How to Value, Buy, or Sell a Financial Advisory Practice

A Manual on Mergers, Acquisitions, and Transition Planning

Mark C. Tibergien, Owen Dahl

• Publisher: Bloomberg Press
• Year: 2010
• Print ISBN: 9781576601747
• eBook ISBN: 9780470884980
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Financial planning is a young industry. The International Association of Financial Planning—one of the predecessors to the Financial Planning Association—was formed less than forty years ago. But as the profession's first tier of advisers reaches maturity, the decisions that may be part of transition planning for their firms loom large. A sale? A partner buyout? A merger? No matter what the choice, its viability hinges on one critical issue—the value of the firm. Unfortunately, many advisers--whether veteran or novice—simply don't know the worth of their practice or how to influence it. That's why How to Value, Buy, or Sell a Financial-Advisory Practice is such an important book. It takes advisers carefully through the logic and the legwork of coming to a true assessment of one of their most important personal assets—their business. Renowned for their years of experience helping advisers tackle the daunting challenges related to the valuation, sale, and purchase of advisory firms, Mark C. Tibergien and Owen Dahl offer guidance that's essential and solutions that work.

PART I

Defining Value

1.

UNCOVERING TRUE WORTH

INVESTMENT OR FINANCIAL-PLANNING professionals—like many small-business owners—often have an inflated perception of the value of their practice. That’s because they typically have 15, 20, or 30 years of blood, sweat, and tears invested in the enterprise, and it has been a fountain of economic rewards during their working years. And they have heard many people quote market multiples that they are certain apply to their practices. But when you assess the value of a practice, shortcuts don’t tell the whole story. You must look more closely to understand nuances like the quality of the client base and the future potential of the practice. It’s also important to understand whether the firm is profitable in its current form and whether that profitability is sustainable.

For a buyer, a realistic understanding of the worth of the practice is essential to paying a fair price. And clarity on these principles will make sellers more effective negotiators. This chapter outlines the valuation process and highlights the factors that drive practice value. Subsequent chapters will address the mechanics of valuation, deal structure, internal versus external transactions, and other factors that should help you prepare for this process regardless of which side of the deal you’re on.

The Unruly Rule of Thumb

For a business as straightforward as financial planning, many ideas that circulate about how to value a financial-advisory practice are surprisingly convoluted. Each month, Moss Adams LLP receives scores of calls from advisers who want us to tell them the rule of thumb for valuing a practice. “Is it the multiple of gross?” they ask. “The multiple of assets under management? The multiple of EBITDA [earnings before interest, taxes, depreciation, and amortization]?”

Especially maddening is that some practices actually do sell for a rule-of-thumb price. That doesn’t mean it’s an appropriate price, but it happens nevertheless. The good news for sellers is that these rising multiples are enhancing the value of their practices every day, and consequently these advisers are in a unique position to capitalize in a big way on the businesses they’ve built. But some important issues are essential for both buyers and sellers to consider in determining value.

The rule-of-thumb methodology presumes that all advisory practices are equal. Such assumptions are just as faulty in comparing advisory firms as they are in comparing stocks. If the price of Starbucks falls below the price that Microsoft is selling for, does that make it a better buy? The question is obviously not relevant because their economics are different. What’s more, each investor’s perception of risk and growth is different.

The inclination to rely on a rule of thumb makes it clear that buyers and sellers of advisory practices view these transactions as they do the purchase and sale of a house. In real estate, one can look at a neighborhood, measure the square footage, see if it has a view and come up with a price. Buyers of homes don’t usually calculate with accuracy what kind of return on investment they’ll get with this purchase, because the whole point is to acquire an asset that they can live in and possibly sell for a gain down the road. Perhaps it’s because buyers of advisory practices look at these firms as a means to an end, a necessary component for their lifestyle, a job, that they fall into this home buyer’s approach to pricing them.

But advisory firms are not tangible assets like houses or cars; they’re living, breathing entities with multiple nuances that could affect their value. What’s the potential in the client base? How old are the clients? How profitable is the service model? Will clients accept the new adviser? What’s the expense structure? What’s the motivation of the buyer? of the seller?

Distorting Value

Rules of thumb tend to distort value. Even market comparables tend to distort value because of the unique characteristics of each business being sold, as well as the particular motivations of the buyers and sellers. We encountered an example of this when we were asked to evaluate a practice on behalf of a buyer-in fact, the buyer was in a bidding war to acquire the business. The owner of the practice had died suddenly, and his widow engaged a broker to find a buyer. The broker set the price at 2.5 times trailing 12 months’ gross revenues. He advised our client not to bother offering anything less. In probing for the opportunity in this practice, we found that 40 percent of the clients were past the age of 70 and many were already withdrawing principal. None were contributing more cash to invest. Looking at the mortality rate of this client base gave the buyer enough pause not to step up to this multiple.

