In the first part of our post, we discussed the many reasons (beyond the obvious) why profitability is crucial to a firm’s success.  In the second part of our post, we’ll discuss the role of profit margins in business stability.

For many planners, a potential business sale may still be many years or even decades away (even for “older” veteran planners who may decide they’d rather keep their business as a lifestyle practice rather than sell it). As a result, short of a buy-sell arrangement to be executed in the event of death or disability, the idea of profit margins as it impacts business valuation is often simply not on the radar screen. However, the reality is that the profit margins of a financial advisory firm are crucial for another reason, too: the stability of the business for its staff and clients.

The reason that profit margins matter in this context is that, unfortunately, the revenue and expenses of a business are not stable; one or both change over time. For instance, in the 2008-2009 financial crisis, the precipitous market decline led to a precipitous revenue decline for firms that were priced directly on assets-under-management (AUM) or indirectly through mutual fund or annuity trails.

If the firm had a 25% profit margin and experienced a 25% decline in revenue due to the market, the owners may not have enjoyed any profit distributions out of the business that year, but there was still room for them to earn their salaries and keep the firm steady. By contrast, a firm that only had 10% profit margins suddenly found itself deeply in the red, forcing the business owners to either plow significant dollars back into the business, or start cutting expenses—which for most planners, usually means firing staff, since professional and administrative staff are the overwhelming majority of all expenses in an advisory firm. In other words, the size of the firm’s profit margin is the size of the firm’s cushion to deal with the uncertainties of business without needing to downsize.

Managing the profit margin also becomes the key for the firm to manage staff stability over time. For instance, many firms chose to go partially or fully to retainer-style models after the financial crisis, in large part due to a desire to stabilize revenues to avoid the problems just noted above (and especially if their firms didn’t have healthy enough profit margins to manage the volatility in the first place).

Unfortunately, though, the stability of revenue simply shifts the profit margin problems to the expense side of the ledger. While those businesses now have more stable revenue, almost five years later many are now struggling because the ongoing inflation of overhead costs, including especially the rising salary expectations of financial planners, have resulted in staff costs that are rising faster than they can raise the retainers for all the existing clients, and it’s still unclear whether or not some clients will leave (and take their revenue with them) when the next bear market comes (if only because they don’t feel they can afford the retainer when their investment accounts are down). The end result, once again, is a firm with narrow profit margins that cannot withstand any shocks without being forced to fire staff. And ultimately, the reason why these potential shocks and risks to staff matter is that as a firm grows, staff are the key to both sustaining the growth of the business and providing the service for clients. In other words, a firm that doesn’t have profit margins healthy enough to manage the unexpected shocks of cost and revenue that inevitably occur in a business runs the risk of a declining ability to keep growing or even just effectively service its existing clients — which is especially concerning, as a firm that provides worsening service due to layoffs may then be stuck in a “death spiral” where the poor service leads to more clients leaving, which causes revenue to decline further, which forces more staff layoffs, which further adversely impacts service, which makes even more clients leave…

The bottom line to it all, though, is simply this: whether the goal is to sell your firm to a third party for a large amount of money in the future, or to craft an internal succession plan to your existing staff, or to simply retain your existing staff, or merely to ensure the continuing of quality service for your current clients… profit margins matter, and should be managed accordingly. In the meantime, if you’d like to learn more about how financial advisory firms are valued (and the levers to adjust to improve it), I do highly recommend Tibergien and Dahl’s “How to Value, Buy, or Sell a Financial Advisory Practice” book.