Tuesday, April 23, 2024

Valuing an Advisory Practice: Fundamentals to Consider -Dlight News

If you’re in the market to buy or sell an advisory practice, valuation is undoubtedly top of mind and usually the first point of discussion. Many well-established methods for valuing an advisory practice exist, but they all involve some degree of complexity and subjectivity. And, of course, a valuation is not necessarily what a buyer will pay or what a seller will accept. A practice valuation is an important resource to have, but, ultimately, negotiations between the buyer and seller are what determine the price and structure of the deal.

Where will your journey take you next? If you’re thinking of breaking away, the Commonwealth Guide to Independence has the tools and resources to help get you where you want to go.

Given the continued pace of advisor acquisitions in our industry, I wanted to dive into some factors and methodologies that should be involved when valuing an advisory practice. At first blush, many potential deals appear attractive, but you want to be sure an acquisition or sale is right for you.

Thinking About Your ROI

For prospective buyers, achieving maximum long-term value is a key goal. When thinking about the potential future profit of the acquisition, it’s important to be realistic about the range of returns you’re prepared to accept and how long it will take to recover if there is a decline in revenue, assets, or clients.

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 weigh the risk involved.

  • Start by assessing the return you generate on your practice today.

  • Next, think about how you’ll continue to provide services to existing clients during the integration period, so they don’t perceive a drop-off in attention.

  • Then, factor in the potential loss of some newly acquired clients, as some are likely not going to 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—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. This means taking a deeper dive into the makeup of the practice.

Assessing Deal Breakers and “It” Factors

We all expect a book of business to grow over time, but unless the existing accounts have the opportunity to provide significant future business or generate quality referrals, prior growth rates won’t necessarily translate into future expected growth rates. Buyers also should consider how revenues from the acquired book will be affected by changes in the broader economy, like a downturn in the stock market, and work those expectations into their calculations to arrive at a downside scenario for the investment.

Potential deal breakers, or factors that can lead to a lower valuation, include an above-average client age, lack of next-gen relationships, asset or revenue concentration, and a large number of small accounts that may not align with your current service model.

Buyers also need to consider their own time horizon. What does your succession timeline look like? If you’re planning to retire in five years, does an acquisition make sense? Or will you be out of the business by the time the book starts generating significant profit?

But, for advisors, who can withstand a longer time horizon, there may be opportunities to maximize the growth potential of the acquired business; for example, you might focus on cultivating meaningful relationships with next-gen clients or targeting a new niche market within the acquired business. Opportunities like these may warrant paying a premium.

Another “it” factor that may warrant paying a premium could be the opportunity to provide comprehensive financial planning for clients who previously didn’t receive those services. Some acquirers might favor a commission-based book if it comes at a lower purchase price and they believe the clients would be well served by a focus on financial planning and a transition to 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 particular client niche or geographic region you currently do not have access to, which may provide new growth opportunities.

Running the Numbers

Let’s review some standard methods for valuing an advisory practice.

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. Here are two common variations:

  1. Multiples of revenue: This method applies a multiple to the selling advisor’s past production data (typically, from the past 12 consecutive months). The multiple is presented as an average, and it is adjusted based on the quality of the book. The multiples of revenue method is an easy way to determine a starting point for negotiations, but keep in mind that it does not account for any firm expenses.

  2. 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.

Although these methods are relatively easy to calculate and commonly understood by market participants, they have significant weaknesses. They don’t forecast the future cash flow to the buyer, which is essentially what’s for sale. Would that same multiple generate an adequate return if you knew significant client attrition was imminent? Plus, since most sales occur privately, there’s a lack of accurate information available for comparison purposes.

How to Command the Best Purchase for Your Business

free download

How to Command the Best Purchase Price for Your Business

Use our complimentary guide to help you create the kind of practice that gets bought at maximum value.

These methods are also commonly quoted as averages, but it’s very difficult to define what that “average” is and how it applies to your business. If you were looking to purchase or sell your home, you wouldn’t want to use the average home price in the U.S.; you’d take into account many more factors, which would contribute to either a premium or a discount from that average figure—resulting in a dollar amount unique to your specifications. So, while these methods provide a great starting point, if a deal progresses to the next stage, you’ll want to perform a more detailed financial analysis.

The income methods. There are two common methods used to estimate the income a practice will produce:

  1. 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. Remember, though, that the market is unpredictable.

  2. 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, you can run several models under a range of market and acquisition retention assumptions to help protect against outsized risk from downside scenarios.

Aligning 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 be sure they don’t interfere with your ability to serve your existing business, jeopardizing your foundation.

It’s important to ensure that buyers and sellers are uniquely aligned in their care for their clients. All thoughtful sellers want to leave their clients in capable, caring hands. Identifying a strong buyer and negotiating a fair transaction are part of succeeding at that goal. For buyers, getting a more granular understanding of the book of business is critical for generating strong financial returns, but it also enables them to focus on what matters most: helping clients meet current needs and fulfill future goals.

In today’s market, both parties have many options for realizing value. By taking a methodical approach to valuation, both buyers and sellers will have a better understanding of the drivers of a successful transition and can feel confident creating positive momentum while moving forward with a potential deal.

Editor’s Note: This post was originally published in January 2020, but we’ve updated it to bring you more relevant and timely information.

Related Articles

- Advertisement -

Latest Articles

- Advertisement -