In my previous column, "Adding New Owners: Planning for Internal Succession" (February 2008) I outlined some key concepts to consider in planning for the admission of a new owner into your firm. We considered:
1. What is the goal of sharing equity?  
2. What does it mean to be an "owner"?
3. What does someone have to do to qualify?
4. Is the firm ready?
Now let's drill down into the execution of admitting a new internal owner and consider:
5. What is the ownership interest worth?
6. What is the appropriate financial structure for ownership transition?
7. What should the terms of the ownership agreement be?

A Fair Price

First, the bad news: An internal transaction is typically not the best way to maximize the price received for an advisory firm. It may be the best way to maximize success and may best meet the seller's objectives, but when it comes to pure dollars, if getting the highest possible price is your objective, then internal transition is probably not your optimal choice. Because external buyers-usually strategic and financial buyers-are usually buying a majority interest, are buying for different reasons and have deeper financial resources, the prices they pay typically appear higher.

"Why would I sell for a lower price internally than I could sell for externally?" many advisors ask. There are a number of reasons. To begin with, many advisors recognize the long-term value of retaining the right people and recognize they may need to make some of those individuals owners to continue growing the business (and perhaps sell at even higher multiples in the future). Others recognize that an internal transition is the best way to meet their personal and business objectives-whether those include continuity for clients or staff, or the ability to define their timing and ongoing role in the business as they choose to.

Also, while it often appears that the "best price" is an external transaction, that isn't always true when the deal plays out. Internal transactions can be easier on the client base, resulting in lower attrition and ultimately a higher realization compared with an external deal. While the external transaction often appears to have a higher value and sounds good at first, these values frequently fail to materialize when earn-out provisions are not met.

Valuation

In many of the articles written that reference valuation, you have been warned against using market multiples to value your business. I will strongly reiterate that here. While multiples can be a helpful smell test, when considering X Revenue or X EBITDA formulas, remember:
Multiples disregard the unique economic and structural issues of a business that drive value.
External buyers (e.g., banks and trust companies) tend to be strategic buyers and therefore pay a premium-the premium is built into the market multiple but should not be included in your transaction.
External buyers tend to buy control-minority interest valuations have a discount for lack of control.
There is a lack-of-liquidity discount for private company stock.
Revenue multiples are commonly quoted because they are more likely to be disclosed and they are easy to reference. However, acquirers who are focused on transferable earnings don't use them. They ignore payments made over time and the time value of money. They do not reflect the financing structure and who bears the risk.

Because most deal structures do not guarantee the full consideration, the actual payments made in a transaction may vary significantly from the stated "face" value. The actual payments made depend on performance of the combined entity and those are rarely communicated and related back to the originally published "valuation multiple."  Most important, multiples are a function of the past, while business value is a function of the future.
In evaluating the value of your business for the purposes of an internal transaction, consider a discounted cash flow analysis as would be performed in a formal valuation: Value = Cash Flow รท (Risk - Growth).

Cash flow is the cash generated by the business after fair compensation to owners, risk recognizes the required rate of return on a closely held business with the unique risk factors of your specific practice, and growth considers the firm's likely perpetual growth rate in earnings.

Some of the adjustments you'll want to make to cash flow include:
Normalize partner compensation-What would you have to pay to hire someone to do your job?  Depending on the owners' roles and the size of the organization, this is typically in the range of $150,000 to $400,000.
Eliminate discretionary items, including things like personal expenses deducted through the business, spousal compensation (if your spouse doesn't work in the business), etc. Keep "normal" benefits, but remove anything that you are doing purely for tax reasons, to generate a true business financial statement.
Eliminate extraordinary items-unusual, one-time expenses or one-time big-ticket sales, for instance.
Adjust for abnormal economics such as delayed hires.
Some of the factors you'll want to consider in evaluating the risk of the specific business include:
Quality of client base;
Dependence of the business on owner(s) or key people;
Strength of management team;
Stability and growth of the local economy; and
Nature (transferability) of the revenue stream.

Of course, the higher the cash flow, the lower the risk and the higher the growth rate, the higher the value. Higher growth results in higher future cash flows, a lower discount rate and higher value. And lower risk and greater transferability results in higher value.
One important point about valuation-whether in an internal transaction or an external one-is that the value calculated is just a starting point for negotiations. The buyer will likely challenge the assumptions made about growth, expenses, timing of hires, risk factors, discount rates-and how all of those factors impact the valuation and the ultimate price they will pay, and the seller will need to be prepared to justify the assumptions made, and negotiate when appropriate. This is not a personal attack. This is just good business/investment sense on the part of both parties.