Oddly enough though, sometimes sellers don’t realize what their firms have to offer. Again, relying on stated market rules of thumb, one adviser actually undervalued his practice. His average client was a business owner or executive, age 45, whose income was increasing each year and who was contributing substantial new assets yearly. The growth rate for the foreseeable future was exponential, and the practice was extraordinarily profitable, but by relying on the rule of thumb, the owner appraised his practice as “average.” He now knows that the only time you should aspire to be average is when you are below it.

The Need for Valuation

Drawbacks aside, rules of thumb and market comparables come in handy as a starting point for a discussion of value. For the buyer, however, that figure should rarely be the end point. So many factors related to structure, financing, terms, and taxes go into a deal that there should be give-and-take in every situation. The key question the buyer of a practice should be asking is, “What is a reasonable rate of return on cash flow when I make this acquisition?” By beginning there, the buyer can move toward an understanding of the principles of business valuation.

It is unnecessary for buyers or sellers to obtain a formal valuation before entering into a merger or sale discussion. Sellers often have an idea of the price they want for the business regardless of economic reality. Buyers, however, will benefit from some form of valuation process. It provides a foundation for early negotiations and will help them put their thoughts through an economic filter. Since most people in the financial-advisory business are financially astute, the valuation process should be easy to relate to.

If a buyer or seller does go through a formal valuation process, the evaluator should consider key standards, such as:

1. Market prices of comparable publicly traded companies

2. Transaction values of similar entities

3. A discounted cash flow analysis of the business being valued

4. A detailed and specif ic analysis of the entity and the market conditions in which it operates

Typically, the first three benchmarks are given less weight than the specific analysis, but they’re considered nonetheless. In using a rule of thumb—or market comparables—only one perspective is considered. Such a single-lens view is a little like making investment recommendations for your clients based on the last conference speaker you heard: compelling but incomplete.

Standards of Value

There are numerous ways to measure the value of a business. Two key questions are essential to beginning the valuation process:

1. What is the purpose?

2. What is being valued?

The answers to these questions determine the purpose of the valuation and dictate which standard of value applies and whether it’s appropriate to consider discounts or premiums in deriving the value.

What Is the Purpose?

Fair market value and fair value. The standards of value relied on for tax, litigation, or contractual purposes are referred to as fair market value and fair value. Fair market value is the standard used in the context of gift and estate tax and sometimes applies in the division of assets in divorce. As promulgated by Revenue Ruling 59-60, fair market value defines a value at which an asset or business would change hands between a typical willing buyer and willing seller, neither party being under any obligation and both parties being fully informed of all the facts. Fair value is a standard usually defined by state law and is typically used in divorce, partnership, and shareholder disputes and sometimes in buy-sell agreements.

It’s quite possible that valuing an asset for tax, divorce, or litigation purposes will result in a conclusion different from that which results in the process used to determine value for purchase or sale. In the case of litigation or divorce or estate tax, however, the emphasis is not on a real-life transaction. When a sale or purchase is contemplated, fair market value may be a starting point, but other factors, including the motivations of the buyers and sellers, could change the result. Another standard—investment value—may also come into play, however, because this standard considers the potential synergy of the two businesses, a measure that’s quite useful for some owners and sellers.

Investment value. The term investment value as used here is def ined in the American Society of Appraisers’ Business Valuation Glossary as the value to a particular investor based on individual investment requirements and expectations. Investment value is different from fair market value, which is value to a typical buyer and seller, for various reasons, including:

♦ Economies of scale available with the buyer’s operations

♦ Synergies available with the buyer’s operations

♦ Differences in future earnings estimates

♦ Differences in perceived risk

♦ Differences in tax status

Using investment value as the primary premise of value is inappropriate in the sale of an advisory practice because the seller should not receive all of the synergistic value; nor should the seller expect to receive the full premium. That premium should be considered as part of the negotiation process.

What’s Being Valued?

Many assume that what’s being valued is the entire business. But there are situations in which portions of the business may have to be valued separately. The difference would influence whether one applies a control premium or a minority or nonmarketability discount to the price. It’s all a function of rights.

The more rights the owner has—such as the right to liquidate the business, declare dividends, or sell major assets—the greater the premium applied. A discount is applied based on the transferability of the asset, lack of voting rights, or lack of a ready market. These matters become important to define in the context of litigation, shareholder disputes, divorce, or the admission of partners or when using stock as currency in a transaction (see Figure 1.1).

The factors related to defining value also play a role in translating market rules of thumb into your planning. We often see buy-sell agreements with multiple shareholders in which the value of each ownership interest is based on an enterprise value, meaning 100 percent control divided by the number of sha...

Table of contents

• Praise
• ALSO BY MARK TIBERGIEN (AND REBECCA POMERING)
• Title Page
• Copyright Page
• Dedication
• Acknowledgements
• Introduction
• PART I - Defining Value
• PART II - Assessing Value
• PART III - Coming to Terms
• PART IV - Ounces of Prevention
• PART V - Inside Stories
• PART VI - The Marketplace
• Appendix of Sample Documents
• Index
• About Bloomberg
• About the Authors