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November 01, 2008 at 04:00 AM
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.
