple geography that either eliminate or severely limit the ability of potential buyers and sellers to come together.

It would also be folly to believe that buyers and sellers are “equally knowledgeable and informed.” No one will know more about the true value of a practice than the person who built it. That person will be aware of the inherent weaknesses, when fortune rather than hard work played a role in the success of the business and how much better the business looks from the outside than the inside. This knowledge will give the seller an advantage in the negotiations.

The definition of FMV also calls for prudence on the part of both parties, meaning they are under no compulsion to act. I can tell you, however, in the real world, more and more advisors are looking to sell their practices or buy others because they have come to realize that continuing on in their current manner, with rising client expectations and increased service and compliance costs, has a declining marginal return.

Add to these facts the number of advi-sors who are in the final 10 years of their careers and we will, in my view, see an accelerating number of advisors anxious to sell as they exit from the industry. A more urgent desire to monetize one’s life’s work or expand through acquisition will inevitably result in less due diligence and more inaccurate valuations.

Finally, the FMV definition assumes the transaction is done for cash. The truth is that very few deals in our industry today are structured that way. Most include some sort of “earnout” of a portion (or all) of the purchase price. It is important to note that every dollar not received on closing is a dollar at risk. Consequently, any sort of vendor financing should increase the price to reflect that risk.

Even with all of this said, there is one thing more than any other that accounts for the differences in perceived value between buyers and sellers: their varying assessments of the value of goodwill.

Most entrepreneurial endeavours, including financial advisory practices, create two types of goodwill — one that stems from the firm’s success in the market and one that emanates from the persona of the founder. Selling advisors want maximum payback for the personal goodwill they have created in and around their practice as represented by client loyalty, recurring business, community profile and future potential. I find this ironic, having looked at the financial statements of quite a few advisors and very seldom seeing goodwill listed as an asset on their balance sheets. Yet, in the minds of many sellers, personal goodwill is the most valuable feature of their practices.

Buyers, on the other hand, are far less interested in what they perceive to be an intangible asset. From their perspective, once the selling advisor has departed, much of that personal goodwill follows him or her out the door. Therefore, buyers are unwilling to pay much for it. There are, of course, things that can be done to reduce the risk of client defection and, to be sure, it is in the interest of both parties to have clients remain with the business, because most agreements are based on some future earnings formula.

At the end of the day, as I have said on the IE:TV videos, the “right price” for a practice should be based primarily on its future earnings potential, not what it has achieved in the past. If there is a good strategic fit and an advisor believes he or she can leverage the acquired firm with his or her existing resources to create greater overall value, he or she should be willing to pay a fair price. Selling advisors, therefore, in order to achieve the highest price, have to be able to demonstrate that the value that will accrue after they are gone will be greater than the price they are seeking. That way, everyone wins.  IE

George Hartman is president and CEO of Market Logics Inc. Send questions, comments and opinions on any aspect of practice management to george@marketlogics.ca.