The coronavirus turmoil has forced many financial advisors thinking of retirement to confront a possible cratering of the value of their firms, and that’s likely led to debates about how they value firms in the first place. As M&A consultant David DeVoe has said in the past, the same firm that wants to buy a competitor for four times cash flow would often sell themselves for four times revenue—two completely different metrics—from either a lack of insight or personal vanity.
DeVoe, speaking about the coronavirus in a DeVoe & Co. webinar yesterday, said he continues to believe that advisors valuing themselves on multiples of revenue are making a terrible mistake, using a blunt instrument based on the “math like a 5-year-old kid can do in their head.” He roots for valuing firms on discounted cash flow multiples.
“Multiples of revenue are dangerous, they’re horrible, they’re an infection into an organization that will destroy firms," he said. "One of those blind spots that can destroy your firm is using a multiple of revenue in some of your internal shareholder documents.”
The big problem, he said, is that revenue hides all sorts of things that might be wrong with a firm: He imagines two identical firms with $500 million in AUM and $4 million in revenue. “One of those firms runs a great business, they really coach their staff, they have all these great things, people are happy, they’re working hard … they have margins that are 30%. The other firm hasn’t paid as much attention, they are not growing anything like the other one. They have all sorts of expenses and too many people. It’s very inefficient and margins are like 5%. Would you pay the same for both firms? No way!” You’d pay more for a machine that could be scaled.
The profits are what pay back an investor, he said. And those dumbed down revenue valuation metrics build direct problems into internal succession plans as well. “When your junior people are risking their life savings to buy into your firm, this is not cool,” he said. He invokes a nightmare scenario with a buyback clause in which an employee shareholder-rainmaker is leaving the firm and wipes out a large chunk of its revenue, yet is forced to buy back shares at last year’s unimpaired version of revenue. “There’s a lot of danger there,” DeVoe said.
Matt Cooper, president of Newport Beach, Calif., acquirer Beacon Pointe, agreed that free cash flow is king when valuing a firm, whereas revenue doesn’t take an advisory’s cost structure into account.
“Multiples of revenue don’t really work when valuing firms because they fail to take into account the cost of the structure needed to support those revenues,” said Cooper. “Free cash flow to the buyer is what is of value. Cash that can be taken home or reinvested in the business or more M&A.” That cash might otherwise be siphoned off by too much staff and operations.
No, But Why Not?
There’s a counterargument that revenue multiples are plenty good thumbnail sketches of a firm’s worth, particularly sole proprietorships, and that valuations that do a deeper dive can be expensive and unnecessary.
David Grau Sr., the president of FP Transitions, in his 2016 book Buying, Selling, and Valuing Financial Practices, writes, “The multiple of revenue can work well for, and should be limited to, job or book owners who are buying or selling less than $50,000 to $75,000 of recurring gross revenue or maybe twice that amount of transactional revenue out of a sole proprietorship model.
“At these levels,” Grau writes, “the margin of error when coupled with reasonable payment terms is acceptable to most buyers and sellers.” A simple earn-out arrangement and revenue splitting approach for a firm with no entity or profits “is close enough,” he writes.