From the March 2008 issue of Wealth Manager Web • Subscribe!

March 1, 2008

Eye of the Beholder

It was a single line item on a simple financial disclosure form, but it may be the most loaded question that could be asked about my personal finances. In addition to the other assets, liabilities, income, and expense items you would expect, the bank wanted to know the value of my interest in the practice. Given all the factors involved, my answer was almost immaterial to the bank's decision about maintaining its modest credit line to our firm. Nonetheless, it got me thinking about valuations.

The most often cited rule of thumb that I've come across over the last few years has been a multiple of revenue. That may be okay as a place to begin thinking about the firm's valuation, but such a simplistic approach ignores many important variables.

Let's start with the revenue itself and its "quality." The sole proprietor who generates $500,000 a year in revenue completely from the sale of products with no renewable income from those sales cannot have as valuable a business as a firm that with revenue of $500,000 a year that automatically renews. Accordingly, when estimating the value for a firm based on how its revenues are generated, different multiples must be applied.

In fact, "recurring versus non-recurring" is more of an issue than is fee versus commission. Practitioners who derive 100 percent of revenue from hourly or flat fees, but have few clients who return for more advice, are likely to find their firm's value to be lower than that of practitioners who generate the same amount of fees--using the same method of charging those fees--but have more regularly returning clients.

The staple of the recurring revenue approach for most practitioners is assets under management. But not all AUM is created equal. As with hourly and flat fees, retention matters a great deal. For years I've been hearing about the commoditization of the assets under management model, but I haven't actually seen prices decline in my firm or those of my colleagues. In our case, I can attribute that to the fact that we deliver far more than investment management. Our firm really does provide financial planning.

We are focused on our clients' unique goals, needs, resources and obstacles. If we had simply been looking at beating some market index, we would have had higher retention when we beat the index and a lower retention level during times we lagged. Instead, we had extraordinarily high retention through both bull and bear markets. Heck--we seem to pick up more new clients when markets are bad because people realize their current relationships are not based on the values that are most important to them.

Retention, however, is only one factor to consider regarding revenue. Firm A, Firm B and Firm C all have $100 million in AUM, each charges a rate of 1 percent, and each has had 100 percent retention for the last five years. Still, these firms should not be valued identically. Why? Firm A has 1,000 clients, Firm B has 100 clients, and Firm C has only one client. I have to believe that a potential buyer will view these respective firms very differently. The personnel, processes, technology, expense structure and skill set required to adequately service these diverse client bases would vary greatly.

I'm not sure which frightens me more: The prospect of having to serve 1,000 households or having a million bucks in revenue dependent on the whims of one family. A great deal of the satisfaction I get from my work stems from the meaningful relationships I have with my clients. I believe very strongly in the power of financial planning to benefit my clients, but doing a good job takes time, and there's only so much time available. Providing services to 1,000 new families as does Firm A would require a large managerial challenge to say the least. I would wonder if that is why that firm's owners would want out.

In the case of Firm C, it takes just one issue to go from owning a business with a million dollars in revenue to one with nothing. So for me, anyway, Firm B has the most appeal. But I'm still not inclined to buy a firm based on a multiple of revenue.

I would also want to look at total expense structure. After all, one significant goal of the business owner is to maximize the difference between revenue and expenses. Revenues may be equal, but the firm with higher expenses produces less profit and should be valued at a lower level.

For the buyer, past performance from both the revenue and expense perspective are important and of interest, but more relevant are the firm's future prospects. After I acquire the new business, how will the revenue profile and expense structure of the newly combined enterprise look? Now that's a loaded question!

We've spent most of this discussion on the headline price one might pay for a firm. Few deals are consummated by the buyer writing a check for cash to the seller. Often there is some upfront money, a promissory note, an earn-out, or all of the above. Buyers love earn-outs because the seller then has a strong incentive to help retain client relationships and the revenue stream that comes with them. All these payments affect expense structure.

It is common to see inefficiencies that, if corrected, could enhance profitability. Often this results from consolidating offices, streamlining technology, and making staff changes. Who's going to stay, and who's going to go? A potential buyer's answer may differ greatly from the sellers, and let's not forget that the staff themselves may have some say in the matter. You may wish to retain someone who may not want to work for you or your current employees. Your own "loyal" employees may start looking elsewhere too, if they don't like the new arrangements or personnel. A buyer who feels they are not operationally or managerially prepared to take on a particular practice will place a lower value on the practice--if not walk away. Potential sellers would be wise to make their firms more manageable.

And what about the clients? I've found that most clients adapt to change fairly well, but few of them enjoy having to do so. Announce the sale or merger, and it's likely that past performance won't mean much. The question on their minds is, "How will this affect me?" The clearer the answer--and frankly, the less change involved--the more likely it is that clients will be satisfied with the transaction and will retain the services of the new firm.

This means that the due diligence process has to consider more than the financial statements. It must carefully examine the clients' experience in working with a firm. How often and in what way are clients contacted? What topics are they contacted about? How much of their interaction is with a firm principal? Is the investment philosophy and implementation consistent enough to not confuse clients?

As a potential buyer you are making a significant investment. Most people would expect to receive, say a 9 percent to 12 percent return on their investments, long-term from a well diversified equity portfolio. That equates to a multiple of profits roughly between eight and eleven. Investing in such a portfolio does not seem anywhere near as involved as sizing up a firm for purchase. Given this, it is difficult to see why one would pay more than a few times profits as a purchase price for a firm. As a potential buyer, I would ignore the multiple of revenue approach and look at the firm for its potential and the deal for favorable terms.

The issues go far beyond numbers.

As a potential seller, I can't help but view valuation from a deeply personal and admittedly somewhat irrational perspective. What would it take to get me to leave my job? I like my work, my clients and my co-workers. I am 40, married with two great kids age 11 and 9. What would I do with myself? I've never really done anything else for a living. (I sure couldn't make it as a writer!) The kids are in school all day, I can play only so much bad golf, and all my friends are at work. Kelly and I love each other, but if we were together every waking moment, there might be challenges. To get me totally out of the picture, the price would have to be pretty high.

Since retention is such an important factor, many buyers put the sellers into employment contracts. Therefore, I could still be in the business, but I'd get to move some of that number on the bank form over to another line item, like "cash." That sounds interesting. The issue here becomes what would it take to get me to give up control?

The bottom line when it comes to valuation is that a firm is worth whatever someone is willing to pay for it. You can crunch all the numbers you want, but that only gets you so far. There are a lot of moving parts. As a buyer, I'd beware. As a seller, well, they say every man has his price, and even though I am unsure what my price may be, I'll be paying attention to seeing what deals get done. I know my bank would appreciate it if my estimate bore some relation to reality.

Dan Moisand, CFP, a principal of Spraker, Fitzgerald, Tamayo & Moisand, LLC, in Melbourne, Fla., has been listed as one of the country's best advisors in several magazines. He is a past Chairman of the Financial Planning Association and a two-time winner of the Journal of Financial Planning's national "Call for Papers Competition."

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