Business valuation: One size doesn’t fit all

As the first baby boomers turn 66, a steady stream of financial advisers also are entering or approaching retirement age. Most current advisers will be leaving the profession within 20 years.

The question they will all have to answer is how to transition and value their practices. But an ensemble practice conducting $1 billion worth of business will probably have a different valuation approach than a solo practitioner with $500,000 in revenue.

And that is what advisers learn as they negotiate to sell their businesses: One size fits one. There are as many variations and nuances as there are advisers doing deals.

But even if each practice has a unique take, an adviser can use some fundamentals to start thinking about succession and value.

VALUATION METHODS

Calculating a business’ value is typically the first step. Though there are several ways to price a business, a range of industry data can be applied to each method.

Most advisers educate themselves about calculating value by talking to other advisers. Because a ballpark estimate is relatively easy to arrive at, advisers most commonly use the multiple approach.

With this method, revenue is multiplied according to industry norms. Typical multiples for advisers are 2.3 for recurring revenue and 1.1 for nonrecurring revenue, though there is a range for both.

Recurring revenue includes asset management fees, 12(b)-1 fees, some annuities and C shares. Because these fees are likely to continue without additional sales efforts, they get a higher multiple than nonrecurring revenue.

Nonrecurring revenue includes items such as upfront commissions, which occur only when a new sale is made.

Another pricing method, the income approach, converts forecast cash flow to present value through a cash flow capitalization or a discounted-cash-flow calculation. The latter is the more refined of the two, as it allows for positive and negative variation in growth.

After the initial estimate has been calculated, qualitative factors will further influence the price. The demographics of the practice, such as clients’ average age and revenue per household, as well as the number of bidders, also can affect value.

The quality of the relationships between the adviser and the clients is a critical factor in the valuation formula. If the relationships are weak, more of the business will be at risk after a transition; if an adviser has regular meetings and solid connections with clients, more of them and the associated revenue will be retained.

DEAL TERMS

It is as common for sellers to overestimate value as it is for buyers to underestimate it. Both parties also tend to focus too much on the price and not enough on terms.

Terms vary greatly and can make a less-than-attractive offer more appealing, and vice versa. Common negotiating factors include the down payment, promissory note and earn-out.

A down payment of 35%, give or take 5%, is a frequent starting point. The remainder typically is offered through a promissory note, an earn-out or a combination of the two.

A promissory note is for a fixed amount to be paid over time. An earn-out is a shared risk/reward approach in which both the buyer and seller receive compensation based on revenue generated from the transitioned clients over a specified period.

Consider a real-life example.

Adviser A was excited to have two offers to buy his practice, for $900,000 and $1 million.

Although the bigger deal initially looked better, the terms changed the adviser’s view.

The lower offer included a $300,000 down payment and a low-risk promissory note for $600,000 due in four payments over two years. The $1 million offer had no down payment and a proposed earn-out over five years.

There are myriad other considerations that a deal can address, such as transfer of the office, continuing employment of staff or consulting provided by the seller. Most important, the seller and the buyer should ensure that the deal includes professional assistance from an attorney and an accountant to help with the sale and transition.

By covering all the bases — from running the numbers and assessing the value of qualitative factors, to studying the components of the deal and working with trusted professionals — advisers can be sure that the price is right for the practice.

Joni Youngwirth (jyoungwirth @commonwealth.com) is managing principal of practice management at Commonwealth Financial Network.