What creates value in an independent fi nancial services or advisory practice?
At its most basic level, value lies in the client relationships. In the earliest phases of the open market for fi nancial advisors, most if not all of the value rested in the client base and the associated revenue. Even the language of the day referenced this characteristic, referring to the sale of an advisor’s book, rather than the sale of a business. In this context, the supporting structure of services and staff, as well as other licensed professionals, was considered of secondary importance to the cumulative assets under management waiting to be transferred to another caretaker.
Valuation techniques have evolved to the point of being able to assess accurately the cash fl ow potential of a practice’s client base, as well as the risk elements in transitioning that client base to another advisor or business.
But the newest valuation techniques factor in more than just the clients and their revenue, adding infrastructure to the equation, what we call “enter- prise strength”—the number of licensed employees who remain through a transition, the nature of the referral channels, and the level of technology in the practice, among other things. In other words, current industry‐specifi c valuation methods consider the business elements as well as the details of the client base to ascertain value.
This approach mirrors exactly what is now happening in the evolving fi nancial services marketplace. Astute and experienced buyers are seeking out advisory practices that have more evolved business structures, and they are paying higher value for these businesses. Accordingly, the valuation pro- cess itself can provide guideposts to owners looking to increase business equity.
The continual use of practice valuations can also help practice owners monitor the equity built or lost from one year to the next, rather than just monitoring fl uctuating cash fl ows. In fact, obtaining an annual valuation is one of the most benefi cial strategies for growing a business, as investment professionals who have their practices valued annually tend to keep equity management in mind through every business decision. And don’t forget:
Equity value is likely the largest number that you can add to your personal fi nancial statements of net worth. That is an important consideration even
from the aspect of a next generation, minority owner who is part of your succession plan.
There are a number of ways to place an accurate and authoritative value on a professional services business, including those in the fi nancial services industry. Accepting that every valuation is an estimate until a buyer accepts and pays the price, the important questions can quickly be reduced to these:
■ How accurate is a given valuation approach?
■ How much does it cost to obtain an accurate valuation?
■ Since almost no buyer pays all cash in this industry, how do the deal terms affect the valuation opinion?
Without positive and affordable answers to these questions, many prac- tices and businesses in this industry would have no choice but to use a rule of thumb approach. Fortunately, there are good answers and at least a couple of well‐accepted approaches when it comes to determining the equity value of an independent fi nancial services practice or business.
In the fi nancial services industry, it is relatively easy to discern a valuation multiple—at least in hindsight. Looking back over the past fi ve years, the multiple paid for every dollar of recurring revenue (manage- ment fees and insurance renewal commissions, or trails) by third-party buyers ranged from a low of just under 1.5 to a high of almost 3.0.
The multiple paid by third‐party buyers for every dollar of nonrecurring revenue ranged from a low of about 0.2 to 1.7. That means that for the average fee‐based practice or business in this industry, the range of mul- tiples is from roughly 0.2 to 3.0. So go ahead and guess. You’ll be wrong, but by how much?
Let’s put this in perspective. If you have $125,000 in gross revenue or GDC and you’re wrong on your valuation guess by just 20 percent, you’ll cost yourself less than $40,000. If you own a practice worth closer to $1 million, the margin of error, in terms of dollars, will easily hit six fi gures. Given that most accurate, professional valuations used by advi- sors cost less than $2,500, it seems almost silly to belabor the point.
Obtain a formal valuation as the fi rst step in your planning process. If you’re thinking of selling and walking away (or fading away), the same rule applies.
The goal of a professional valuation is to approximate closely a given business’s fair market value. Fair market value has been defi ned as the price at which a property or asset passes between a willing buyer and a will- ing seller, with neither under any compulsion to buy or to sell, and both with knowledge of all relevant facts. Of course, where less than the entire
ownership interest is being acquired, discounts may be applied to refl ect the lack of control or lack of marketability.
Traditionally, a formal business appraisal uses a standardized format and one or more of these valuation techniques:
■ Asset approach
■ Market approach (multiple of revenue, multiple of earnings before interest and taxes/earnings before interest, taxes, depreciation, and amortization [EBIT/EBITDA], or comparable sales)
■ Income approach (present value of discounted future cash fl ows) Many of the tools of traditional business appraisals are poorly suited for valuing a dynamic, fl uid, and personality‐based business like an inde- pendent fi nancial services practice. The least appropriate of the traditional valuation approaches is the asset‐based approach. This method is not applicable to fi nancial services practices, because there are relatively few tangible assets (computers, copier machines, and fi le cabinets) in such a model. In contrast, the real value of a fi nancial services practice lies in the strength of the client relationships and the transferability of those relation- ships, which, in turn, generates the future cash fl ow of the growing and enduring business.
