There is nothing that makes as little sense as spending decades building a business — only to sell it for a price based on little more than a hunch.

But that’s often what happens in the financial services industry, in which books of business are evaluated based on time-worn rules of thumb, such as percentage of gross revenue.

“In no other industry do we value a business in this way,” says Julie Littlechild, president and founder of Advisor Impact Inc. in Toronto. “It doesn’t look at the quality of the business, or the probability of retention or the quality of clients. It doesn’t get at the true value of the business.”

And many advisors discover the difficult way that although buying a book can indeed translate into a higher revenue stream as a result of more assets under management, it can also mean more work. In fact, research from Advisor Impact indicates that, on average, advisors who have bought books manage 100 more clients than their peers.

“So, their profitability numbers are marginally better, but that doesn’t include the time they have to invest in managing those clients,” Littlechild says. “It’s not an indictment of buying a book of business; it’s an indictment of buying a book when you haven’t analysed the book properly.”

Then again, she adds, as long as there are buyers willing to buy at the price set by sellers, no one is complaining.

But that is about to change. As demographics shift and a glut of baby-boomer advisors look to retire over the next decade or so by selling their books to the smattering of younger advisors coming along, a buyers’ market could develop. A more precise method of valuation will be required, as buyers will want to be sure that the price-tag is fair. Sellers will need to be more savvy to get top dollar.

Littlechild says a client audit can help both parties to this end. It can provide information about whether a book fits a buyer’s practice in terms of satisfaction, expectations, interest in additional products, share of wallet and willingness to refer, while supporting an asking price for the seller.

This move toward a more sophisticated approach to valuing a business is already happening in the U.S., Littlechild says, but it is not an overwhelming trend: “It makes the most business sense, but I don’t think it’s going to happen quickly.”

According to Advisor Impact’s 2005 Practice Update, only 6% of advisors surveyed underwent a formal valuation of their business. (See “Defining value” table, above.) While few would argue there won’t be enough buyers for a good book of business, a more disciplined approach to valuing and handing over a business might fetch an offer that better serves both the seller and the buyer.

“Cash flow is king,” says Darren Miles, founder of Fair Market Value Inc. (formerly Advisor Connector), a Toronto-based company that has been matching sellers with buyers in the financial services industry since 2003.

Miles has spent the past three years earning his chartered business valuator designation, with the intent of managing succession deals from start to finish, setting a fair selling price and transition schedule based on a number of measurements. So far, he says, he has arranged the transition of about 35 advisors.

Miles is quick to point out that the cookie-cutter approach no longer works for advisory practices: “Basing a transaction worth a million bucks on rules of thumb doesn’t take into consideration the type of practice that exists on an individual basis.”

Factors heeded in other industries — such as depreciation and amortization of physical assets — don’t play a large role in valuing a service-based business. But there are other areas that need to be investigated to get an accurate picture of an advisor’s cash flow and capitalization rate. This is not an easy task because it involves such a wide range of factors, says Miles, from general economic conditions to specific earnings stability, asset mix and client age ratios, among others.

The greatest portion of value is assigned to goodwill, which is based on earnings and the qualitative aspects of those earnings, such as consistency and sustainability, he says. That is why no two business valuations are alike.

@page_break@Miles provides an example: Advisor A has built his practice over the past 25 years, enjoys a steady profit margin, sells mainly fee-based products and maintains a systematic client-service model with strong client retention. He manages assets of $100 million, representing 200 clients who have an average age of 61. He has made an effort to get to know the children and beneficiaries of his clients so that he can assist with the eventual wealth transfer.

Advisor B has built her book up for the same number of years and also manages assets of $100 million. But her client roster is much larger, spread among 1,000 clients averaging 42 years of age. Her clients’ portfolios contain a wide variety of individual securities and mutual funds, meaning her average turn ratio can be volatile. She is under considerable client-service pressures and has no system to help her manage this process.

According to Miles, Advisor B’s unmanageable book, volatile revenue and lack of control over service time and net profitability will force her to accept a much lower business valuation than Advisor A.

“A lot of people are relying on the sale of their book for a huge part of their retirement income,” Littlechild points out. Thinking about how to ensure your business will bring the money necessary to fund retirement should be done well ahead of time. “You need to be thinking strategically about it 10 years before retiring,” she says. “And you need to get down to the work five years before.”

Advisor Impact has asked advisors who have bought a book what they would do differently if they could do it again. “You are starting to see advisors saying, ‘I should have spent more time with the selling advisor’; ‘I should have documented things a little more closely’; ‘I should have contracted how the transition would take place much more carefully’,” Littlechild says. “There are lessons to be learned that might drive a more disciplined approach in the future.”

Sometimes it’s simply a matter of talking to someone who has already been through the experience. Clay Gillespie, a financial advisor and vice president at Rogers Group Financial Advisors Ltd. in Vancouver, says he wishes he had talked to another advisor who had bought a book of business before taking on about 200 clients from company founder Jim Rogers.

Setting a value on a wide range of products can be complicated. “One of the most complicated things is what you should pay,” says Gillespie, who also warns other advisors that, no matter how watertight their contracts, they shouldn’t expect to be able to anticipate every event that will occur in the transition period. “We put together a gazillion-dollar agreement, and we listened to about 50% of it.”

The unknown factor is how clients will warm to a new advisor. Gillespie had to spend more time than he expected with some clients. The effort was well worthwhile, as he had a retention rate of 97%. “But that’s because our personalities are very similar,” he says of himself and Rogers.

Gillespie had been at the firm for a decade before taking on a portion of another advisor’s book, so clients already knew him, he adds.

His advice for buyers and sellers: “Start a lot earlier than you think you should. In many cases, you’ll see that the fit isn’t there.” IE