The Wisdom of the Crowd

In the past five years, financial services practice values have moved steadily upward in the open market to well over two times gross revenues. Is that a fair assessment of the actual value of those practices? The answer is both straightforward and nuanced, and it’s critical. After all, the starting place for almost every buyer, seller, partner, merger candidate, employer, and employee interested in a sale to a third party, an acquisition, or an internal succession plan is determining practice value. Using data from comparable sales generated by the many participants in the open market that now exists for practices, this issue can be addressed quickly and definitively, and usually without the help of an expensive appraiser or valuation expert. The wisdom of the crowd is all the expertise the marketplace needs. The process of buying and selling practices using an open market system is still in its infancy, but plenty of data has been gathered over the past five years. That data, which forms the basis for this article, is encapsulated in the 2005 RIA Transitions Report, available at www.BusinessTrans.com. Rather than focusing on the past, however, let’s look into the future, and use the historical data to suggest where practice values are going.

The open marketplace, as defined largely by the Transitions family of Web sites and its buyer and seller participants, tends to be small-cap practices, selling for less than $3 million and with about $1.5 million or less in gross annual recurring revenue. The open marketplace, at least in terms of quantifiable data, is composed largely of four Web-based platforms: FP Transitions, Fidelity Transitions, RIA Transitions (my company’s platforms), and Schwab Transitions (owned and operated by Charles Schwab & Co.). The data provided in this article includes all sites but Schwab’s.

The evidence we’ll review starts with historic valuation performance and data collected from sales in years past, since past sales provide a clear benchmark and perspective on recent selling activity. We will examine the current high demand for financial services practices, determine its source, and forecast the near-term future of that demand. We’ll look at marketplace efficiency and evolutions in practice transitions. Even transactions between employer and employees have some impact on this discussion. Acquisition financing will also be considered as it pertains to fostering demand and extending the marketplace to younger, less-well-capitalized buyers. Finally, we will consider the wisdom of the crowd–the buyers and sellers of practices at this level.

The Uniqueness of Small Practices

As we compare notes with investment bankers and business brokers of practices at the mid-cap level and beyond, one thing seems clear: the data from small-cap practice sales and acquisitions is leading the way in both quantity and quality. I keep hearing about how larger practices are, or should be, selling for a higher multiple of value than smaller practices, but there doesn’t seem to be much reliable, consistent, or quantifiable data on which to base that statement.

Intuitively, mid-cap practices selling for between $3 million and $10 million and even larger-cap practices should sell for a higher multiple in that the buyers (and sellers, for that matter) are larger and better capitalized, and both buyer and seller will have a more institutionalized approach, such as multiple principals, a trained staff, and so forth. These factors would almost certainly make the post-closing client transition much easier, more predictable, and more valuable. But the data doesn’t support this intuitive reasoning. So far, at least, it appears that small-cap practices, and practitioners, are paving the way in terms of sheer numbers of closed sales, closing percentages, and data reporting.

But small financial services practices are unique in several aspects. A small financial services practice centered around one licensed professional, unlike a larger financial firm or even an unregulated business, has some inherent limitations in its business model. These limitations affect the value of the practice when it is time to sell. For example, such a “practice” is more likely to be dependent on just one or a few individuals for the bulk of its income. Even the referral sources to the practice tend to be based on the owner’s unique reputation and skills in the industry, something not easily transferred.

These limitations tend to show up in the deal terms that affect the practice’s value. Most transactions at the small-cap level are not all-cash at the time of closing, and the market multiples, or any valuation method used, should reflect this. These deals often have about 35% to 45% of the purchase price paid in cash at closing, and the balance over three to four years using seller financing. The balance owed after the down payment is usually contingent, in one form or another, on transition results, reflecting the perceived challenges in transferring the personal relationships, goodwill, and referral sources.

Few valuation approaches, and fewer professional appraisers, are using current information to value these types of professional practices. In the midst of a seller’s market with almost excessive demand, and three to four full-price offers per seller listing, it is important to use a valuation method or methods that accurately reflect the current level of supply and demand. In fairness, it won’t always be a seller’s market, but that’s a fact that should be taken into account as well at the time of the valuation.

Ironically, the uniqueness of the small-cap financial services practice may also be what makes this type of practice so highly valued. The small size of the practices, with a limited number of client relationships and, usually, a narrower range of services, products, and advisors, can be acquired for a smaller capital investment and at less risk than mid-cap and larger practices. Then there is the familiarity of the small-cap model. Since most buyers are larger than the acquisition target, buyers have a clear understanding of what they are acquiring, since that is where most started themselves.

