From the November 2008 issue of Investment Advisor • Subscribe!

Measure Twice, Sell Once

Turbulent financial markets can be the best of times to buy, sell, or build value in an advisory practice--if you know what makes a firm valuable

By Brad Buffermann, David Grau, and Bob Clark

Down markets are traditionally good for independent advisory practices. Many firms get a flood of new clients deserting wirehouses and also reconnect with existing clients, which can lead to more client assets and increased client referrals. In fact, many successful practices get the majority of their new clients during turbulent markets.

Perhaps surprisingly, troubles on Wall Street also create good times for the practice transition market. Normally skewed to sellers of advisory practices, the tough times tend to level the playing field between sellers and buyers. The number of sellers increases as advisors who were thinking about selling get pushed off the fence. Moreover, with practice revenues down, and fewer firms in a position to buy, today's buyers sometimes find sellers a little more willing to negotiate.

With credit tight, seller financing becomes a major plus. What's more, with investment returns struggling, the already healthy risk premium that buyers traditionally pay financing sellers is even more attractive. As firms attract new clients, there's also greater potential for sellers to increase the purchase price through higher revenues during the "earn out" phase. In fact, during the past 12 months, we've seen values for similar practices climb between 15% and 25%.

Calculating Real-World Value

Whether you're buying, selling, or looking to increase the value of your practice, your success will depend on knowing what makes an independent advisory practice valuable. However, in our work facilitating the buying and selling of practices, we've found that none of the traditional valuation models works well for independent advisory practices. To help advisors determine the "real world" value of independent advisory firms, we've come up with a better valuation model. Based on FP Transitions' 10-year experience operating an open market for advisory firms, and analyzing and collecting data from the thousands of practice transitions we've consulted on, listed, or closed, we created the FP Transition Practice Valuation Matrix: a systematic approach that consolidates more than two dozen factors that influence practice values into a range of prices that advisors can expect to receive for their practices on the open market.

Appraisers typically use three methods to value businesses: Asset valuation; revenue and/or income multiples of comparable sales; and the present value of future income. But as we said, each has flaws when applied to independent practices. For instance, advisory firms rarely have much in the way of tangible assets, and without specific market data, comparables are simply someone's best guess.

The income approach works best for firms with more than $5 million in annual revenues, where the buyers tend to be institutions or internal employees who intend to continue operating the firms as business units. But for the vast majority of advisory practices, defining "income" becomes more elusive: How do you treat an owner's income and bonuses? What about cars, retirement plans, insurance, travel and entertainment, or the education of a child?

What Makes a Practice More Valuable?

To get a more accurate picture of advisory practice value, our Valuation Matrix compares each firm to market data in the four areas that determine a practice's open market value: Transition Risk, Cash Flow Quality, Market Demand, and Deal Structure. The result is a valuation that assesses the transferability of the client base, evaluates the quality of the cash flow being transitioned, and reflects the general market demand for a practice of similar size and quality.

Of the four areas, three offer an opportunity to increase value long before the sale of a practice: transition risk, cash flow quality, and market demand. The remaining factor--deal structure--becomes important once a practice is put up for sale. In fact, of the four, the deal's structure can have the greatest impact on the selling price. That's because the structure of the acquisition allocates the risk of the transaction between the seller and the buyer.

The more risk a seller is willing to take off the buyer's plate, the more a buyer will be willing to pay for the practice.

Valuation Evaluation 1: Deal Structure

These days, advisory practice acquisitions typically contain three components: a down payment, a promissory note for between three and eight years, and an earn out contingent on the performance of the firm for three to eight years. The extent to which each element is used can shift the risk of a transaction.

Because advisory practices are service business with little in the way of tangible assets, buyers are "buying" the client relationships. The primary risks, then, are that the clients won't transfer over, or that they won't stay with the new advisor, or that the practice won't continue to grow as expected. How a transition deal is structured determines who is taking the client transition risk.

