Learn to focus on the things that drive up the value of your practice.
By David DeVoe
What's your business worth? It's a question that all
principals-from industry veterans to recent entrants-need to carefully
consider. After all, your business is most likely the largest asset
you'll ever possess. Knowing its true value and the factors that drive
its value are crucial to your success as a business owner.
Valuing your firm is imperative if you're nearing retirement and intend to monetize your years of hard work by selling or merging-an increasingly likely scenario for advisors, roughly 25% of whom are over age 60. But getting a handle on your firm's overall worth is equally important even if you're nowhere near retiring.
The reason: Understanding what drives the value of a firm will not only increase your payday when you sell, it will also increase the firm's profitability-and consequently, your compensation-each year you continue to own the business. By applying the concepts discussed here, your firm will be better prepared for a sale or merger, and better positioned financially in the short- and mid-term.
The Right Approach
Your college finance professor would be happy to remind you that there are essentially three standard ways to value a business. However, only one of t the three methods is truly appropriate for the RIA industry. In order to correctly assess the value of a business, you need to be aware of what really counts-and what doesn't. For example:
Asset-based valuation. This approach is based on valuing the physical assets of a company. This technique may be a good way to value a wholesale distribution business that has a lot of hard assets, such as equipment, trucks and buildings. But it's not a relevant method for advisory firms, which typically have less than $100,000 worth of physical assets. The most valuable assets of an RIA are the client relationships and the experience of your employees, two factors that are beyond the scope of an asset-based valuation.
Comparables-based valuation. A second way to value a business is to look at how the market has priced "comparable assets" to determine a valuation. For example, a commercial realtor might look at similar, recently sold office space in a neighborhood to determine how to price a building that is going on the market.
Some in the RIA industry advocate using comparables of revenue to value firms. (Does "two times revenue" ring a bell?) There are several problems to this approach. For this method to be effective, the businesses must be identical or comparable. RIA firms are not identical. In fact, their unique characteristics are some of their greatest selling points in the marketplace. There is a wide variety of business models, service models, pricing models, product offerings-the list goes on and on. Additionally, there are regional and individual economic differences, profitability metrics and levels of competition in each market. Therefore, most firms are just too dissimilar to use a comparables approach effectively. This challenge is exacerbated by the lack of transparency into the important metrics in this business-or the actual transactions themselves-because most advisory firms are small, privately traded companies. As a result, this comps-based approach usually results in something that's far too simplistic-a rule of thumb such as "advisory firms are worth two times their revenue."
Discounted cash flow valuation. This method involves estimating your annual cash flows (or essentially profits, in this industry) for the next five to seven years, determining a terminal value and applying a discount rate to come up with a present value. This is the best approach for the RIA industry, because it examines an acquisition for what it really is: an investment. The buyer of an RIA business essentially is investing in the expected value of the business' future cash flows.
Cash flow-or net income-is what counts in any business. Revenue, by contrast, is much less relevant as a driver of valuation (you don't take your revenue home at the end of the day). For example, consider two firms each with $1 million in sales. One is well run and generates $300,000 in yearly cash flow while the other is inefficient and generates just $10,000. Clearly, both firms aren't worth the same.
Maximizing your cash flow, and valuing your business based on it, will help ensure you get top dollar when you eventually sell. Otherwise, you're potentially leaving lots of money on the table.
Adjust Your Thinking
That said, your basic cash flow-based valuation is just a jumping off point. Ultimately, valuation is influenced by three key variables: cash flow, growth and risk. Your ability to enhance the first two and mitigate the third will increase the value of the firm. Therefore, the most accurate valuation will take into account factors such as:
Your employees and business operations. Your ability to demonstrate that you have "institutionalized" your business is critical. Buyers need to see that your business can survive and thrive even if you're not there. That means bringing junior employees up through the ranks and giving them the skills and ability to take the reins. It means creating an environment that will encourage staff to stay with the firm-from attractive compensation packages to noncompete/nonsolicit contracts that prevent staff members who leave from taking your firm's clients with them. And it means building systems and processes that institutionalize how you run your firm. The more standardized your operation is-in terms of decision making, client contact and follow through, and back-office functions-the less risk buyers see in taking it over (resulting in a better valuation).
Growth trajectory. The ability to demonstrate a proven ability to grow the organization, and a clear plan to continue growth, is key to enhancing the value of a firm. Growth in profits is important, of course, but growth in assets under management and growth in clients also affect valuation.
Clients. Your client base is a bit like an oil well: it's better to have plenty left to tap. If your average client is 45 years old-and therefore in his or her prime working years-buyers likely will see you as a more attractive candidate than if your client base consists entirely of retirees who are drawing down their savings (an indication that assets under management could decline going forward.) Likewise, buyers are reassured, and willing to pay more, if no single client represents a disproportionate percentage of your total assets or revenues.
Client satisfaction is another major issue. Conduct regular client satisfaction surveys. The mere fact that you survey clients sends a powerful message that you're focused in this crucial area.
Economics. Take into account not just profits, but the quality of those profits-which is determined largely by your business model. For example, wealth management firms almost always command the highest relative valuation because the wide breadth of services they offer generates deeper and more loyal client relationships. By contrast, some investment managers whose primary value proposition is based around performance are more likely to attract "hot money" and lose assets when the market falters. As a result, this business model typically commands a lower valuation. Interestingly, family offices generally are even less profitable due to their bloated cost structures, and carry even lower cash flow multiples. Finally, financial planners tend to have the poorest earnings quality, because there's essentially no guarantee of recurring revenue and earnings visibility.
The deal structure. The structure of the transaction can have a significant effect on the amount of risk each party assumes, and consequently, the valuation. Assume that if the deal you strike with a buyer is typical-for example, 20% to 30% down with a five-year earn-out period-your firm might command a valuation of five times cash flow. But alter that deal structure and you'll alter the risk profile-and the resulting valuation. For example, if a buyer offers 100% cash up front instead of buying you out over five years, you would probably agree to a lower valuation-you are reducing the risk that you may not get paid down the road. If a buyer wants to extend the payments to 15 years, however, you would require a higher valuation to reflect the greater risk you assume.
Proper business valuation requires time and effort. And it's tempting to want to cut corners by taking the easiest and most direct path to a final dollar amount-by accepting simplistic rules like your business being worth two times revenue. However, a simplistic approach will almost certainly leave you with less money in the end than if you approach business valuation the right way. The upshot: Take the time to get everything that's coming to you, before you start thinking about selling your firm. After all, you spend your days helping clients maximize their wealth-isn't it about time to make sure you're maximizing your own?
David DeVoe is Director of Practice Management Programs for Schwab Institutional.