“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: You have done lots of valuations for advisors looking to buy or sell their businesses. What do you look for in determining a fair price? I am five years away from my planned exit date and want to know what I can do between now and then to maximize value when I sell my practice.

COACH SAYS: The process to value an advisor’s practice properly is comprehensive. (See A major purchase.)

I don’t want to take anything away from the valuation process, but there is only one thing that determines the value of a financial advisory practice: future cash flow. Everything else that is captured, counted and commented on is just information to help determine the expected cash flow after the business is transferred to the buyer.

Put another way, the value of your practice at any time is determined by the cash flow it is expected to generate in the future – not what it has done in the past. Almost every advisor who comes to us for a valuation tells us how successful the business has been, how great their reputation is, how wonderful their clients are or any number of accomplishments.

These things tell us how well the practice has been managed and provide insight into the strengths (and weaknesses) of the business under the direction of the founder. What these factors don’t tell us is how the business will perform under new management.

The first step in assessing value is to examine current cash flow. This is a straightforward calculation of revenue from all sources (e.g., asset management fees, trading commissions, service fees, insurance commissions and bonuses, life insurance and employee benefit plan renewals, financial planning fees, etc.).

For simplicity’s sake, we then deduct the costs of running the business to arrive at net revenue. We also need to determine which expenses are appropriate, depending on whether we are just valuing a book of business (a.k.a. a client list) or an operating practice that will continue under new ownership. (We will examine this determination process in a future column.)

As noted earlier, we cannot assume that all current revenue will continue after the transition. Some clients will use the change in advisor as an opportunity to move to a new advisor.

The second step in the valuation process, therefore, must be to estimate how much revenue will not continue post-transition.

The most obvious factor to examine is the extent to which current revenue is recurring vs non-recurring. All other things being equal, practices with greater certainty about future cash flow are valued higher. Recurring revenue from fee-based arrangements with clients, service/trailer fees, insurance renewals and ongoing service fees typically result in consistent cash flow from year to year.

Other factors that may affect future cash flow include:

  • Age of clients. Older clients often slow down their contributions to revenue because they draw down their assets to fund retirement or transfer wealth to their children.
  • Concentration. A small number of people, closely related to the selling advisor, may leave when he or she does.
  • Advisor goodwill. The more clients are loyal to their departing advisor, the greater the likelihood they will follow him or her out the door. (A good transition plan can reduce this risk.)
  • Declining fees. These can be the result of changing consumer demands and the competitive landscape.
  • Capital market conditions. Volatility can dampen enthusiasm for investing.
  • Sales strategies. Certain methods may no longer be appropriate, such as using leverage or a certain tax-reduction strategy.

An example of a contentious sale

Ken (age 59) and Ella (age 40) merged their practices five years ago with the understanding that Ken would retire at age 65 and Ella would buy out his half of the business. In the spirit of true partnership, they pooled all revenue and shared expenses equally. The arrangement worked well, and the combined business grew steadily.

As Ken approached his planned exit date, he asked us to calculate a value for the practice. We collected all our usual data and interviewed Ken and Ella to get their views on the practice – past, present and future.

When the partnership was formed, both Ken and Ella were licensed for life insurance only. Two years into the deal, Ella became securities-licensed and began to offer fee-based investment services to the firm’s clients. Ken had no interest in the money side of the business and gave Ella his blessing to deal with any clients who were interested.

While the proportion of revenue contributed by each was approximately equal over the five years, Ken had one productive year when changing tax regulations made the purchase of permanent life insurance attractive, particularly to high net-worth clients. He quadrupled his previous best year of production.

Ella’s results, on the other hand, grew steadily with an increasing percentage from recurring asset-based revenue.

You can probably guess how this valuation worked out. Ken’s revenue from insurance was mostly non-recurring, buoyed by one great year that was unlikely to be repeated. Consequently, we had to discount its value compared with Ella’s rising recurring revenue, which deserved a higher valuation on a dollar-for- dollar basis.

Ella argued that she should pay Ken an amount substantially less than half of our overall valuation. We were brought back to mediate a final settlement; however, neither party was satisfied with the outcome, and the ill will between Ken and Ella persists to this day.

As the Ken and Ella example illustrates, the answer to your question – “How do I maximize value in my practice?” – is to do everything you can to increase the amount and certainty of future cash flow.

There are several ways you can do that, including:

  • Increase net cash flow through efficiency and scale
  • Increase the percentage of recurring revenue
  • Demonstrate an effective, replicable marketing plan to replace aging clients
  • Build a diversified client base
  • Promote your team, instead of just yourself.

One final note: there is a difference between “value” and “price.” Value is reflected in the valuation report; the final price is influenced by the motivations of the buyer and seller to reach a deal, the terms of the deal and competition for purchasing the business.

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 investmentexecutive.com.