From the October 2006 issue of Investment Advisor • Subscribe!

Swimming With The Sharks

Read the fine print before selling your firm to a strategic buyer

My education on the investment banking acumen of financial planners came at the old IAFP. Early in 1990, the IAFP Board decided to sell Financial Planning magazine, where I was editor-in-chief. The Board cited "strategic" reasons; they wanted a financial cushion for economic downturns such as the then current collapse of the investment partnership business.

As an aside, I should mention that I always suspected that the IAFP Board sold us for political motives. My predecessors and I ran the magazine with rigid editorial independence from the Association. Then some articles criticizing some of its biggest supporters caused the Board to rethink our arms-length status, and to avoid an embarrassing debate, sold the magazine to a publisher who promised not to offend any deep pockets.

Anyway, while the experience certainly taught me something about the cost of editorial integrity, a bigger lesson came from how advisors on the Board approached the sale.

The magazine generated cash flow of just under $1 million on $4 million in revenues. Yet, through creative allocations, the Association staff made the profits appear closer to $500,000. They did this, presumably, to make the sale appear more reasonable to the membership, even though it cost them millions. That was their first mistake, although without someone with magazine savvy assisting the Board (they didn't ask me), I've always wondered whether they fully understood this legerdemain.

Next came a few publishers from our niche with low-ball offers (the best was around $1.5 million) involving paying for the magazine out of its own revenues. The Board was too wily for that approach. They wanted a nest egg, which meant a nice chunk of cash upfront. Then came publishing giant Thomson Corporation of Toronto and New York. Yes, it was a small division of Thomson, but their acquisitions team bought and sold the likes of the IAFP every day for a very good living. I don't think it took them 10 minutes to size up the Board.

The Board wanted cash, so Thomson said: "Fine, how about $3 million?" I think the Board's glasses fogged up so fast they couldn't read the fine print. They only wiped them off long enough to sign on the bottom line. When you're dealing with folks who buy what you're selling for a living, it's all about the fine print.

First, the $3 million was reduced by $500,000 for "payables" (which would have been paid out of cash flow had the Board kept the magazine). But Thomson got to keep $400,000 in receivables from ads that ran before the sale, so the real cash price was $2.1 million.

It gets better, or worse, depending on your perspective. The IAFP then agreed to pay Thomson $450,000 a year for the next five years to provide the magazine to its 15,000 members. Present value that payment stream, and the Board got maybe $500,000 for the magazine, which the magazine generated back to Thomson in about half a year.

The Details

That was my first exposure to financial planners in the M&A world. I was reminded of that first experience when I was recently looking over the acquisition of an advisory practice by an institutional buyer. This deal had all the same elements: a complex acquisition for millions of dollars, an advisor drooling over the high "purchase" price, and on the other side, an experienced M&A team that did deals like this every day. The results were predictably similar as well: The advisor didn't do nearly as well as he thought. Moreover, he may not realize it for years.

Unfortunately, this isn't the only deal I've seen lately which fits that description. As the independent advisory industry moves through another wave of prosperity, "strategic" buyers--institutions and other firms that are not advisors themselves--are buying practices in seemingly record numbers. Problem is, just like back at the old IAFP, there are experienced M&A folks on one side of the table and inexperienced advisors on the other. My recommendation: Before you jump at whatever fat carrot they're dangling in front of you, look at the deal the way you would a client investment, and consider all the implications.

Most deals that warrant a jaundiced look involve an offer quite a bit higher than the practice is actually worth. Unfortunately, it's not hard for the sharp-pencil guys to push the vanity buttons of any of us. When it comes to their practices, advisors, it seems, are human. Of course, your practice is one-of-a-kind, your knowledge and presence have created unparalleled client loyalty, and your approach to serving them is, dare we say, brilliant. That goes without saying.

Still, and I know this is crazy but bear with me here, perhaps we should at least entertain the possibility that there are some other advisory practices with similar client bases, professional experience, compensation structures, and service offerings. Naturally, those practices would be exceptional as well. And if they exist, then it's probably fair to say they'd have a similar value to your practice, don't you think?

Even better, let's further suppose that some of those similar, dynamic practices have been sold. And not to just anyone, but to other like-minded advisors who also have incomparable, yet similar practices. Impossible as this might seem, you'd have to admit that if a number of practices like yours were bought by advisors with practices like yours, the price they paid would have to be a pretty good gauge of what those practices, and your own, were actually worth.

