Overview: The professional valuation primarily focuses on the cash flows and profitability in the advisory firm being appraised. An equally important consideration is the specific value characteristics of the subject business and what additional worth those positive aspects will bring forth for your business assets.

How profits are generated can be as crucial as having profits in your business. It is
common acceptance In this industry that recurring revenues tend to be more predictable and consistent than non-recurring revenues. Therefore, these types of revenue streams have a propensity to attract more successors and bring greater prices for their owners, than nonrecurring revenue streams. Another critical non-financial aspect of your business is the transferability of your business assets. If what helps to produce profits in your business is not transferable or assumable, then you must take action to reconstruct your business assets to make them transferable. It is the combination of profits or cash flows, the transferability of clientele and the business assets, and the probability of future growth that set the foundation for the value of your practice.

After the quality and transferability of client relationships and the firm’s free-cash flow, there is an equally important measure of value: the “secondary assets” that bring value to your enterprise. These assets may be tangible or intangible, but the key to unearthing their value is jf they can be transferred to a successor.

So what are some of the secondary assets that can increase the worth of an advisory firm?

There are many considered as value drivers, including the following examples:

• Where you are In the business Ufe cycle-If your business is in its infancy, that factor may have a different impact on value, than if it is a mature business.

• How revenues are produced-Are the revenues recurring or non-recurring? Have you focused expense and time investing in the latest technology to maximize your firm’s efficiency? Have you developed a broad offering of services for clients that will generate a diversity of revenues?

• Transferability of clientele, processes, and systems – The transferability of your business assets is essential in most succession plans, even more so when transferring ownership to an outside party and possibly less with an internal transfer.

• Entity type and tax considerations-How the proceeds from the transfer will be treated for tax purposes will vary as to the type of entity sold and the tax allocations. Work with a qualified tax professional, to explore if you should be selling assets or stock.

• How the transfer is paid for-The risk of using an earn-out financing arrangement may demand a price premium over what a deal financed with promissory notes would bring. Also, internal succession plans usually offer more assurance of payment, and therefore may increase the business value due to lower risk: factors.

• Structure of agreements- Terms in an agreement will either add or reduce value.

For example, agreeing to a non-compete with the successor may call for a price premium, whereas not staying on through a reasonable transition period may call for a reduction.

• Location, location, location-Adjustments can be made for the geographic location.

If the business is in an area without many potential buyers, the price may need to be reduced.

Conversely, jf the business is in a high population area, it could bring a premium.

• Goodwill, reputation, and the intangibles-Some firms have significant goodwill built into their business, including the business’ “on-going concern”, the firm’s involvement in the community, and reputation in the industry or locally could add additional value. Also, certain firms have other intangibles that help generate revenue, such as brand names, a highly productive staff, which could add value to an appraisal.

Valuation Premiums and Discounts

A somewhat subjective, but very important aspect in determining the value of an advisory firm, is the use of premiums and discounts. These adjustments are frequently used to help narrow the value range of both the book of business (defined as selling only the client accounts and not the entire business itself). and an advisor selling all of the business’ assets. Premiums and discounts help to account for the inconsistencies found among firms, which are difficult to flush
out when using just mathematical computations based on the financial aspects of a subject firm.

Added value may also be derived from a client base that is from a certain niche, such as within the medical community Of from large corporations, whereby consistent client referrals are sent into the firm. Location, average lower age of clients, and diversity of services offered may also add premiums to the value of the business. A case-in-point is that a business for sale in a large metropolitan area with plenty of affluent population as potential clientele can be considered in
general somewhat more valuable than one in an area with a very low population (unless of course the later firm has other special attributes to offset this detraction).

Usually, any adjustments applicable to the value of an advisory business, is applied after determining the “foundational value” of the business. Regardless of which valuation approach is used (the capitalization-of-earnings approach or the free-cash-flow approach), the value range can be considerable. For example, today’s market norm for multiples in these models runs from three to eight times net operating profits (before taxes and interest). It is accepted that net profits generated from commissioned revenues bring the lower end of the scale (three to five multiple) while those generated from fees bring the upper end of the scale (six to eight multiple). The result is considered the foundational value of an advisory firm.

