June 18, 2013

Why Profit Margins Matter

They’re crucial to an advisory firm’s value, among many other reasons

The profitability of a financial planning firm is a sensitive issue for many advisors. For some, the income of the business is a primary focus, and the balance between the financial success of the firm and its owners, and the services it provides to clients, is carefully balanced. For others, however, there is far less focus on the profitability of the firm, and more on the depth of service delivered to clients (even at the cost of profitability), especially if total income is "comfortable" to support the advisor's lifestyle.

Yet the reality is that whether the goal is to maximize income or not, the profitability of an advisory firm matters, in far more ways than "just" the income paid out to the owner. The profit margins of a firm are also crucial to its value; in the case of a sale to a third party, it may be the difference between selling or not finding a buyer at all, and even for an internal succession plan, a business that isn't profitable is simply unaffordable to the next generation at any price. And of course, if the owner's exit from the business is unexpected — for instance due to disability or death — the profitability of the firm has a direct impact on whether the surviving family members receive any value at all.

But beyond the financials of the advisory firm owner, family members and successor owners, the profitability of an advisor firm matters for another reason as well: the stability of the practice helps it to retain its staff. After all, a firm that is only marginally profitable simply has no flexibility to deal with the vicissitudes of business. Like living from paycheck to paycheck, it creates an environment where even a small disruption can have major ramifications, as many firms discovered when the 2008-2009 financial crisis forced them to fire staff and reduce services to clients at the exact time clients needed them the most.

And perhaps, ultimately, that's the real reason why running a firm with healthy profit margins matter: a firm that doesn't have a healthy profit margin as a cushion to deal with inevitable difficult times that can occur may be unable to sustain the quality of its services to clients... or at worst, may have to cease serving them entirely.

To discuss profit margins for a financial planning firm, it's first necessary to clarify what exactly we're talking about.

An excellent guide on the issue is "How to Value, Buy, Or Sell a Financial Advisory Practice" by Mark Tibergien and Owen Dahl. The basic framework is captured in the advisory firm Income Statement below:

Revenue                                      $1,000,000         100%

Minus Direct Expenses                  $400,000              40%

Equals Gross Profit                       $600,000              60%

Minus Overhead Expenses             $350,000              35%

Equals Operating Profit                 $250,000               25%

The category of "Direct Expenses" includes all the compensation paid to professional staff — e.g., the financial advisors who are directly responsible for the generation of revenue, including the owner for the work he/she does "in" the business. The category of "Overhead Expenses" includes all over expenses of the firm, from the remaining (operational) staff salaries to rent and equipment to software and IT and everything else. The percentage of revenues that are available after direct expenses is called the Gross Profit Margin ($600,000 / $1,000,000 = 60%), and the portion of revenues left after all operating expenses is called the Operating Profit Margin ($250,000 / $1,000,000 = 25%). In the context of advisory firms, the latter would typically also be analogous to EBIT — earnings before interest and taxes.

Notably, the percentages above — 40% for direct expenses and 35% for overhead expenses — are considered a good target for an advisory firm according to Tibergien. In fact, the whole purpose of benchmarking is to evaluate the way a firm allocates its expenses, between direct and overhead expenses, and down to individual line items, to better understand where the firm may be spending too little or too much, in pursuit of reasonable profit margins. In some cases, firms simply reinvest a lot of profits into future growth of the firm and may not necessarily take much out of the business, but a firm that isn't generating reasonable profits in the first place may be signaling other problems, that can be concerning for the owner, the staff, and the clients.

 

Profit Margins And Business Valuation

The reason why profit margins should matter to a business owner is relatively straightforward: it impacts both the actual profits that the business owner can take home, and also the value of the business itself. In practice, though, both of these factors are often misjudged by planning firm owners.

The first reason that looking at profit margins from a proper income statement matters — including an assignment of a proper salary for the owner — is that it can help to highlight when a practice may be more or less profitable than it should be.

For instance, a lot of business owners fail to distinguish between the salary that they receive from the practice and the profit that they generate by owning the practice. If a firm generates $500,000 of revenue and the owner takes home $150,000 after all expenses, that may be a comfortable income that satisfies their needs and goals. However, from the business perspective, if a fair value for the work the owner does in the firm is $150,000 — i.e., that's how much it would cost to hire a replacement to do all the work the owner does — then the reality is that the take-home salary is $150,000 and the take-home profits are actually $0, which raises the question of whether there is something else unhealthy in how the business is structured that is leading to zero profitability.

The second reason that profit margins matter is that they directly impact the valuation of the business, since ultimately, the value of any business is simply the present value of the future free cash flow of profits. As a result, a lower profit margin for the firm can drastically impact the price of the business to a third-party seller. In fact, it can also be a serious issue even for an internal sale, if the profits of the business cannot effectively help to finance the deal.

For instance, imagine a practice with $1,000,000 of revenue, two planners (the owner and a second lead advisor earning $250,000 each), and supporting staff and other overhead costs that add up to $400,000. The gross profit margin is 50%, and the net profit margin is only 10%.

From the owner's perspective, he may feel quite satisfied, taking home $350,000 of total compensation ($250,000 of "salary" plus $100,000 of "profits"), and his intention is to sell the business for 2X revenue, the popular price multiple he's read in the industry press, with the other lead advisor as a successor owner. However, from the successor's perspective as a buyer, he would still need to hire another lead planner to replace the original owner, for likely a comparable salary given the cost of living in his area. Which means as a buyer, he'd be paying $2 million for the practice, and only generating an additional $100,000/year of profits. That's a whopping price/earnings (P/E) ratio of 20, or a 5% return on his investment, which means it would take 20 years to recover his capital (and that's before generating any interest/growth value!)! This deal is simply not going to happen.

In reality, it's more common for firms to sell for what ultimately amounts to about 4 to 8 times profits, which means due to the low profit margins, this business shouldn't even be valued at 1 years' worth of revenue, not to mention twice that!

(Notably, estimating profits for some advisory firms is difficult, because the owners aren't always accurate in separating salary and profits; in fact, the primary reason many valuation expects use EBOC — earnings before owner's compensation — is specifically to strip out any confusion between how the owner pays themselves, and instead focus on what the business earns before owner compensation in all forms, substitute in what the buyer knows it would cost in salary to replace the work the owner does in the business, and thereby more accurately determine a true profit margin and estimate of free cash flow for valuing the business.)

By contrast, if the business had a healthier 25% profit margin (valued based on what the buyer thinks the profits would be after replacing the owner, not what the seller claims the profits are now!), the results are quite different. Now a valuation of $2,000,000 would equate to a multiple of 8 times profits, and an expected return of 12.5% on equity, which both makes the business valuation more reasonable, and ensures that the purchase will not be an unmanageable burden on the successor owner.

Or viewed another way: whether you're aiming for a sale to an outside third party or an internal successor, if the profits of the business aren't reasonable, the purchase is simply not affordable, as the outside buyer won't want to buy due to a poor return on investment, and the internal successor won't want to buy because the price tag is just too high given the cash flows that will be available to pay for it. And of course, if the business exit must occur unexpectedly — due to disability or even death — a practice that's not profitable may not survive at all, and certainly will not leave much to surviving family members.

In the second part of our post, we’ll discuss the role of profit margins in business stability.

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