Caveat Emptor

In spite of these risks, growth through acquisition still presents a viable opportunity for advisors to grow their practices quickly, but it is important that they apply the same common sense to these transactions as they do when counseling clients. At a minimum, here are seven questions every buyer should ask herself before buying a practice:

1) How independent is the source of the deal? Independence has been a professional battle cry for many advisors, but they often deem it less valuable when engaging professional help for their businesses. It is common for advisory firms to use intermediaries or business brokers that represent both sides of a transaction. For expediency’s sake, advisors would rather have one person facilitate the deal in order to share the cost. The risk is that the broker’s goal is to see that the deal gets done, not that one side or the other has an advocate. It is therefore prudent to always have an independent set of eyes–your attorney’s, CPA’s, or an experienced M&A advisor–take a look at the deal before you execute. Plus, there are numerous deal points that must be considered, including tax, liability, non-compete, and terms.

2) Can the practice reward me for both my labor and my risk? In conventional valuation theory, analysts make adjustments for issues like personal expenses, compensation, and the true cost of doing business before they apply a multiple or capitalization rate to the free cash flow of the enterprise. Since many advisors do not differentiate between gross income and their compensation, this concept is often hard to grasp. But one of the real costs of running an advisory practice is the labor of the professionals. In other words, if you were an employee of the business (which, in fact, you are), what would your labor be worth? In conducting your own valuation of a practice, add dollars to reflect this cost and deduct it from the revenues along with all other expenses in the business to come up with a bottom line number. That will be your operating profit, or the return for your risk of buying and owning a business. This is the number that should be capitalized, not the gross. We have been asked to help far too many practices that have a large gross, but cannot afford to pay their owners fairly and produce a profit.

3) Is there a more effective way to deploy my resources? You have a finite amount of time, money, and energy, so is buying an overvalued practice with limited growth potential the best deployment of those resources? For example, if the seller is asking $400,000, would you be better off investing that amount–or even a fraction of the amount–into your own marketing efforts? This is especially important if you are not already part of the practice and are uncertain if the practice’s existing clients will continue to retain you. Could you get to your net return goal as quickly, and for less money, than through this acquisition?

4) Is the acquisition a good cultural fit? The excitement of consummating a deal often causes advisors to forget some basics–is this a relationship that will work? When acquiring a practice, be sure to understand the philosophy, the process, and the reasons for the previous advisor’s recommendations to his or her clients before you make the plunge. If your approach–or your target clientele–is in conflict with the seller’s, your potential for attrition is very high. This may sound obvious, but we have seen far too many buyers think that they can change the way in which clients buy products and services from their advisor. Ask yourself how you will do this. Trashing the approach used by the previous advisor is not usually a formula for success.

5) Do I have the capacity to serve this client base? There may be a temptation to skim off the top clients and ignore the rest, which could make it easy to manage the capacity problem of taking on all of this new business. That’s your call. But recognize that, especially in the early years, you will need to expend an extraordinary effort to keep these clients in the fold, to make them feel valued, and to provide them with a service experience that either they have come to expect or that they desire. You should work through an operating plan as to how you will touch these clients and with what frequency, then determine if there are enough hours in the day–or the year, for that matter–for you to handle them in addition to your current capacity.

6) Have I evaluated all of the hidden risks? In every practice, there is the potential for risks that are not apparent at the outset. They could involve compliance, or client satisfaction, or they could be in the form of recommendations that are a time bomb ready to explode. In an ideal world, you would have the opportunity to do a client satisfaction survey before you acquired the practice; there are several good and relatively inexpensive tools in the market available for this. At a minimum, you will want to engage an independent compliance consultant to perform due diligence on the seller’s practices and procedures before you commit. Both of these can be covered in your letter of intent, which is normally the prelude to the purchase agreement. Reluctance on the seller’s part to these kinds of evaluations should be a big red flag.

7) Am I making this decision for emotional reasons? For many practitioners, one of the biggest challenges is client acquisition. Buying a book of business can be an expedient way to gain clients without having to make calls, develop meaningful referral sources, or do the type of marketing you are not comfortable with. But be careful not to delude yourself into a potential that has never been realized in the book of business before. Evaluate it on its own merits, and apply your professional analytical skills to temper the excitement and emotion of doubling or tripling your growth overnight through this purchase.

If the tone of this column sounds a bit shrill or frightening–good. Sometimes it’s important to be scared into contemplating the risks so that you act more prudently. Personally, I see a tremendous potential for advisors to grow through acquisition. There are opportunities in most local markets to create a dominant practice, and it is clear from looking at the economics of evolving practices that attaining a critical mass is necessary for the success of many practices. In addition, it appears that there is an oversupply of clients that need and want to be served by able advisors. My only caution is that you shouldn’t make this investment because you think it is a sure bet. Our experience tells us that like most everything else in the financial world, the opportunities that come with the acquisition of an advisory practice also come with risks that need to be managed.