The Open Market Participants

What are the characteristics of buyers and sellers in the open market for small-cap practices? The data from the Transitions sites shows that sellers over the past few years have ranged in age from 29 to 78, and selling prices have ranged from $50,000 to $3 million. Some sellers reported they were retiring; many more wanted a course change in their lives; a few became fed up with the increased burden of compliance; and some didn’t make it through the clutches of the regulators. Buyers ranged in age from 22 to 83. Some wanted to grow more quickly. Others wanted to step to the next level with the help of a senior practitioner, a mentor.

The data indicate that participation in buying and selling practices continued to grow for the fifth year in a row. Where will it stop? The answer, it would seem at first glance, depends on the sellers, or at least, the number of sellers. At this point, buyers still outnumber sellers by at least 30 to 1, a ratio that seems to be still climbing in favor of the sellers.

What is most interesting about the increase in buyer demand, though, is that it has kept pace with the number of available sellers, leaving still more buyers than sellers.

In his column in Investment Advisor in October 2004, “A Voice in the Wilderness,” Mark Tibergien cautioned that “we are in a bubble for practice transitions.” But the facts lead to a very different conclusion. While the average number of interested buyers per seller listing has increased from 19 to 35 in the past five years, the multiple of value has increased from 2.00 (times the last 12 months’ recurring income) to 2.10, a gain of only 0.10 in the past four years. As you can see, this isn’t eBay, and auctions for an individual practice, given the miniscule rise in value, are the exception, not the rule. Compare these sets of facts from the FP, Fidelity, and RIA Transitions sites and draw your own conclusions.

Participation in the open market will ultimately determine how high, and how fast, practice values will grow, and it will be the buyers who will drive selling values, not the sellers. So why didn’t practice value increase more with so many interested buyers? In fact, it did, but not in terms of the purchase price paid. Like the smart business people and counselors of investment risk they are, buyers studied the data flowing from the deals completed in the open marketplace and began to restructure the terms of the deals rather than increasing the purchase price paid for the practices. This was a smart and daring business move that, in hindsight, has paid off.

How Deals Have Changed

Rather than pay a higher price, buyers’ confidence in the marketplace prompted a more subtle change in practice values in recent years. Consider these trends from 2002 through 2004:

• The average down payment increased from 26% in 2002 to 36% in 2004;
• The percentage of the deal coming to the seller in the form of an earnout dropped from 64% in 2002 to 33% in 2004;
• Promissory notes became more prominent, increasing from 10% of the value of the average deal in 2002 to 31% in 2004.

The tax treatment shifted as well:

• The capital gains tax allocation went from an average of 59% of money received from a deal in 2002 to 68% in 2004;
• The Consulting Agreement component (subject to Social Security taxes) dropped from 29% in 2002 to 26% in 2004;
• Ordinary income (attributed to the non-competition/non-solicitation agreements) dropped from 12% in 2002 to 6% in 2004.

With these better terms, sellers are getting more of their money up front and with better tax treatment. At the same time, the repayment period stayed fairly constant and the interest rate demanded on the seller financing stayed constant as well. Buyers paid off their acquisitions faster, and avoided paying a higher purchase price.

There is every indication that buyers are increasingly confident that they will reap the underlying value in the small-cap transaction–long-term client retention. Because of that, buyers are clearly willing to take on more risk. Obviously, there is a limit to the enhancement of internal deal dynamics, and it seems reasonable to expect the value multiple to pick up as soon as an equilibrium is reached on the down payment and other deal terms.

What’s Missing?

If greater access to practices for sale by more buyers is to occur, it will have to begin with better outside institutional financing for these acquisitions. Currently, most small-cap practice acquisitions rely on a limited, ad hoc variety of financing assistance, including seller financing, business lines of credit, home equity loans, and broker/dealer financing. Strangely absent from the mix is bank financing.

At this time, only Small Business Administration loans are available to assist in the acquisition process at the small-cap level, and the time and resources needed to complete the cumbersome SBA loan process is generally fatal to the buyer’s chances. However, given that banks are currently willing to lend on deals involving the acquisitions of doctor, dental, veterinary, and CPA practices, the longer-term future of institutional financing looks promising. When it happens, the marketplace will truly be open, for the first time, to all interested and qualified participants. But even without the availability of bank financing, practice values have continued to increase.

Currently, the buyer population largely comprises practitioners who can afford a 35% to 45% cash down payment, which suggests that these buyers may constitute the best of the next generation. It also indicates that younger, less experienced, or less-well-capitalized advisors are basically shut out of the process.

The same is true of women buyers, who make up only about 1% of the marketplace demand by buyers, but comprise 27% of the supply of selling practices. External acquisitions by experienced but frustrated employees are virtually non-existent, again due primarily to lack of capital. When, and if, these potential buyers can be added to the marketplace, demand should increase significantly across the board.