Not too long ago, a financial advisor called me to say he heard that a colleague had just sold his independent practice for a pretty penny: three times revenue. Could I get him the same deal?
Matt Brinker, senior VP of United Capital, practically rolls his eyes when he hears a story like this: “Every time I am on a panel discussing M&A in wealth management, the first question from the audience is, ‘What are the current multiples?’” Multiples are nice, but they aren’t everything. And they may, in fact, be deceptive. “Price matters, but terms trump price,” says Brinker.
In our view, a seller needs to consider five components in a deal; they are interrelated. If you get more in Column A, you may get less in Column B. That means sellers need to prioritize what matters most.
A deal with a topline of “just” two times revenues can turn out to be better than a deal that boasts three times revenues – if sellers get bigger annual payments or better tax treatment. (See box for an example.)
Here are what experts consider to be the “big five” elements to consider and the role each plays in a deal:
1. Cash down payments: The less involvement sellers have, the more they will want up front.
Down payments typically range from 10% to 40% of a practice’s value. The value, of course, is a moving target.
David Grau Jr., head of Succession Resource Group, puts it this way: “Practice valuation is as much an art as it is a science. If five CPAs evaluated the same practice, each would come up with a different valuation number. The true value is determined between a willing buyer and a willing seller.”
In 2013, FP Transitions says that the average cash down payment was 33%.
2. Adjustable rate notes for the hands-on sellers.
These notes, known as ARNs, are basically promissory notes issued by the buyer that guarantee the seller payments of principal plus interest. That means sellers will want to keep a hand in the practice, adding as much value as possible by smoothing relationships with existing customers and helping the buyers transition and retain assets.
The ARN payouts can vary dramatically both in timing and size. Some are paid annually, others every few years. Interest rates can be adjusted up or down depending upon the buyer’s attainment of asset and/ or revenue targets. The incentives need to encourage both buyers and sellers to do more, not less.
3. Earnouts: another incentive for sellers to remain involved.
Advisors are familiar with back-end incentives. But in this case, the earn out bonuses really mean sellers need to do all they can to encourage the success of their buyers. Depending on the buyers, that could mean appearing in the office daily until the earn-out period expires, or simply being on-call over that time. Earnouts, like back end bonuses, typically set both gross revenue and asset bogies. (Note: Deals can have claw-back provisions to punish sellers who don’t do enough to stoke the business.)
4. Taxes: Everyone pays them, but only one gets to claim the capital gains rate.
Advisors who’ve owned their practices for more than one year can elect to have the proceeds from a sale taxed at capital gains rates. However, the buyer must agree to be taxed at ordinary income on the same transaction. That’s a big bargaining chip to work with when considering the other factors: revenue multiples, earn outs and the rate on ARNs.
Note: If the seller is paid yearly consulting fees, these are taxed as ordinary income.
5. Revenue multiples: What everyone always looks at first.
Sure, the revenue multiple matters. And many practices sell between one and a-half and three times revenues. But they are just one factor to consider in the deal. Hammering out a deal requires patience and savvy. Before sellers get to this stage, they should have vetted potential sellers to be sure they are a good match. Sellers should seek buyers with similar types of practices and philosophies.
You don’t want to sell your ETF business to an SMA rep. That, as I have written previously here, is a recipe for disaster. These deals are like snowflakes, observes Mark Penske, chairman and CEO of United Advisors. “If you focus just on the multiples, deals may look the same at 50,000 feet, but each one is different when you look close.”
A Tale of Two Practices
If you look only at the revenue multiple, Seller A appears to have out-negotiated Seller B. But dig into the details, and you’ll see that Seller B is the winner.