Structure Of The Deal

The structure of the ownership also impacts how much the candidate values buying in, and therefore how much they will be willing to pay. The rights associated with the ownership they are buying will impact the price they are willing to pay, including:  
Will they have participation in the board or other governing body?
Will they have participation in management?
What will the voting mechanisms be?
Will they have ownership of specific assets (e.g., a client base)?
Will they have the right to block specific decisions (such as the sale of the business to an outside partner, or the admission of future partners)?
What will the terms be of the ultimate buy-sell agreement?
Will they have the right of first refusal to acquire the remaining interest when you are ready to sell?
Will they be required to sell on exit?
How the risk is balanced between the buyer and seller will also impact the ultimate price. Factors that would increase the risk for the seller, and therefore increase the price would include:
The seller is asked to carry a large note.
The purchase will happen over a long period.
The buyer experience level is low.
The price is based on client retention.
High growth is projected.
Factors that would increase the risk for the buyer, and therefore decrease the price would include:
A large down-payment is required.
A high level of bank financing is needed.
The seller's role in the future is unclear or undesirable.
The client potential is limited or in question.
A rigorous payment schedule is set.

Financing

One of the most burning questions for sellers and acquirers alike-once they get past the valuation question-is "How in the world are they going to pay for this?" There are three ways to finance an internal transition. In order of prevalence of use they include:
Through compensation: An individual uses their incentive pay, ownership distributions and perhaps salary increases to finance the purchase.
Through internal borrowing: The business lends the money from cash flow, repaid by the individual over time, with interest.
Through outside borrowing: Financing comes from banks or other sources.

Funding the acquisition through personal earnings and cash flow is the most common method, and is a viable option in smaller firms and/or where the value of the equity being purchased is manageable. However, if the stake being sold cannot be paid off over a term of five to ten years, we would suggest that another method of financing needs to be considered.

While bank financing may be unavailable or too expensive, some organizations (particularly larger ones) have been able to arrange favorable terms with banks with which they have good relationships to facilitate borrowing by team members to whom they are transitioning ownership.
Some interesting external financing alternatives are available specifically to advisory firms. If you are willing to give up some control in return for capital then you may be amenable to working with a more hands-on professional acquirer, including Focus Financial, United Capital, NFP or Mesa Holdings-the more active national players. But for internal transitions, the focus of this article, the purest solution providers are Fiduciary Network and Asset Management Finance.

The Fiduciary Network (FN, coming soon to http://www.fiduciarynetwork.net) offers unique, if somewhat complicated, financing that involves multiple classes of equity. With some $600 million in funding from the Milstein family, owners of Emigrant Savings Bank, FN is looking to become a passive investor in advisory firms.

An FN transaction creates the means for a company to either broaden its ownership or gradually conduct a generational transition, or both. Mechanically it works as follows: The current owners sell equity in the firm to their successors over many years. FN lends the next generation the money to purchase as much equity as possible while FN in parallel buys the remainder. FN's investment is done in the form of an instrument that converts into nonvoting stock so control always remains with the current and future management regardless of how much FN may ever own.

Asset Management Finance Corp. (AMF) also has a creative solution. Instead of purchasing a share of the firm's net cash flow, AMF bypasses the expense line completely by purchasing "revenue-share interests" from the firm, which is simply a right to a fixed percentage share of the firm's total gross revenue for a finite time period. The revenue share interests have a limited contractual life after which 100% of the firm's revenue returns to its internal owners.

When AMF's capital is used for generation transitioning, AMF often does not deal directly with the next-generation ownership team, but instead provides capital to the existing owners. These owners are then free to transfer equity to the next generation when and how they want to. The transfer of equity can be accomplished with internal financing or through other customized equity transfer structures. At no point during the process does AMF acquire an equity stake (passive or otherwise) in the firm, allowing the owners to maintain their independence.

Remember To Think Strategically

Although this column has been focused on implementation, don't forget to start your planning process with the strategic considerations outlined in part one of the column in the February issue. Throughout the process of planning and implementing your transition, continue to go back to your strategic planning as your touchstone to ensure you are implementing your plan in a way that is consistent with the objectives you originally outlined. There is a risk of getting so wrapped up in the implementation-and the sense of victory at finally negotiating a valuating acceptable to both parties-that you lose focus on the strategic objectives.

Internal transition is the desired growth plan and succession plan for the vast majority of advisors and good planning, strategic thinking and thoughtful implementation will allow many to enact a transaction that ensures the desired outcomes for their staff, their clients and themselves.