For instance, if a buyer pays the entire purchase price for a practice in cash, up front, then that buyer has assumed all the risk that the clients will transfer, and that they will stay. Conversely, if a seller accepts an earn out for 100% of the purchase price contingent on the revenues the practice will generate during the following five years, then he or she has taken the vast majority of the risk. As you might expect, most deals fall somewhere in the middle, with the transfer risk shared between the buyer and the seller. The value of the practice, then, depends on how much risk the seller is willing to take.

So that potential sellers can see exactly how much more buyers have been willing to pay to share this risk, our Valuation Matrix computes the value of a practice under three types of deal structures. They are: all cash, all contingent, and the standard deal terms of 36% down, 35% in a note, and 29% contingent on performance. As you would expect, due to the time value of money, the dollar amount of a purchase price paid in all cash will be less than if the payments were spread over, say, four years. Yet, the present value of the all-contingent scenario will be quite a bit more than the discount for today's interest rate environment at, say, 7%. That's because the buyer is paying the seller a premium for assuming some of the transfer risk and an incentive to help generate more referrals and new business.

The chart below compares the purchase prices of a typical advisory practice under the three deal term scenarios and timeframes: immediate payment for all cash; and three to five years, and six to eight years, for the all-contingent and standard deal terms. This case involves a fee-based practice that has been in business for four years, has $42 million in assets under management, another $24 million in assets under advisory, and gets 56% of its $310,000 annual revenues from fees.

Notice the all-cash value of the firm based on our open market data is $520,000, while the all-contingent value is $1.04 million if paid over three to five years, and $1.15 million over six to eight years. Taking the cash price as the present value, the shorter period represents a discount rate of 23.5% and the longer term 21.2%. More important, the values of the practice under more typical deal terms paid out over those same two time periods are $871,000 and $1.023 million, representing discount rates of 23% and 24%, respectively. Buyers do indeed pay a healthy premium for the privilege of sharing some of the transition risk with the seller--rates that would be hard to match in a seller's retirement portfolio.

Once you've begun the process of selling a practice, you can maximize the purchase price by accepting as much of the risk as you're comfortable with. That means taking a down payment lower than 36%, a contingent earn out of greater than 29%, or both. With market discount rates ranging from 15% to over 25%, you'll be well compensated for your additional exposure. Conversely, to keep the purchase price down, a buyer can pay more up front, and ask for less of an earn out on the back end. In a typical environment where multiple buyers compete for each seller, such a show of confidence in the transition can win over a seller.

Valuation Evaluation 2: Transition Risk

The other three factors that determine a practice's value can be enhanced long before a practice is sold. The first step in our valuation process is to evaluate the transition risk. Although the deal terms can spread this risk between the buyer and the seller when a practice is sold, each practice has its own inherent level of transition risk which is largely under the control of the firm owners.

Transition risk has two general components: client risk--the likelihood of transiting a firm's clients to a new owner/advisor; and continuity risk--how the clients and the community are likely to perceive the change in ownership. To get a handle on the client risk, we look at client tenure, firm tenure, and client demographics.

Advisors are well aware of the problems associated with client inertia: Trying to get someone to change the way they approach their personal finances is often the toughest hurdle to getting a new client. But inertia can work for an advisor, too, when it comes to retaining clients--even during a practice transition. Our data shows that clients who have been with a firm the longest are the least likely to leave following a change in ownership, particularly during the critical 12 months following a sale. That grace period gives the new owner/advisor time to establish his or her credibility and build a rapport with their new clients.

Market data tells us that when clients have been with the firm for fewer than nine years, the risk of their not making the transition increases substantially. Above that point, however, the risk drops incrementally as tenures lengthen. Consequently, practices with high concentrations of clients who have been with the firm for less than nine years are considered more risky to transition.

The average practice on the market has had its doors open for 16 years. Consequently, buyers tend to value more highly firms that are older than the average.

