For most people in the advisory business, the question of practice value arises in purchase and sale situations. The owner often has an inflated perception of the value of his or her firm, and the prospective buyer is usually certain he's overpaying. There are instances, however, in which those roles are reversed. For example, in the context of a divorce, shareholder breakup, or other litigation, typically the owner will say, "This business is entirely dependent on me. Without me, all the clients would go away."
Recently, we received a call from a financial advisor who terminated a part owner in his limited liability corporation. It was an ugly scenario that raised an even touchier question: When does a practice have no value at all?
Here's what happened: Just over a year ago, two advisors left their broker/dealer and affiliated with a new one. They invited a third person, an attorney they knew, to join them in their practice, which was organized as an LLC, with the job of working on their orphaned accounts. As part of the deal, he was given a third ownership in the LLC in return for "sweat equity." A simple operating agreement was drafted for the LLC stating a value of $100,000 for the business, but no buy/sell provisions were ever incorporated into the agreement. In other words, there were no clear guidelines as to what to do in the event of a termination or breakup. All three members of the LLC personally guaranteed the lease agreement, which is with the individuals, not the business entity.
More than 90% of the income in this practice comes from commissions, with a high proportion of that figure coming from the sale of annuities with substantial front-end loads and small trails. Last year, the practice generated just under $1 million of gross dealer concessions, which resulted in a 90% payout (or $900,000) to the advisors. The commission checks were signed over to the LLC, which paid the expenses and distributed the income in thirds to each of the members, regardless of who produced the revenue.
Because of the cost of transitioning to a new B/D, the distraction of the switch, the investment in their new initiative, and the challenge of coming off three years of a down market, the group didn't show much on the bottom line. After expenses, each netted an average of just over $100,000.
At the end of the first year (and perhaps partly due to the lower-than-expected profits), the two advisors decided to terminate the attorney for failing to contribute in a meaningful way to the LLC. Apparently acknowledging his lack of ability in this business, this gentleman has decided to leave the financial advisory business and return to the practice of law. While he may have had an epiphany about his lack of impact on the business, he nonetheless is suing his two former partners for his "proportionate" value in the practice. His attorney claims that the industry rule of thumb is 1.5 times the last 12 months of gross revenue including broker/dealer concessions. Using such a formula in this case values the firm at about $1.5 million, with $500,000 due to the departing member.
Depending on your point of view, this might be either an extraordinarily fair deal, or a major ripoff. If you accept that this rule of thumb is gospel in valuing advisory practices, why wouldn't it be fair? Put another way, if you owned this practice, would you sell it for this amount? If you were a buyer, would you pay this amount? (By the way, readers, I would be interested to hear your answers to these questions. You can e-mail me at firstname.lastname@example.org.)
Certainly, there are problems with the plaintiff's claim, not the least of which is that his "rule of thumb" is probably a lot of blue sky, and that the starting point (total GDC) may be equally fanciful. But there are other questions we need to ask first to determine whether there is even a basis for negotiation.
Among the standard inquiries are these: If you were the valuation expert, what questions would help you ascertain the fair market value of this business? Is the income consistent, predictable, and renewable? What about the demographics of the client base? What are the future prospects for this business? Finally, are the expenses in line with benchmarks?
It turns out, however, that there is an even bigger issue that we have encountered recently in a number of tax and litigation situations--NASD technically prohibits the sharing of commissions with entities. Only appropriately licensed individuals are allowed to share in commissions. It is common policy for registered reps to set up business entities and assign their checks to that enterprise as if it were a real business, but the business itself does not own the clients, or the right to income from the clients.
So if one is an owner in the LLC, what he literally has ownership of in this case are the liabilities and expenses of the business. What are they worth?
In the case in question, it would seem that the LLC has no earnings capacity, and its book value would be determined by its capitalization, which is $100,000. But since the lawyer's is a minority interest, and the minority stakeholder cannot liquidate the enterprise, he does not have access to book, or liquidation, value. Therefore, the value has to be based substantially on earnings capacity, with some nod given to market prices of publicly traded companies, and transactions in similar businesses. Since the earnings capacity is nil, with the LLC serving merely as a funnel for paying expenses, it would be hard to find related public company comparables to this situation. Moreover, it's hard to imagine that there are many transactions that involve shell companies serving small advisory firms.
To make matters worse for the departing attorney, there are no instructions to the broker/dealer to split the commissions between the advisors, meaning there is no shared commissions report. The terminated advisor was paid as an employee of the LLC, so even though it was probably categorized as profit distribution, it was actually wages. So is the terminated rep entitled to a share of the income? If he can't access it through the LLC, and he is not on the commission run with the other advisors, how would you resolve that question?
As in most cases when one is terminated, the aggrieved party would like some payment for damages, or compensation for pain and suffering, or at a minimum, return of his capital. In this case, the capital was sweat and emotion, for which he was awarded ownership. The problem is, the ownership is in a shell, not a real business. Frankly, there is some question as to whether the LLC could even legally process the income in the eyes of the NASD. This ludicrous situation makes a case for why the NASD should allow for corporate contracts. But until they recognize that independent contractors are a different animal from employees of wirehouses and regional brokerage firms, and that corporate contracts with the broker/dealers should be permitted, then independent financial advisors are stuck in this nether world of compliance. In the meantime, no NASD-licensed advisor's "business" can own the assets, i.e., the client base, and consequently, the entity does not have value.
Unfortunately, the terminated partner's attorney's perception of value was already out of line, which only aggravated the remaining owners to the point that they didn't want to negotiate. The deal he was asking for was not cash-flow affordable, and the owners were damned if they were going to work for the next five years for somebody who didn't contribute a nickel of value. They are now forced into a situation of either terminating the business and walking away from any obligation to their former partner, or at best, paying the terminated member severance pay as their employee. From our arms-length point of view, to say his interest has value in this circumstance would be a reach.
In any event, this will not be a simple negotiation for the remaining parties. The failure to define the terms of membership before going into business together, and the failure to have a written agreement that spells out what happens in termination, could cost these folks many thousands of dollars in legal, accounting, and expert-witness fees. Moreover, this assumes the judge will grasp the nuances of their business; minority shareholders in many states, like California, are very well protected. So our advice to advisors going into business with somebody else is simple: Get it right up front.
The main lessons learned from these advisors' experience can be summed up in the following five points:
1) Make sure your entity can legally receive compensation for investment advice--if it is an NASD rep practice, that's not likely; if it's an RIA, it is.
2) If you become co-owners with someone else, make sure that you put in place a bona fide, enforceable buy/sell agreement that prescribes the terms and price of a separation.
3) Make sure the agreement keeps your co-stakeholders on the hook for the lease, even after they leave, until you are able to find another solution.
4) Make sure you understand valuation principles before you declare a value in your business at the lawyer's or insurance agent's prompting. Sure, a high value might make you feel good, but it does have consequences.
5) Finally, make absolutely sure you understand that any "rules of thumb" in pricing businesses are a double-edged sword--you are as likely to get a divorce or break up with your partner as you are to sell the business. Remember that the first two eventualities are rarely pleasant or cheap.
Mark Tibergien is a nationally recognized specialist in practice management for financial services firms, and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S. He can be reached at email@example.com.