After a 10-year bull market, with threats of recession on the horizon and lots of advisors set to retire, it’s likely that RIA firms are trying to value themselves—and a lot of them are going to overdo it, especially as asset levels soar.

“I have heard that the Belgians have a joke,” says consultant Philip Palaveev of the Ensemble Practice. “The easiest way to make money is to buy a Frenchman for what they are worth and sell them for what they think they are worth. Perhaps some (but not all) advisors have the same ‘price differential.’”

“It’s pretty typical for owners of RIAs to have a high value of themselves, and quite often they are initially overvaluing themselves,” said David DeVoe of DeVoe & Co., an M&A consultant. “The human brain naturally gravitates towards data that supports what that person wants.”

In some cases, he says, he’ll talk to an advisor who at the beginning of a conversation says he would be curious about acquiring firms and would be willing to pay three or four times cash flow for one. “Ten minutes later, they talk about the value of their firm and they think they are worth three to four times revenue. I point out that in the same conversation they have used a similar metric but one that’s literally four times the other.”

The misconceptions about value all stem from how it’s defined, says Palaveev: “It is the present value of transferable future cash flows—with emphasis on ‘transferable.’”

Time plays into the deal, as well as the terms and the risk. “If the payments are contingent on the performance of the firm, then the risk is higher,” Palaveev says. “If the risk is higher, the value is lower.” It changes the value of a firm if the buyer gets preferred payments ahead of other shareholders, whereas it’s different if the buyer is a minority shareholder getting the same dividends as other shareholders, he says.

Sometimes advisors with extremely high margins expect that the margins will continue to expand, DeVoe says. “Well, a buyer will take a hard look and think, ‘Wait! The margins are actually going to compress.’ In other cases, [sellers] are using an extreme multiple that they heard about in a conversation or at an event. And they are applying it to their firm where their firm doesn’t have those growth or profitability metrics.”

The problem is that there are so many metrics, some of which can boost premium and some of which can punch a hole in it. Says Palaveev: “A single number can describe the ‘value’ only if that number is written on a cashier’s check.”

Looking at earnings before owner’s compensation is one way to look at valuation, says Jeff Maurer, CEO at Evercore Wealth Management. “If the owner is staying and signing a long-term contract where they are turning some of their compensation into capital gains—so they are going to work five years, and instead of making a million dollars a year they are going to make $500,000 a year—that could translate itself into an increase in the purchase price of $5 million. That goes into the whole calculus of what a firm is worth.

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