At the other end of the spectrum, the income approach analyzes the earnings of a given practice or business; it is “bottom‐line, looking up.” This method uses a going‐concern approach, assuming that the fi rm will continue into perpetuity. Earnings‐based appraisals work best for larger businesses and are well suited for those businesses of approximately $20 million or more in value. This approach also fi nds a practical application in support of an internal ownership track where advisor/investors purchase a minority interest of stock in a fi nancial services or advisory business. One challenge with the income approach lies in trying to accurately and consistently defi ne what income is.
A second and more serious problem with the income approach is its cost. These valuations are accurate and very useful, to be certain, but they tend to cost between $10,000 and $35,000, depending on the cir- cumstances, the purpose of the valuation, and the appraiser’s skills and credentials. At this cost level, the income approach becomes problem- atic when used by next‐generation advisor/investors to track the value of their investments and to consider buying additional stock from year to year.
The market approach, which is the primary methodology of FP Transi- tions’ Comprehensive Valuation system, determines the value of a fi nancial services practice by comparing it to similar practices that have been sold in
a competitive marketplace. It is “top‐line, looking down.” This approach is intended to answer two specifi c questions:
1. What will a buyer pay for this income stream in a competitive, open market environment?
2. How will a buyer pay the seller the determined value? (That is, what are the deal terms?)
The analysis in the Comprehensive Valuation system is based on the standard currency of the independent fi nancial services market, that of gross revenue (or gross dealer concession [GDC] under FINRA rules). This top‐
line approach refl ects the common practice of buyers in the competitive open market, and makes comparisons from one practice to another far more accurate and consistent.
There is an assumption in the fi nancial services industry that the skills of the buyer are fungible, and that, within reason, a professional can take over the practice and render approximately the same level of service and generate an equivalent level of client satisfaction. This assumption works because of the size of the marketplace. With a suffi cient pool of talent to draw on, successful and experienced fi nancial professionals can be found who have reasonably similar levels of education and experience. As such, it can be assumed not only that a buyer with the requisite skills can be found for a given practice, but also that many buyers can be found that possess the necessary and complementary skills.
This result shifts the focus of valuation almost completely to the client base being acquired and the revenue stream that results, and not how the services are delivered, nor the cost effi ciency of the services, nor even whether the practice provides a unique service in the community. The seller is simply transferring the client base, and therefore a valuation analysis is principally focused on the revenue potential of the client base being transferred.
FP Transitions’ approach is unique in terms of taking into account criti- cal factors in assessing the strength and durability of the revenue streams of an independent fi nancial services practice or business (see Figure 2.5 ).
The fi rst step is for the system to assess the transition risk for the subject practice. The next step is assessing the strength of the revenues of the subject practice, referred to as cash fl ow quality. The last step in determining value is to apply a market‐driven capitalization rate to the adjusted GDC or gross revenue. This is the process that fi rmly links the valuation to market real- ity by applying capitalization rates that are keyed to the type of practice, its size, and, geographically, where in the country it is located. It should be noted that, as with the adjustments to transition risk and cash fl ow quality,
none of the individual assessment factors tend to be large, but rather result in incremental adjustments to value and, in sum, produce results that closely mirror the reality of the marketplace as we see it every day.
The indexes of transition risk, cash fl ow quality, and marketplace demand were fi rst introduced to the independent fi nancial services industry in a 2008 white paper commissioned by Pershing, LLC, entitled “Equity Management: Determining, Protecting, and Maximizing Practice Value.”
Here is a closer look at some of the essential, underlying elements in FP Transitions’ industry‐specifi c valuation approach that will help you better understand what drives value in the independent space.
Recurring versus Nonrecurring Revenue
Because the value of a business is based on the assumption of a continuing stream of revenue into the future, it is important that the analysis take into account the revenue sources—specifi cally, what proportion of the revenue is recurring versus transaction based. Fee income is the most important con- tributor to cash fl ow quality, as it represents recurring cash fl ow, which, in turn, is among the most predictable and durable of the revenue streams pro- duced by a fi nancial services practice. Recurring revenues also are the most important revenue streams to a potential acquirer or successor, and hence these fee‐based revenues usually generate the highest interest and value.
From a valuation perspective, these revenue categories form an important starting point for determining value.
Recurring revenue is one of the most important single determinants of value of a fi nancial services practice. Revenue produced through manage- ment fees or trails is ongoing and reasonably predictable, and highly sought after by buyers. In the case of insurance renewal commissions, or trails, these are considered only to the extent that they can be transferred to a buyer. Most insurance trails are restrictive in terms of their transfer. While
FIGURE 2.5 Valuation Indexes