When assessing continuity risk, we look at whether the B/D or custodian will change; if the firm bears the name of the seller, will key employees stay; and most important, how much, if any, post-closing assistance will the seller provide? Clients are far more comfortable with a new owner who has the same style and investment philosophy as their current advisor, which is why most practices are sold to advisors who are very similar to the seller, rather than to the highest bidder. While cosmetic appearances such as a generic firm name help with that perception, the most powerful indicator is that the former owner continue to work with the new owner, not only to make introductions but to hand off client files and knowledge over time. The longer the seller agrees to work with the firm, the less dramatic the transition appears.

Our data shows that post-closing assistance time preferred by buyers is a function of the strength of client relationships: It's less for fee-only firms than for commission firms, with fee-based firms in the middle. As the chart at right shows, sellers of fee-only firms average 410 hours of assistance, compared with 517 hours for fee-based owners, and 620 hours from transaction-oriented firms.

Buyers also like to see that key employees have made a formal commitment to staying with the firm they are buying. Having non-compete/non-solicitation agreements in place with employees--especially professionals who interact with clients--add to the value of a practice. Moreover, a non-competition agreement from the seller (with minimums of three years and a 25-mile radius) are essential: Most firms are virtually valueless without one.

Other ways firm owners can reduce the transition risk of their practice and increase its value include: Having a generic firm name rather than the name of the advisor; periodic culling of smaller, marginally profitable clients with short firm tenure; and affiliating with a large broker/dealer or custodian. Not having to move client accounts is so important that many practice owners won't sell to a buyer who is outside their affiliation or they will require the buyer to transfer his current clients, rather than the ones he "buys" with the acquisition. What's more, using the same technology, the same back office, and having the same relationships with the home office make a practice much more valuable to a buyer.

Valuation Evaluation 3: Cash-Flow Quality

The next area that market data shows affects practice value is cash-flow quality, i.e., the sustainability and growth potential of a practice's revenue stream. To get a handle on this, we look at who the clients are, where revenues come from, the expense drag on those revenues, and the future potential of both the clients and firm revenues. After all, while the buyers are buying the clients, they are paying for the revenues. To determine a firm's value, you need to know the quality of both, and have a good idea about the direction they are headed.

When it comes to the client base, the factors that determine value are age, wealth, and the revenues they generate. Buyers highly value clients in the "prime age" range between 50 and 70 years, in their peak earnings years and at the top of their savings cycle. While older clients tend to be wealthier, they are also in their drawdown phase. It is also important to assess the average wealth of clients and the corresponding revenues per client. The market averages are $360,000 in AUM per client, and $2,539 per client, per year. Practices with numbers in excess of those are more valuable. Also consider who holds those assets and generates those revenues: Practices with a higher concentration of assets in the prime age range are more valuable, as are those with lower concentration of assets in the over-70 bracket.

Factors that determine the value of a revenue base are revenue mix, revenue growth, client growth, and expenses. Recurring fee revenues are the one most highly sought after by buyers on the open market, making practices with the highest concentration of fees the most valuable. Annual revenues from fees are typically valued at multiples between 2.0 and 3.0, while non-recurring commission revenue multiples range between 0.5 and 1.6. The average revenue multiplier for commissions is 1.1, but sometimes owners of fee practices will value non-recurring revenues at the higher end of the market if they sense the opportunity to convert a substantial portion of its clients to recurring compensation.

As you would expect, a history of solid revenue growth and the potential for revenue growth make a practice more valuable. Healthy advisory practices grow at between 10% and 20% per year, with value increasing as growth approaches the high end. Ironically, practices with growth rates much higher than 20% don't usually see a corresponding increase in value--most buyers will pay for a growth rate they believe that they can achieve, not one they don't feel they can match.

To project a firm's revenue growth potential, we compare the historical revenue growth rate over the past two to three years against the growth of new clients during the same period. Our market data shows that new clients typically tend to increase their assets under management for the first few years with a new advisor, as their comfort level grows. Consequently, new clients represent future revenues: new client growth rates that exceed revenue growth rates are a strong indicator of a firms potential for growth, increasing its value.