What method is used to further narrow value? In an acquisition, typically it comes down to the negotiations between a buyer and seller. Financial buyers tend to focus on the bottom-line profits, where strategic buyers may better appreciate the non-financial value drivers of the business. Therefore, strategic buyers often pay more for a business with these attributes, than a financial buyer does.

Usually, premiums, discounts, or not used in partnership buy/sell agreements, or internal successions. There are several exceptions to the rule. Take for example the circumstance where a merger candidate will bring to the business certain skills or synergies that did not previously exist. A premium may be expressed either through the value of the stock they receive in return for the merged assets, or they may be given more total shares than otherwise would be justified.

Conversely, discounting may apply to some buy/sell agreements to account for the fact that not everyone should have the same share value. This may include the use of a traditional valuation concept called the “lack of control discount”.

Lack of Control Discount. This refers to the concept that a minority business interest should be worthless than a majority business interest. Though sometimes referred to as a “minority discount”, this valuation adjustment has less to do with minority ownership itself and more with the non-controlling aspect of having the minority ownership in a business.

This discount is applicable in the profession in those circumstances where a transition of a minority ownership position exists. For example, it could apply in situations such as the partial sale of a business, or in a merger of two businesses of different sizes, or where a majority partner is buying back a minority ownership from a departing partner. All of these occurrences may call for applying a lack. of control discount.

For example, let’s assume that Sam has 70 percent voting stock ownership of a firm and Dave has 30 percent voting stock ownership. If Dave voluntary leaves the business, the buy-sell agreement might have a provision for a lack of control discount to recognize that Dave’s ownership interest is non-controlling. Lack of control discounts tend to range from 10-25 percent in the profession.

Where warranted, one could also consider applying other discounts in addition to the lack of control discount. For example, if you as a buyer determine that the after acquiring the client base, you’re likely to experience the loss of Clients, a client attrition discount should be applied.

Again, most premiums and discounts are subject to negotiation. Suffice it to say that who your buyer is or what succession option you’re focusing on, will ultimately determine whether these or any other premiums/discounts are applicable.

Important note: Generally, in the financial services field, each premium Of discount run from about 5 to 10 above the base foundational value produced from the Asset-Based Approach, the Free-Cash Flow Approach or the Capitalization-of-Earnings Approach. Certain assets or deficiencies may, in specific cases, warrant a premium or discount of more than 10 above the base business appraisal. For any premium or discount to apply, it should be of either higher than average quality, or less than average quality than what is seen in the average advisory firm.

There are a few additional critical aspects to be aware of when unearthing the value in your firm. The following three categories are characteristics that can affect value, which should be of concern to all owners of an advisory business:

Thinning Margins
Margin compression is of concern in most financial firms today. The ability to control gross and net margins has been a struggle for most advisors. The recent increase of competition and inconsistent stock markets has made creating profits a challenge. It is also clear that some are not charging clients enough for the services they render and therefore are experiencing thinning margins. In other firms, it could be that the advisor(s} are spending time on the wrong projects and not enough time with the clients to generate new revenues.

All advisors should keep a watchful eye on the ebb and flow of the profit margins in their business. ff you are not currently tracking the business’ margins on a monthly basis using the Profit & Loss statement, you should consider doing so starting now. It is the best way to be nagged of changes in the firm’s profitability early and correct them before too much time has passed.

The Importance of Client Persistency and Asset Weightings

Without client relationships, your business would have no cash flow. Without cash flows, you will not have a business that you will be able to sell. Two value drivers that aren’t usually unearthed in the valuation process, but can truly help to show a buyer hidden value, are the persistency weightings and asset weightings of your client base.

Client Persistenct Weightings. Simply put, the greater the loyalty and the lower the client turnover, the more attractive your firm will be to a successor of any type.

