People often remark that advisory firms are now worth so much that nobody can afford them. This ironic observation reminds me of Yogi Berra’s memorable quote, “Nobody goes there anymore. It’s too crowded.”
Estimating the value of an advisory firm begins with the development of assumptions. In the simplest calculation, divide cash flow by risk minus growth: V=CF÷(R-G). On average, advisory firms have grown in size. The numerators are getting larger, boosting valuations.
Further, many firms are making strides to mitigate risk by focusing on three areas: managing client selection and retention, improving compliance and reducing dependency on a few key people. In addition, even though the rate of growth has slowed considerably and the cost of doing business continues to rise, many firms are experiencing absolute growth in revenue and profit. Yet how accurately do these factors predict firm value?
When appraising a business for a gift, an estate tax or divorce, where the standard is fair market value, the hypothetical price assumes “a willing buyer and willing seller, both parties being fully informed of all the facts, and neither party being under any compulsion.” (IRS Revenue Ruling 59-60) As a practical matter, however, these conditions rarely exist in a real-life sale. If the asset or entity is not transferrable for whatever reason, it does not have much value.
The Seller’s Dilemma
A comparison may be drawn between this dynamic and the valuation of restricted stock. How does the marketplace treat a security that cannot be sold freely relative to securities in the same company that are liquid? Further, how does the market treat an investment opportunity when the supply exceeds the demand? In both cases, lower prices are the consequence.
Firm leaders seeking to sell must consider this reality. First, they face an important decision:
Should I ensure the continuity of my business by transferring ownership to key employees who have helped me to build value? or
Should I try to get as much as I can by selling to a strategic or financial buyer who is willing to pay a premium for my business?
An internal transaction involving successors requires the seller to determine if key employees possess the financial ability and risk tolerance to buy him out.
A qualified strategic buyer has the unique ability to use creative financing and to pay for synergies that an internal buyer cannot. As a result, strategic buyers may be inclined to pay more.
In the first case, the seller will optimize value and in the second they will maximize value.