From the October 2005 issue of Investment Advisor • Subscribe!

October 1, 2005

The Wisdom of the Crowd

Yes, buyers are paying more for practices. But we can learn much from these wise buyers

In the past five years, financial services practice values have moved steadily upward in the open market to well over two times gross revenues. Is that a fair assessment of the actual value of those practices? The answer is both straightforward and nuanced, and it's critical. After all, the starting place for almost every buyer, seller, partner, merger candidate, employer, and employee interested in a sale to a third party, an acquisition, or an internal succession plan is determining practice value. Using data from comparable sales generated by the many participants in the open market that now exists for practices, this issue can be addressed quickly and definitively, and usually without the help of an expensive appraiser or valuation expert. The wisdom of the crowd is all the expertise the marketplace needs. The process of buying and selling practices using an open market system is still in its infancy, but plenty of data has been gathered over the past five years. That data, which forms the basis for this article, is encapsulated in the 2005 RIA Transitions Report, available at www.BusinessTrans.com. Rather than focusing on the past, however, let's look into the future, and use the historical data to suggest where practice values are going.

The open marketplace, as defined largely by the Transitions family of Web sites and its buyer and seller participants, tends to be small-cap practices, selling for less than $3 million and with about $1.5 million or less in gross annual recurring revenue. The open marketplace, at least in terms of quantifiable data, is composed largely of four Web-based platforms: FP Transitions, Fidelity Transitions, RIA Transitions (my company's platforms), and Schwab Transitions (owned and operated by Charles Schwab & Co.). The data provided in this article includes all sites but Schwab's.

The evidence we'll review starts with historic valuation performance and data collected from sales in years past, since past sales provide a clear benchmark and perspective on recent selling activity. We will examine the current high demand for financial services practices, determine its source, and forecast the near-term future of that demand. We'll look at marketplace efficiency and evolutions in practice transitions. Even transactions between employer and employees have some impact on this discussion. Acquisition financing will also be considered as it pertains to fostering demand and extending the marketplace to younger, less-well-capitalized buyers. Finally, we will consider the wisdom of the crowd--the buyers and sellers of practices at this level.

The Uniqueness of Small Practices

As we compare notes with investment bankers and business brokers of practices at the mid-cap level and beyond, one thing seems clear: the data from small-cap practice sales and acquisitions is leading the way in both quantity and quality. I keep hearing about how larger practices are, or should be, selling for a higher multiple of value than smaller practices, but there doesn't seem to be much reliable, consistent, or quantifiable data on which to base that statement.

Intuitively, mid-cap practices selling for between $3 million and $10 million and even larger-cap practices should sell for a higher multiple in that the buyers (and sellers, for that matter) are larger and better capitalized, and both buyer and seller will have a more institutionalized approach, such as multiple principals, a trained staff, and so forth. These factors would almost certainly make the post-closing client transition much easier, more predictable, and more valuable. But the data doesn't support this intuitive reasoning. So far, at least, it appears that small-cap practices, and practitioners, are paving the way in terms of sheer numbers of closed sales, closing percentages, and data reporting.

But small financial services practices are unique in several aspects. A small financial services practice centered around one licensed professional, unlike a larger financial firm or even an unregulated business, has some inherent limitations in its business model. These limitations affect the value of the practice when it is time to sell. For example, such a "practice" is more likely to be dependent on just one or a few individuals for the bulk of its income. Even the referral sources to the practice tend to be based on the owner's unique reputation and skills in the industry, something not easily transferred.

These limitations tend to show up in the deal terms that affect the practice's value. Most transactions at the small-cap level are not all-cash at the time of closing, and the market multiples, or any valuation method used, should reflect this. These deals often have about 35% to 45% of the purchase price paid in cash at closing, and the balance over three to four years using seller financing. The balance owed after the down payment is usually contingent, in one form or another, on transition results, reflecting the perceived challenges in transferring the personal relationships, goodwill, and referral sources.

Few valuation approaches, and fewer professional appraisers, are using current information to value these types of professional practices. In the midst of a seller's market with almost excessive demand, and three to four full-price offers per seller listing, it is important to use a valuation method or methods that accurately reflect the current level of supply and demand. In fairness, it won't always be a seller's market, but that's a fact that should be taken into account as well at the time of the valuation.

