How transferable is your business?

We frequently ask financial advisors to think about this question, since the ability for someone new to take over a business with minimal disruption goes hand in hand with that business’s sustainability and, ultimately, its value. Often, advisors believe their practices are much more transferable than they actually are, regardless of whether they have formal succession plans in place.

The sustainability of an advisory practice is a major concern for clients as well as employees. After all, if a top advisor leaves or passes away, clients will worry about the future of their assets and financial plans, and employees will be anxious about their jobs and livelihoods.

All too frequently, advisors make the mistake of solely looking at revenue when determining the value of their businesses. However, revenue alone does not determine the true value of an advisory practice—or any business, for that matter—and financial advisors need to internalize this truth to ensure the long-term well-being and security of their clients and employees.

An Incomplete Picture
The most common business-valuation method used by advisors involves applying an industry merger/acquisition multiple to their practices’ revenue. This method is easy and cheap for advisors to calculate, since it doesn’t require them to retain consultants, investment bankers or other valuation specialists.

However, attaching M&A multiples to a practice’s revenue may lead to a misleading and incomplete picture of its true value. This approach assumes all advisory businesses are exactly the same, except for differences in types of revenue generated—similar to the way Zillow computes the value of individual homes.

Zillow takes all of the comparable home sales in a certain neighborhood and consolidates them based on square footage. The estimated price doesn’t take into account whether the home has, for example, hardwood flooring or a pool—features that affect the property’s value over the long term.

Similarly, using multiples of revenue to value an advisory practice will result in a price that ignores critical factors such as revenue per client or number of clients currently serviced—and whether the business is leveraging new technology or experiencing compliance difficulties.

This valuation method falls short because buyers are interested in more than just current revenue. They also want to know if a business is positioned to generate healthy revenue and cash flow over the long term. They want to know to what extent the business is transferable and sustainable.

Discounted Cash Flow:  A Better Way To Value Your Business
To achieve a valuation that provides a deeper understanding of the overall quality of their practices, advisors should use the discounted cash flow approach, in which projected future cash flows are discounted against the average cost of capital and various business risks. This method is more complex than applying multiples to current revenue, but it gives advisors and potential acquirers an idea of the business’s future cash flow and revenue streams—in other words, how sustainable the practice actually is going forward.

Nevertheless, no matter what valuation method advisors use, the values they calculate are not the end-all, be-all of their businesses’ worth. Depending on an acquisition’s deal structure, a practice could sell for more or less than its actual value. For example, if an advisory firm is worth $1 million, its owners could receive $850,000 up front, or $1.4 million over five years, depending on how the buyers and sellers prefer to structure the deal.

Increasing Your Business’s Value
Proactive measures taken by advisors today can make their businesses more sustainable and transferable—and more valuable to potential buyers—tomorrow. For example, practices with a broad focus on wealth management and financial planning tend to have higher values than investment planners whose revenues are tied to a single product or service.

In addition to diversifying their revenue sources, advisors can also raise their practice valuations by joining investment and consulting platforms designed to help them offer more efficient service and more robust product suites to clients. These advisor-focused platforms provide technology solutions and other tools that enable fee-based businesses to outsource back-office tedium and spend more time guiding their clients toward financial goals. They also deliver much-needed scalability to advisory firms, allowing advisors to take on more clients without hiring significantly more staff. In the event of a change in ownership or leadership, advisory practices with these characteristics would be easy to manage without significant disruption.

Another key offering from investment and consulting platforms are business valuation tools that show advisors what their businesses are currently worth, and what steps they need to take to reach their desired values. Consultants can work with advisors to create peer group benchmarks measuring criteria such as total revenue per client and clients per advisor, and guide advisors on how to reach their objectives.

Looking Ahead
No matter what steps advisors take to increase the values of their practices, they must remember that those figures are tied to more than just revenue—they also rely on the sustainability and transferability of their businesses over the long term. Practices which can be taken over by new leaders with minimal disruption to client service are more valuable in the eyes of potential acquirers, and offer clients and employees greater peace of mind. 

Matt Matrisian is Senior Vice President and Director of Practice Management at AssetMark Inc. (www.assetmark.com), an independent provider of innovative investment and consulting solutions serving financial advisors, and author of The Power of Practice Management: Best Practices for Building a Better Advisory Business.