Formulas for Success: Cash Flow Cachet

“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.