Ironically, the uniqueness of the small-cap financial services practice may also be what makes this type of practice so highly valued. The small size of the practices, with a limited number of client relationships and, usually, a narrower range of services, products, and advisors, can be acquired for a smaller capital investment and at less risk than mid-cap and larger practices. Then there is the familiarity of the small-cap model. Since most buyers are larger than the acquisition target, buyers have a clear understanding of what they are acquiring, since that is where most started themselves.

The Open Market Participants

What are the characteristics of buyers and sellers in the open market for small-cap practices? The data from the Transitions sites shows that sellers over the past few years have ranged in age from 29 to 78, and selling prices have ranged from $50,000 to $3 million. Some sellers reported they were retiring; many more wanted a course change in their lives; a few became fed up with the increased burden of compliance; and some didn't make it through the clutches of the regulators. Buyers ranged in age from 22 to 83. Some wanted to grow more quickly. Others wanted to step to the next level with the help of a senior practitioner, a mentor.

The data indicate that participation in buying and selling practices continued to grow for the fifth year in a row. Where will it stop? The answer, it would seem at first glance, depends on the sellers, or at least, the number of sellers. At this point, buyers still outnumber sellers by at least 30 to 1, a ratio that seems to be still climbing in favor of the sellers.

What is most interesting about the increase in buyer demand, though, is that it has kept pace with the number of available sellers, leaving still more buyers than sellers.

In his column in Investment Advisor in October 2004, "A Voice in the Wilderness," Mark Tibergien cautioned that "we are in a bubble for practice transitions." But the facts lead to a very different conclusion. While the average number of interested buyers per seller listing has increased from 19 to 35 in the past five years, the multiple of value has increased from 2.00 (times the last 12 months' recurring income) to 2.10, a gain of only 0.10 in the past four years. As you can see, this isn't eBay, and auctions for an individual practice, given the miniscule rise in value, are the exception, not the rule. Compare these sets of facts from the FP, Fidelity, and RIA Transitions sites and draw your own conclusions.

Participation in the open market will ultimately determine how high, and how fast, practice values will grow, and it will be the buyers who will drive selling values, not the sellers. So why didn't practice value increase more with so many interested buyers? In fact, it did, but not in terms of the purchase price paid. Like the smart business people and counselors of investment risk they are, buyers studied the data flowing from the deals completed in the open marketplace and began to restructure the terms of the deals rather than increasing the purchase price paid for the practices. This was a smart and daring business move that, in hindsight, has paid off.

How Deals Have Changed

Rather than pay a higher price, buyers' confidence in the marketplace prompted a more subtle change in practice values in recent years. Consider these trends from 2002 through 2004:

  • The average down payment increased from 26% in 2002 to 36% in 2004;
  • The percentage of the deal coming to the seller in the form of an earnout dropped from 64% in 2002 to 33% in 2004;
  • Promissory notes became more prominent, increasing from 10% of the value of the average deal in 2002 to 31% in 2004.

The tax treatment shifted as well:

  • The capital gains tax allocation went from an average of 59% of money received from a deal in 2002 to 68% in 2004;
  • The Consulting Agreement component (subject to Social Security taxes) dropped from 29% in 2002 to 26% in 2004;
  • Ordinary income (attributed to the non-competition/non-solicitation agreements) dropped from 12% in 2002 to 6% in 2004.

With these better terms, sellers are getting more of their money up front and with better tax treatment. At the same time, the repayment period stayed fairly constant and the interest rate demanded on the seller financing stayed constant as well. Buyers paid off their acquisitions faster, and avoided paying a higher purchase price.

There is every indication that buyers are increasingly confident that they will reap the underlying value in the small-cap transaction--long-term client retention. Because of that, buyers are clearly willing to take on more risk. Obviously, there is a limit to the enhancement of internal deal dynamics, and it seems reasonable to expect the value multiple to pick up as soon as an equilibrium is reached on the down payment and other deal terms.

What's Missing?

If greater access to practices for sale by more buyers is to occur, it will have to begin with better outside institutional financing for these acquisitions. Currently, most small-cap practice acquisitions rely on a limited, ad hoc variety of financing assistance, including seller financing, business lines of credit, home equity loans, and broker/dealer financing. Strangely absent from the mix is bank financing.