High levels of client satisfaction can translate into significant added value, when you have taken the time to document it for a potential buyer. The process is straightforward and uncomplicated, but it will require time to sort through all of your client files to determine certain data. What you are determining is how long clients have done business with you, and what percentage fall into what category of years, as in the example below:

This simple but powerful information will also: 1) help an appraiser better understand the stability of your business, 2) puts on paper what you already knew about you business that others don’t, and, 3) provides any potential successor a quick snapshot of your clientele’s loyalty.

Clearly J you want any buyer of your business to know the loyalty of your clientele. Very often buyers will be open to paying a higher-level multiple for high client persistency, or in some cases, a premium over the business’ foundational value.

Client Asset Weightings. Like client persistency ratings, this second technique for unearthing business value is a simple way to convey information to a business appraiser or a potential successor. It also requires setting aside time to gather data from client files, but why not do both projects at the same Urne? In this task, you’re looking for the total invested income and assets that each client has with your firm. Then categorize clients into how much of the firm’s income and assets each group represents. Think of this as an exercise to determine how the
“80120 rule” applies to your client base. (The 80120 rule states that, on average, 80 of an advisory firm’s revenues are generated by just 20 of the firm’s Clients).

You may decide to arrange your data differently and in a way that will have specific meaning to your particular clientele. For example you may list the top five percent of client assets first, then the next five percent and so on. You should include footnotes to explain each of the client categories, especially when an aberration exists. A case-in-point would be to describe who your largest clients are and how they affect the overall asset weighting. Another is to explain why the percentage of profitability and income generated, differs in the various categories.

Tip: This exercise is also helpful from a practice management perspective to better understand where your revenues and profitability lie within the client base. Some may want to take the process several layers deeper by examining what product assets are invested in and determining the profitability of each client regardless of size.

The Take-Away: Many factors over and above gross revenue streams go into the
process of determining the value of a financial planning firm. These include the size of the client base, client-age demographics, and profitability per client. Others involve the uniqueness that each advisor has applied in building his or her business. Rules of thumb cannot take into consideration the individuality and distinctiveness of each advisor’s firm. That in itself should prod anyone building their business value to set aside those rules and to adopt a more serious
and fruitful approach to unearthing value in their firms.

Written By:  Succession Planning Consultants

Before you look at multiples, figure out where all your firm’s value lies.

FEW SUBJECTS ARE AS CONFUSING AS assessing the monetary value of a financial practice. Many advisers believe that they can follow a simple rule of thumb based on gross revenues. Others look at forms of revenues, such as fees versus commissions, to price a firm.

You can’t just compare your quantitative data to that of practices some thousand miles away. Two firms that generate similar fee-based revenues don’t necessarily have anything like the same value. Every outfit has different clients, services, efficiencies and niches—which combine with revenues to establish its value. Using broad multiples is misleading and may cause sellers to leave substantial value on the table—or risk mismatching a successor to their clients.

To understand your firm’s true value, you must analyze it as if you were a potential buyer. It isn’t in spreadsheets or rules of thumb. Three main value drivers, in order of importance, that will determine the value of your firm are:

• The quality and transferability of client relationships;

• The “other assets” transferable to a successor;

• Your firm’s available free cash flow.

CLIENT RELATIONSHIPS

Your practice’s fundamental value lies in the quality and transferability of its client base. Without client relationships, there would be no cash flow and hence no business to sell. Client relationships can affect more than 50% of your price.

The most efficient way to unearth the value in your client base is through client demographic studies. Two industry-specific methods that you can pre- pare yourself are:

Client persistency weighting. The greater the client loyalty and the lower the turnover, the more attractive your firm will be. Take the time to document your clients’ loyalty through their positive experiences. The process is straightforward, but it will take time to sort through all of your files to extract the data. You want to show how long clients have done business with you, as shown in Figure 1 at right.

This is a powerful analysis you should perform periodically, even when you have no intention of selling. It helps you grasp the stability of your business while offering potential successors a quick snapshot of your clients’ loyalty. Buyers with high confidence in a firm’s clients tend to offer higher prices and better acquisition terms.

Client asset weightings. This is a simple way to convey client information to a buyer or potential internal successor. In this study, look for the total invested assets each client has with your firm.

