When parents transition their businesses to grown children, family events can get tense. So too do the business dynamics, especially if non-family employees are left behind upon the older generation’s departure. Adding to this, the rising valuations of advisory practices make it almost impossible for people to buy in, let alone buy out the owner.
A well-reported transaction illuminates this difficulty. In the deal, a West Coast financial advisor set up the transition of his practice to his son and another colleague. The terms of the “sale” are unusual if not innovative, especially in how the financing was structured.
According to news reports, the father has turned over all client relationships to his two successors, and is winding down his involvement with the business. In return, his son and the other advisor will pay him 50% of the total fees generated for the next 20 years.
To ensure I evaluated this transaction fairly, I asked a group of my colleagues who specialize in practice management at BNY Mellon’s Pershing for input. These four — Lisa Crafford, Tom Kindle, Barbara Novak and Adam Verchinski — have worked with hundreds of advisory firms on management and succession issues, and bring a balanced and informed perspective to the discussion.
While none of us is privy to the unpublished details, the news articles provided enough facts from which to draw assumptions. As an example, the practice manages just over 300 client relationships and roughly $400 million of assets, and not one of these clients has left because of the transition. That level of loyalty and belief that the founder is acting in their best interest is encouraging, and common among practices where an advisor has built deep relationships over decades.
Using the published numbers, we made some rough assumptions: Average fees of 100 basis points. Annual revenue of $4 million. Average client aged 60, about the same age as the transitioning founder. Each advisor will be managing just over 150 client relationships, which is two to three times greater than the average advisor, according to recent studies.
Using data from financial performance benchmarking studies of advisory firms, which I have been involved with since the early 1990s, we also made some rough assumptions about the economics of the practice by comparing this firm to top-performing advisory businesses of comparable size.
In our example, the father will receive $2 million from his two successors each year, assuming the fees from the clients he transferred remained constant. This would leave $2 million to cover their compensation, pay the overhead and generate a profit. With the estimated overhead expense at $1.4 million, this leaves only $600,000 pre-tax to split between the two buyers.
Again, assuming the fees and the payout remain constant, this would put the valuation of the $4 million practice at $40 million ($2 million x 20 years). Put another way, the math translates the sale price into a 33x price-to-earnings ratio; or a 3% required rate of return. At this valuation, the required rate of return is just a smidge over a 20-year Treasury yield, which is on the opposite end of the risk spectrum.
As a counterbalance, I asked Dan Sievert of Echelon Capital Partners, a specialist in advisory firm M&A, how this might be valued on a Discounted Cash Flow (DCF) basis. Using a sensitivity model to evaluate various scenarios of revenue and discount rates, he said a 16% discount rate would be within the realm of reason, though he too did not have details on the firm involved. Applied to the cash flow paid out to the seller, this would put the valuation at somewhere between $9.6 and $12.8 million, depending on whether the cash flow grew or remained flat.
Normally when doing a valuation, professionals consider three core elements: cash flow or earnings, earnings growth and risk (or uncertainty). In this circumstance, the earnings are impaired by the obligation to distribute half the fees to the founder and the growth prospects are impaired by the average age of the clients, many of whom will be entering the de-accumulation phase if not already there. The lack of physical capacity to serve more clients also will impair the capacity to grow.
This deal structure may have been designed to make it cash-flow affordable for the buyers, but it does not make economic sense.
Many advisory firm founders face the same dilemmas: How do I ensure my clients are tended to when I am no longer willing and able? How do I transition my clients and my business on terms that are affordable? How do I extract value from a business I built over many decades?
The first question is a non-negotiable. When clients come to rely on you through many of life’s critical choices, you must assign someone in the firm to take over these relationships or refer them to a trusted advisor who is likely to outlive them. While this is not a regulatory responsibility, it feels like a moral duty.
The question of “affordable terms” includes consideration of a fair price and manageable terms. The West Coast example feels like the old lay-away plans or a big-ticket sales promotion where you drive away your new SUV for no cash down and zero to pay for the next 12 months. As an advisor, how many times have you had to explain to clients that nothing is free? You know as well as I do that making something cash-flow affordable does not necessarily make it a wise or prudent purchase. Terms rarely make it less expensive.
Selling a practice with an aging client base is much like selling a depreciating asset. I was always told not to borrow to buy something that was declining in value, but rather to use leverage for something that is increasing in value.
In some ways, the transaction resembles a viatical settlement. In a similar vein, you no longer have a need for the expensive insurance policy/firm ownership — your children are grown, you have medical bills to cover, you want to fund your retirement, the business is not fulfilling anymore. Much like insurance, you could let it lapse or you could take a cash payout and relieve yourself of the burden. And then hope for the worse.
For the recent West Coast buyers, twenty years is a long time to be giving up half of their earnings. Put another way, they are working until July before they earn any income. Every year. For 20 years. At what point does resentment take over? Or a desire to re-do the deal?
A good guide for buyers is that if the cash flow can support the purchase price over a reasonable period of time (say five years), then the purchase price is within the realm of reason. If it takes as long as 20 years to fund the purchase of a depreciating asset, the deal may not make sense.
A more practical option for the deal in question would have been to assign a fair valuation to the practice, then work out the terms from there. A combination of bank financing and seller financing, maybe with some type of discounted payment of the first tranche (typically 15–40%) would achieve the same goal in terms of ensuring the clients are tended to and the business is acquired for a reasonable price. It would not, however, ensure such a high income stream to the seller, which seems to have been the goal of this deal.
Mark Tibergien is CEO of BNY Mellon’s Pershing Advisor Solutions. Tibergien is also the author most recently of “The Enduring Advisory Firm,” written with Kim Dellarocca of BNY Mellon and published by Wiley. He can be reached at firstname.lastname@example.org.