At this time, only Small Business Administration loans are available to assist in the acquisition process at the small-cap level, and the time and resources needed to complete the cumbersome SBA loan process is generally fatal to the buyer's chances. However, given that banks are currently willing to lend on deals involving the acquisitions of doctor, dental, veterinary, and CPA practices, the longer-term future of institutional financing looks promising. When it happens, the marketplace will truly be open, for the first time, to all interested and qualified participants. But even without the availability of bank financing, practice values have continued to increase.

Currently, the buyer population largely comprises practitioners who can afford a 35% to 45% cash down payment, which suggests that these buyers may constitute the best of the next generation. It also indicates that younger, less experienced, or less-well-capitalized advisors are basically shut out of the process.

The same is true of women buyers, who make up only about 1% of the marketplace demand by buyers, but comprise 27% of the supply of selling practices. External acquisitions by experienced but frustrated employees are virtually non-existent, again due primarily to lack of capital. When, and if, these potential buyers can be added to the marketplace, demand should increase significantly across the board.

Younger, inexperienced buyers aren't the only ones missing from the marketplace. Older, more experienced sellers are still in limited supply as well. Many people think that the primary reason a seller decides to leave the profession is to retire, but statistically, that's inaccurate. The majority of sellers fall between the ages of 42 and 57. These sellers categorically prefer a sale to a third party--a faster sale with a shorter transition period allows these sellers to maximize their cash down payment and exit the profession relatively quickly so they can pursue other career plans. Sellers who are in their 60s or 70s tend to prefer an internal succession plan over a sale to a third party, primarily because this age group wants both a successor and the opportunity to stay on and work after the sale, a unique challenge demanding a compliant buyer.

Ironically, current sellers also tend to be impulsive sellers, based on the practitioners' immediate career needs, rather than carefully planned multiyear exit strategies that would better incorporate employee and client needs and provide better value as a result. Nonetheless, practice values continue to increase and deal terms continue to improve.

These results mean that the demand and practice values we're actually talking about are from younger sellers buying less mature practices with less assets under management than are likely to be found in practices that are 10 years older.

Internal Succession and Practice Values

But practice values, and the data supporting our assertions, don't just come from third-party sales. A significant part of the information on practice values, though less than a majority at the small-cap level, comes from internal sales--partner to partner, employer to employee, father or mother to son or daughter. These sales are among the more challenging deals to complete.

The problem with practice values derived from an internal sale of a practice stems from the reliance on the sole practitioner business model that makes up 70% or more of the small-cap industry. Sellers often name their price based on their personal needs: the amount of work they put into their practice, and the amount of cash they need to retire. Employee buyers make offers based on their limited resources and the amount they feel they've been underpaid or have overcontributed in years past. Professional appraisers tend to be hired by the buyer and deliver a result that often favors the lower end of the spectrum. All these positions are wrong, and right, depending on your point of view. And that's exactly the problem.

Unfortunately, internal succession planning is very poorly developed in the financial services industry, and national organizations like the Financial Planning Association have done very little to foster a better understanding or a standardized approach, at least where sole practitioners are concerned. NAPFA may be the one exception, having invested in a private label site and extensive workshops on this subject matter.

In small financial services practices, where the ambition for an internal succession plan often starts with the owner, and the time to hire and develop younger talent is limited, succession plans don't work nearly as well as in larger firms, at least where practice value and valuations are concerned. If you're mentoring just one employee and depending on that one employee to buy you out, and to provide your clients with the best possible advisory talent in the local industry, you've created a situation where there is no competition, only expectations, gratitude, and loyalty. It might suffice; it might not. Your clients will be the judge.

Valuation Techniques

Whether you are a buyer or a seller, there is no surefire way to value a financial services practice. Every method yields an estimate. CPAs who sell their own practices generally rely on a multiple of value to determine the selling prices of their practices, and most small-cap financial services professionals do the same.

In order to arrive at a solid, logical opinion of the value of your practice, or someone else's practice that you want to buy, you need to understand how valuations work. Many valuation methods require the knowledge and experience of a professional appraiser. Valuation methods such as "discounted cash flow" work very well, if you understand the rationale and can apply it to your practice. If you can't, it will cost you upwards of $12,000 for someone else to explain it to you. And the answer is still an estimate.

