“When your outflow exceeds your inflow, then your upkeep will be your downfall.” That pithy phrase was often repeated by a former partner of mine at a previous firm where we trained bankers on lending to small businesses. It is a line worth pinning to your wall as a reminder of what fuels your business.
While one would expect this basic principle to be obvious to financial advisors, I have had a number of meaningful discussions with personal financial planners, breakaway brokers, and other financial professionals who did not see it so clearly.
In one case, a large breakaway team was accustomed to a steady paycheck from their employer, a wirehouse brokerage firm, so they never had experienced the spigot being turned off. In another, a financial planner had always been able to bootstrap his business because he only had to cover his rent, his assistant’s pay, and something for himself–but then he embarked on an acquisition strategy and felt the pain of low liquidity. In yet another case, an advisor confused profits with cash so he felt confident in his commitment to infrastructure like leasehold improvements, forgivable loans to new recruits, and accelerated payments on personal debt without contemplating the effects down the road.
These are random examples, of course, but not unrepresentative. Sometimes I think advisors share a fundamental belief that either the markets or new clients will always cover additional cash outlays. But when a business springs a leak, the owners often find it difficult to plug the hole and row at the same time.
The Growth/Cash Paradox
Advisors leaving wirehouse firms are often surprised by the initial outlay and the delayed income when they create their own independent firm, whether affiliated with an independent broker/dealer or starting an RIA. To establish their offices, they must commit to a lease and leasehold improvements in advance, engage an attorney and compliance specialist, and acquire furniture and equipment even before they leave their employer. Once they actually leave (often over a weekend), they have to scramble to get new account forms completed and signed, then await the ACAT transfers before they can start working with their clients again. Moreover, and at least to the extent that they are acting as an RIA, in most cases they will not be able to bill and collect on the fees for three months (assuming billings are done at the end of each quarter).
Practices that attempt to grow through acquisition or recruiting also are forced to lay out a substantial amount of cash in the beginning, with the expectation of eventually getting a return. It is easy to be seduced by the big numbers projected over time and to forget about the first three months.
Even when an acquisition is made on an earn-out basis, in which the outlay is tied to performance expectations or a time schedule, advisors are quite surprised to discover that the agreed-upon value which formed the basis of the agreement is not supported by the cash flow of the business.
For example, take a practice that generates $1 million in gross revenues. Some sources (definitely not me!) believe that such a practice should sell for 2X gross, or $2 million in this case. Assuming it would take about 40% of revenues to operate that practice (rent, utilities, marketing, administrative staff, etc.), $600,000 per year would be left to amortize the purchase price plus compensate the advisors working with the clients. If the parties agreed to complete the transaction in three years, the buyer would have to lay out $666,000/year, not including interest, to cover the purchase price. The term could be stretched out over four or even five years, but for that period of time, the buyer would not receive any return on his investment and would have to hope that the assets and revenues don’t go down or that acquired clients don’t leave.
In many of these cases, the business cash flow and personal cash flow are inextricably tied. One circumstance I know involves an advisor who planned to simultaneously open several offices and recruit advisors to staff them. The five-year projection showed dramatic growth in revenue and profitability. This individual rationalized his decision by applying a multiple of revenue to the combined practices to come up with a value of the business that would show a very big balance sheet to a lender.
But when we evaluated the monthly inflow and outflow of this advisor’s business and personal life, combined with personal obligations tied to repaying a line of credit, alimony payments, and mortgages and balances due on boats and cars, we could see that he would run out of money in three months. This scenario causes most bankers to keep a tight grip on their DENY rubber stamp. For them, loans are supposed to be repaid with cash, not collateral or personal guarantees. If a borrower defaults and forces the lender into collection mode, it is too late for both the business owner and banker and can be career defining for both.
So while a business may seem profitable and growing on an accrual basis–matching revenue and expenses to when they occur, not when received and paid–the timing of cash distributions or collections may be out of sync. Even when firms utilize a cash basis of accounting, it is tempting to look at annual statements or projections which often indicate the gross revenues generated and expenses disbursed on an aggregate basis. What happens to cash each month between January 1 and December 31 causes the big surprise.
Take Control of Your Business
My firm, Pershing, has created a tool to help breakaway teams and others evaluate different scenarios and anticipate what might occur in the near term (you can access the demo at www.pershingadvisorsolutions.com). Short of this, advisors can and should create spreadsheets that match the timing of cash flow to reality in order to avoid a personal crunch.
A simple template starts with Beginning Cash, adds Fees and other Inflows, then a detailed list of monthly Outflows. The template should conclude each monthly column with Ending Cash, which is carried over to the next column. When adding the actual data, be especially sensitive to the timing of receipts and payments. For example, fees should be received each quarter while certain insurance payments or other obligations could be paid every six months. It is always best not to be overly optimistic when developing the Cash Flow projection because this data will inform many of your decisions. It is also a good idea to overlay one’s personal cash flow with this projection in order to keep it tied to what’s going on in your life.
One of the bits of insight this exercise will help you to glean is whether you will require a working capital line or loan to fund short-term gaps. You will also get a sense of whether you need to time your fee assessments to even out your cash flow, or manage the timing of your payables.
The key is to recognize that annual snapshots of revenue and expenses do not give you an adequate understanding of cash flow, and oftentimes can be deceiving when used to make important growth decisions in your practice. In traditional businesses, most bankruptcies occur in the growth phase because owners are not able to fund their balance sheet. While this phenomenon has not yet hit the advisory business, the failure to project and monitor cash flow on a monthly basis has caused many owners of advisory firms to make ill-informed decisions.