Finally, to assess the quality of a firm's cash flow, we look at the drag that expenses put on revenues. Since an owner's compensation is difficult to normalize, we look at the compensation paid to key employees who would be likely to stay following a sale, as well as overhead. With overhead, however, it's important to differentiate costs that aren't likely to affect a new owner from expenses that indicate higher costs of servicing a firm's specific client base.

Opportunities to increase the value of an advisory practice by improving the quality of its cash flow are many. By far, the biggest factor within an owner's control is the type of compensation. As we saw above, recurring fee revenues can be more than three times as valuable as commission revenues. It's far better to convert your clients to fees and then sell, rather than sell and let the new owner reap the benefits of that conversion.

Attention to the client base can also yield big dividends in the form of increased practice value. You'd be surprised how many firm owners simply assume that their wealthier clients are also their "best" clients. Make sure clients who require costly services adequately compensate your firm. Also, don't hesitate to periodically jettison unprofitable clients outside of the prime age range, younger clients who drag down average AUM and revenues, and those with higher-than-average costs to service. Finally, make a concerted effort to recruit new clients in the prime age range: they're more valuable and profitable, and usually easier to service.

Valuation Evaluation 4: Market Demand

We call the last set of factors affecting practice values "market demand"--an assessment of specific firm characteristics that our market data tells us buyers tend to highly value. Some of these are pretty intuitive, while others are more subtle. For instance, take location. It's not hard to understand that it's easier to find buyers in Southern California than South Dakota, so a practice in Newport Beach is simply worth a bit more than one in Sioux Falls. The states with highest demand are predictable: California, Florida, Illinois, Michigan, Massachusetts, New Jersey, New York, Ohio, and Texas (to view a map of the entire country showing demand in each state, visit InvestmentAdvisor.com).

However, the reason that buyers pay slightly higher multiples for firms with more than $1 million in revenues isn't so clear. We're also seeing an increased demand for practices with revenues of less than $500,000, and even smaller deals involving partial book sales are fetching higher multiples these days. We suspect the higher demand for firms at either end of the size spectrum stems from different kinds of buyers: larger firms are usually bought to be run as is, not merged into another practice, so the entire business has value. Conversely, smaller practices are easier to absorb into an existing practice.

Any restrictions on potential buyers also adversely affects practice values. A practice that can only be sold within its own broker/dealer or custodian network, particularly if it's not one of the larger networks, can reduce market value by 20% or more. Or severe limitations on the type of buyers will effectively move a practice from a strong seller's market to a strong buyer's market. (A common example of this is the desire to sell to internal employees.) The result can be the loss of one-third of the practice value or more. That's not to say that internal sales are bad, only that firm owners need to make informed decisions based on the real opportunity costs involved.

Lastly, there's the practice niche to consider. For decades, consultants have recommended that advisors focus their practices on specific client niches to increase marketing and referrals and decrease service costs. But there is a downside to that strategy, particularly if taken to extremes. A firm that focuses too narrowly, particularly on an unusual clientele, can limit potential buyers.

How to Build Value

When it comes to advisory firm values, the bottom line isn't the bottom line. Even in challenging markets such as these, owner/advisors can increase the value of their practices and maximize the purchase price in a transaction by focusing on the elements that create value: transition risk, cash flow quality, market demand, and deal terms.

Perhaps the most value-adding move you can make is to convert all your clients to fees, followed closely by taking on as much risk as you can stand when you sell. Before that happens, position your firm to transfer with a generic name, and get those non-competes signed. Don't forget to focus your client base in the prime age range, with profitable clients in an attractive niche. Finally, a good, steady growth rate is always a plus, and if aggressive growth is in your strategic plan, you'll be well rewarded for breaking the $1 million revenue barrier. Bigger isn't necessarily better--but it is more valuable.


Brad Bufferman is executive VP of business development of FP Transitions, and creator of the Valuation Matrix; David Grau, Sr., JD, is president and founder of FP Transitions, a leading provider of continuity, succession planning and practice valuation services. For more information, visit www.fptransitions.com. Bob Clark, writes and works with firms who provide services to independent advisors from Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.

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