Most acquisitions in the financial services industry, at the small-cap level, are strategic. For example, a particular buyer may be in a unique position to take advantage of an acquisition opportunity to eliminate a competitor, acquire a coveted niche, address excess capacity or office space, or reduce costs by combining activities and talents. A strategic purchase is usually worth more money to the right buyer. On average, strategic buyers are willing to pay much higher multiples of the seller's earnings than financial buyers.

Also, the same practice can have different values under different circumstances. For example, a practice with $500,000 in gross revenue and 35% overhead that needs to be sold very quickly will be worth less than if it can be sold with adequate time to prepare, market it, and wait for a good offer. A practice with $500,000 in gross annual revenue with 60% overhead may be sold for the same price as the practice with 35% overhead if the buyer, during due diligence, decides that many of the seller's expenses can be eliminated or reduced by combining the practices. If not, the latter practice will receive a lower multiple or reduced terms.

Determining value should focus on the clients who are being transferred from buyer to seller. Without their approval and long-term cooperation, the question of "value" is almost irrelevant. For this reason, the most important factor in the success of any deal, and ultimately in achieving the best value, is the match between the seller and the best qualified buyer for that particular seller's clients. If the match works, a very high client transition rate almost always follows, and any contingent payments to the seller will be fully realized. If the match doesn't work, the price and deal terms are almost irrelevant. If the clients leave, so will your value. Don't lose sight of this basic premise as you work through the textbook theories of valuation.

Growing Market Efficiencies

Whether through an internal succession or a sale to a third party, the market is gradually shifting towards experienced, capable, and qualified buyers, and value is shifting as a result. Here is a case in point. In April 2005, we listed a practice for sale in Bethesda, Maryland, at just under $2 million. The practice received three full-price offers and one above the asking price, a situation not all that surprising. What was different in this case was that all four of the prospective buyers had purchased at least one financial services practice before, and had seen for themselves that the value proposition really didn't revolve around the difference between multiples of 2.0 or 2.2. Value was greater than the simple multiples when new investments, new client referrals, and the synergy of a buyer and seller were combined for even a short time after closing. "Discounted cash flow" models completely missed the point. Add in a trained and qualified staff, an office location and presence in another city, and the reduced expenses of purchasing similar assets and combining systems, and, well, you get four full-priced offers. What do these experienced advisors know that we--the industry experts--don't?

The wisdom of the crowd--experienced financial advisors trained in assessing risk and investment potential who know the value in matching client and advisor--has decided that practice value is what a willing buyer pays to a willing seller.

It doesn't matter whether a valuation of a small-cap financial services practice is based on a multiple of value or discounted cash flow or book value. Sales at this level are asset sales; expenses are not part of the acquisition process and a more profitable practice may, or may not, be worth more money on the open market--it depends on many other factors discovered and negotiated in the due diligence process. And it depends on the terms of the deal, from all cash to no cash to something in between.

It seems clear that financial services practice values are going to continue to rise slowly but surely based on actual, successful transaction data, not the irrational exuberance of a mob. Of course, at some point, market equilibrium will be reached, but it will be up to the buyers and the sellers, on a nationwide scale, to determine when the apex has been achieved.

Bank financing, or some type of bridge financing, such as broker/dealer or custodian financing support for at least the down payment on the acquisition, will become a common component in the future. We are already seeing evidence for this now.

Across the board, the demographics are clear: sellers are getting older, and that holds more meaning than just an increase in the number of practices likely to come up for sale. Practices will be listed for sale with more developed systems and procedures, more qualified employees, larger, more affluent clients, and institutionalized procedures that will make the post-closing client transition work even better. These improvements should almost certainly result in practices being sold, and acquired, at a higher value than we're seeing today.

At this juncture, there is little choice but to predict that the value of financial services practices is going to continue to rise. It may go as high as 2.5 to 3.0 times the practice's last 12 months' gross recurring revenue, but time will tell, not us. Or, better yet, the marketplace will tell us. All we have to do is listen to the wisdom of the crowd.

David Grau is president of Business Transitions in Portland, Oregon, a succession planning consulting firm and facilitator of buying and selling financial services practices. He can be reached at david@businesstrans.com. William Grable is president of Business Transitions Publishing, Inc., publisher of the Transitions Reports. He can be reached at bill@businesstrans.com.

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