This, of course, is exactly the situation on FP Transitions' various Web sites, which match advisors who are selling and buying practices. Consequently, its data provides a pretty good idea of how advisors value practices. Sadly, David Grau at FP Transitions has stopped publishing that data, under the theory (as best I can tell) that it was just too important for the advisory industry to have. Hopefully, Grau will see the light and resume publishing what was one of the industry's most valuable resources. In any event, to get an idea of the value of your practice, the 2005 FP Transitions Report will work fine for at least another couple of years. (For more on what you should know about the structure of many deals for advisory firms, see Terms of the Deal, at the end of this article.)

Stock in Trade

The point is that savvy sellers know the value of what they are selling, especially something as important as an advisory practice. Armed with that knowledge, you won't be duped by a low-ball offer, and you'll be suspicious of offers that are too high. You may end up taking the higher price, but first (as you protect your wallet), you'll want to understand why someone, especially a sophisticated buyer, is willing to pay so much.

One of the more popular formulas these days involves offering a higher-than-market price for a practice, then breaking the payment down into three sums cash, stock in the buyer, and ongoing compensation to the advisor. Here's the deal: The buyer gets the practice, and in return, the selling advisor gets to keep running it for a salary that's deducted from the price, and gets the balance in cash and stock. Oh, and the cash is limited, typically to 33% of the price.

Starting to get the picture here? The buyer can "afford" to pay the seller almost any price he wants, as long as he'll take most of it in stock, and the balance in salary that's paid out of the practice's cash flow. Even if the seller pays three times what the practice is worth, but only 20% of it in cash, he got the practice at a 40% discount. Nice work if you can get it.

The key, as always, is in the fine print. In this case, that's the compensation and the stock. Maybe I'm missing something here, but this part seems sadly laughable. Typically, an owner advisor's compensation comes from what she pays herself, plus the value compounding in her firm. After she sells, although the compensation is "set" by the seller, the deal formula virtually ensures that it's less than the seller is currently making. That means the selling advisor will be doing the same job for less money, with the objective of growing their former firm for someone else. So, we're talking about a huge hit to comp here, and for what?

Well, there's the stock. If the buyer is a public company, and if your stock has no restrictions, then it's as good as cash, or better--if you like the company's prospects. Of course, most of these deals don't involve a public company, which raises a whole host of additional risk and complications. The seller is really investing a substantial portion of their retirement portfolio in a private (and usually a startup) company, that they've likely never heard of. Hmmm. What would you advise a client if they wanted to do deal like this?

Stick With Your Own Kind

If 20-plus years covering the financial services industry has taught me anything, it's that you shouldn't try to beat the big boys at their own game. Independent advisors buying and selling practices to each other are on a level playing field: they're both in the business and they both know what a workable price and deal terms would be. However, if you're set on selling your practice to an institution or a rollup firm, get professional help: A big boy on your side of the table. Or you'll likely follow in the footsteps of the IAFP. By the way, Thomson recently sold the magazine group anchored by Financial Planning magazine to Source Media for a reported $300 million. How are you going to beat that?

Bob Clark, a former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.

Terms of the Deal

Here's what you should know about the structure of many deals for advisory firms

FP Transitions' independent marketplace for advisory practices provides a great deal of data about what advisors themselves value in a practice. This information (www.fptransitions.com) remains surprisingly constant from year to year, indicating a mature and relatively efficient market. Some of the most valuable information describes how practice acquisitions are structured: the standard deal terms, if you will.

The key to a successful acquisition is transferring the clients to the new advisor. So deals tend to be structured to give the sellers maximum incentive to help transition their clients. Typical deals involve a down payment, a guaranteed partial payment to the seller, and the balance paid out of future firm revenues, known as an earn out.

Cash down payments generally run between 15% and 35%, with lower figures going for commission-based firms (which average 22%), and the higher down payments for fee-only firms, averaging 30%. Fee-only firms command higher down payments because clients who pay ongoing fees are easier to transfer than clients who pay commissions on transactions, so the demand is greater.

The balance is usually paid over four years, in a combination of a promissory note and an earn out. In a note, the buyer guarantees fixed payments on a predetermined schedule, often secured by tangible assets such as the buyer's home. The remaining portion of the purchase price is paid to the seller as a percentage of firm revenues. If most of the clients transfer to the new advisors, then revenues will remain constant, and the seller will get full value. If not, then the value will go down. And it's not unusual for revenues to actually go up; greater attention from a new owner can stimulate clients to add to their portfolios under management.

By structuring transitions in this way, the seller has considerable incentive to see that his clients are transferred to the new owner/advisor. FP Transitions says that in a properly structured deal, an average 95% of clients will stay with a new advisor.

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