Articles on succession planning may have prompted you to think about selling your own financial planning practice and wondering what price you would get. As both a business consultant and a former acquirer of financial planning practices, I can tell you, your practice is very likely worth less than you think it is. It is important that you understand this because if you want your succession to get implemented, you are going to need to adjust your expectations. The challenge is in setting up a deal that can be funded.
Valuation of Financial Planning Practices
The commonly cited valuation multiples for financial planning practices of 1.1x non-recurring revenues and 2.2x recurring revenues, is no longer an appropriate basis for valuation. Revenues have dropped, but expenses have not; clients have more choices, competition is greater and market projections are flat.
Assume a practice with $500,000 in gross dealer concessions (GDC) and 85% payout from the broker dealer (BD), with a 60/40 split on recurring versus non-recurring revenues. Using the expected norms, it would be valued at $750,000.
This valuation ignores the quality of the revenues being generated. If the practice has a 30% gross margin, its annual profit from operations would be $127,500. Repayment of debt on the purchase price of $750,000 over a five-year term would be $150,000 per year.
It can be argued that profit earned under the existing owner might not take into account the future potential of the acquired assets or the cost savings of the existing owner leaving the practice, but most owners do not leave immediately. Instead, they stay on to provide “continuity” and draw a salary or fees for some period. If we assume the seller wants to stay on for a year and the transition results in 90% retention, profit would be reduced substantially. Available free cash flow might not be sufficient to handle the debt repayments at this valuation level. It can be seen that the deal is negative coming out of the gate.
The effective attrition rates for assets being moved within the same broker dealer are low; however, a change from one BD to another demands intensive client involvement and the attrition rates can be as high as 20% of clients and/or assets under management (AUM). The industry average multiples for valuation ignore the higher rates of attrition that commonly affect transactions involving two BDs.
Several industry reports suggest that a debt-funded sale is simple and beneficial. What they fail to point out is the risk of something going wrong. When it does go wrong, it goes quickly and sometimes catastrophically. The cash flow issues are obvious, but profitability is also affected by challenges to morale, organizational stability and service models.
So, What is the Real Value of a Financial Planning Firm?
Well it’s the same as any other business that has a capacity to generate a profit from its underlying value proposition – in this case, skilled advice and investment services. Its value is directly correlated to its future cash flow. If a buyer knows the cash flow history, he/she can make assumptions on future growth rates, margins and expenses, and build a credible cash flow model with net present value (NPV) of future cash flows and an internal rate of return (IRR). Future cash is the single benefit you are offering to a buyer.
In the example of a practice with $500,000 GDC and 85% payout from the BD, assuming 6% compound growth and a modest discount rate of 20% over a 10-year period with a terminal valuation, the firm would be worth approximately $620,000.
This valuation increases the IRR for the buyer by 50%. In the model above, the reduction in the asking price from $750,000 to $620,000 pushes the IRR to 11% from 7%, which is the difference between making it attractive or not because the buyer has other ways to make 7% on his/her money.
You may reply, “But there are 50 buyers to every seller.” If this was true, practice valuations would be soaring. The fact is that many “interested buyers” are kicking tires. They do the math and recognize they cannot buy a practice that is priced above a point where cash flow will service the debt.
This reassessment of valuation is important to you because a debt-financed acquisition is leveraged and uses the firm’s cash flow to pay down the debt. If the debt cannot be paid because the firm bankrupts itself, the outcome benefits neither the seller nor the buyer. The last thing clients want is to be involved with a firm where the senior parties are in court! It is better to value a practice on its predictable cash flow, add a shared benefit bonus for the seller if the firm does well under new management, and enjoy a successful succession.
Buying practices and assets is a proven method for developing a financial services firm and it serves the industry well. Being realistic, rather than optimistic, about the value of our practices benefits all parties involved in the transaction. We have to recognize that our valuation models should be based on realize-able cash flow, not simply notional historical multiples.