Valuing an Advisory Practice: Fundamentals to Consider

Posted by Maria Considine King

January 22, 2020 at 1:30 PM

valuing an advisory practiceIf you’re in the market to buy or sell an advisory practice, valuation concerns are undoubtedly top of mind. Many well-established methods for valuing an advisory practice exist, but they all involve some degree of complexity and subjectivity. And, of course, a value calculation is not necessarily what a buyer will pay or what a seller will accept. Negotiation according to each side’s interest is what determines the price and the terms of the deal.

Given the continued pace of advisor acquisitions in our industry, I wanted to dive into some factors and methodologies involved in making a deal happen. Many deals tend to appear better when we’re riding a 10-year bull market, but it’s critical to be sure your deal terms work during an economic downturn as well. So, as we review the fundamentals, we’ll also think about business valuation in a recession.

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Business Valuation in a Recession

For those who are buyers, a recession puts the projected revenue stream of your investment at risk. With an AUM revenue model, for instance, if account values decline, you’ll obviously receive less revenue on the acquired book of business than when the economy was stronger. Accordingly, it’s important to be clear about the range of returns you’re willing to accept and how long it will take to realize if we experience a downturn.

A practical way to think about your return is simply to measure if an acquisition is worth your time, which is your most valuable asset, and to balance the risk involved. This approach begins with an understanding of the return you generate on your existing business today. Acquisition integration is time-consuming—time that you would otherwise spend with existing clients will be spent with the acquired book of business.

You’ll want to think about how you’ll continue to provide services to existing clients during the integration period, so that they do not perceive a drop-off in attention and, potentially, leave due to lack of attention. And, realistically, you may lose acquired clients during the transition. Not all clients will be a good fit for your firm. The riskier or more time-consuming it is to manage an integration, the higher the return you should demand, and one that presumably exceeds the return you currently realize on your own book of business.

Part of getting to the right number is focusing on the opportunity cost of your time and capital. No one wants to invest hundreds of hours in making a deal and establishing new client relationships only to realize their efforts have generated an insignificant return. To avoid this, think about what you’re willing to pay based on your estimates for a worthwhile return on your investment. That means looking closely at the book.

Deal Breakers and “It” Factors

We all expect a book of business should grow over time, but unless the existing accounts will provide significant future business or generate referrals that you otherwise could not access, it has a finite life. And a recession would likely significantly reduce its value. Consider how revenues from the acquired book will be affected by the broader economy over the course of a recession, and work those expectations into your calculations to arrive at a downside scenario for your investment.

Potential deal breakers, or at least factors that may lead to a reduced valuation, may include an average client age over 70, geographic distance, too many “dead” assets, and small average account balance. Or, say the buyer is planning to retire in five years. If so, he or she will be out of the business by the time a book starts generating significant returns, especially within the time frame of a recession. So, buyers need to understand their own succession plan to monetize the book of business they acquired. But for younger advisors, who can withstand the time horizon over which gains will be realized, or are in a position to help with the transition of assets from older acquired clients to the next generation, the same book may be more attractive.

An “it” factor may warrant paying a premium. Some advisors might favor a commission-based book if it comes at a lower purchase price and they believe its clients would be well served by a focus on financial planning and a fee-based model in time. The cost and effort of conversion can be absorbed in the short run, with the hope that it will pay off several years out. Other attractive features might be acquiring a book of business in a client segment you currently do not have access to, which may expand your network and referrals, generating additional opportunity.

What’s a Practice Worth in Theory?

Let’s review some standard methods for valuing an advisory practice, and why some are more insightful when needing to factor in the potential for a bear market:

The multiples methods. This approach compares the key statistics of a practice with those of similar businesses recently sold. This is not a bad place to start when doing preliminary analysis or negotiations. The two most common variations look at multiples of revenue and multiples of cash flow.

  • Multiples of revenue.This method applies a multiple to the selling advisor’s past production data (typically, from the past 12 consecutive months). These multiples are presented as averages, and advisors adjust them based on the quality of the book. Multiples of revenue is an easy way to determine a starting point for negotiations and the most commonly used method. But it doesn’t account for expenses.
  • Multiples of cash flow. This method allows buyers and sellers to account for expenses by applying a multiple to net operating income (NOI), earnings before income taxes (EBIT), or earnings before income taxes, depreciation, and amortization (EBITDA). These metrics are of particular importance if the acquisition target is a complete business, not just a book of clients.

These two methods are relatively easy to calculate and commonly understood by market participants. But they have significant weaknesses. They don’t forecast the future cash flow to the buyer, which is essentially what is for sale. Would that same multiple generate an adequate return if you knew a recession was imminent? Plus, since most sales occur privately, there’s a lack of accurate information available for comparison purposes. As a result, if a deal progresses to the next stage, it is important to perform a more detailed financial analysis.

The income methods. Two common methods used to estimate the income a practice will produce are discounted cash flow and single period capitalization.

  • Discounted cash flow (DCF). This method forecasts cash flows for a specified period and then applies a discount factor. In addition, a terminal value is calculated using an assumed long-term growth rate. This method allows buyers and sellers to account for future internal and external risk, but making predictions can be challenging in unpredictable market cycles.
  • Single period capitalization. This method is a shortcut of the DCF approach that assumes a normalized growth rate. It calculates value by dividing next year’s adjusted cash flow by the capitalization rate (discount rate minus growth). As with DCF, the challenge is to fairly project each input.

In both cases, one of the strengths of these methods is the ability to run several models under a range of market and acquisition retention assumptions, to help protect against outsized risk from downside scenarios.

Alignment in Care for Clients

By taking an analytical approach to valuing an advisory practice, buyers and sellers alike reduce the risks inherent in these transactions. An acquisition is a great way to jump-start growth in your business, but if challenges arise, you want to see that they do not create excess risk to your ability to serve your existing business, jeopardizing your foundation.

It’s important to keep in mind that sellers and buyers are uniquely aligned in their care for the clients. All thoughtful sellers want to put their clients in good hands, and identifying a strong buyer and negotiating a fair transaction are part of succeeding at that goal. For buyers, not only is the right deal structure critical for generating strong financial returns, but it also enables them to focus on what matters most: helping clients meet their needs and fulfill their dreams.

In today’s market, both parties have many options for realizing value, even while considering and accounting for the impact of a possible recession. By being clear about your goals and focusing on the fundamentals, you put yourself on the best path to strategic success.

What are your thoughts about valuing an advisory practice? Which fundamentals or other considerations have the greatest impact? Please share your comments below!

From Theory to Practice: Complimentary Consulting to Evolve Your Business

Topics: Practice Management

   
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