In Figure 2, the top 20 clients generate 64% of the firm’s revenue (30.57% plus 33.48%). Losing just a few top clients during a transition could have a big impact. Clearly, maintaining their loyalty is crucial to a sale.

When looking at your own practice, you can arrange data by listing quintiles of client assets, the top 5%, the next 5%, etc. Include footnotes to explain each client category, especially when a few clients generate a disproportionate amount of your revenues.

Some more studies you should per-form to value your client base:

• The percentage of assets under management invested in various products and services;

• Profitability per client;

• Profitability per employee;

• Client age versus asset level.

These exercises also help reveal inadequacies in your business that you should correct before selling.

OTHER TRANSFERABLES

Many owners don’t realize the importance of the systems, processes and intangibles that create their firms’ revenues and profits. But such elements can increase your firm’s value by up to 50%. You may know you have some- thing special to offer, but potential buyers won’t unless you tell them. Document the tangibles and intangibles that add value to your practice in a bound manual. A list of suggestions appears in Figure 3 below.

Just one or two of these elements can raise a practice’s market value dramatically. For example, firms with exceptional referral systems and well-placed niches can fetch a premium. The more detail you provide, the more useful this document will be in your negotiations.

FREE CASH FLOW

The third major driver of practice value is its free cash flow or net profit. The greater the net profit, the greater the value. This net value is always calculated after the owner’s compensation has been deducted (including salaries, bonuses and commissions).

There are significant value differences between a fee-based firm that generates $1,000,000 in gross revenues and $400,000 in net profits, and another firm with the same fee-based revenues that generates only $200,000 in net profits.

Significant free cash flow is always necessary for a buyer to make the payments and still profit from the deal.

COMPUTING VALUE

Only after all this should you calculate how to price the firm. This is where you use multiples of net profits, premiums and discounts.

Market norms for multiples run from 2-7 times net operating profits before taxes.

Generally, net profits from commissions are less valuable (2-5+ times) than those from fees (4-7 times) because recurring revenue tends to be more predictable than nonrecurring revenue. There are some exceptions, owing to processes or systems that give firms superior business platforms. This is where premiums (and discounts) come into play.

Certain tangibles, intangibles and good will warrant a premium over the net profits a firm generates. These include highly skilled employees, advanced technology and a client base that generates higher-than-average revenues.

Similarly, you may have to discount the business to account for flaws such as a shaky client base that may not produce the same revenues once you sell. Then a client-attrition-risk discount may apply. Poor location or lack of diverse services could justify discounts as well.

Additions or subtractions are often in the eye of the beholder. A financial buyer looking for an immediate bottom- line return may ask for a 10% discount on a firm with an aging client base, while a strategic buyer focused on estate-planning services may be willing to pay a premium. Most industry-specific premiums and discounts run from 5% to 10% of the total value and are always subject to negotiations.           

Written by Succession Planning Consultants.

The Take-Away: A carefully structured plan that considers all parties fairly is critical to
an acquisition. Never approach a buyer before you’ve done your homework on what type of acquisition fits your firm’s profile, how it is best financed and the specific elements that are important to you. Always be in the driver seat when considering an acquisition, but be sure to provide a comfortable front passenger seat to your seller and that the backseat that is to carry the clients is clean, pleasant and provides a secure ride.

1. Neither the buyer nor the seller has a plan, and they have been mismatched
2. The seller’s need to have a “flawless deal” wears out the less-than-patient buyer (sellers only do this once, and they feel they can’t make a mistake)
3. Buyer’s inability to come up with down payment for earn-out deals
4. Buyer & Seller inability to agree on financing
5. Tax issues related to the type of entity being sold (such as C corporations and the potential “double tax penalty” to the seller)
6. Internal organizational mismatches where the buyer has difficulty integrating the seller’s software, hardware, processes, and systems into their framework
7. Philosophical differences between the buyer and seller, or between the buyer and the potential clientele
8. Either the buyer or seller has difficulty with the negotiation process
9. Disagreement on valuation issues (especially when a professional valuation has not been performed)
10. Geographic issues with buyers who are not local to the seller’s area