Revenue multiples don’t tell the story of your firm’s value

Most small business owners have no idea what their businesses are worth. Many turn to financial planners to determine the value of their most crucial asset. But if you ask a registered investment adviser about the value of his or her practice, you will often get very strongly held opinions about some multiple of revenue.

Unfortunately, this is usually no more sophisticated than back-of-the-envelope formulas. Worse still, RIA owners don’t truly understand how to get the right revenue multiple.

A generic revenue multiple does not define a practice’s value. Wouldn’t it make sense that two firms with the exact same revenue would be worth different amounts if, for example, the majority of one firm’s clients are in decumulation while the other firm had a robust growth rate and clients in their 40s?

Similarly, a firm that has made significant investment in next-generation resources, staff and clients is worth a different amount than one with no client website and antiquated back-office procedures, even if the revenues are identical.

(More: RIA owners should know what their firm is worth, but many don’t get valuations)​

Advisers often declare the worth of their business based on a revenue multiple “rule of thumb” they picked up from a breezy news article or half-remembered bits of wisdom heard at a conference. This leads many firm owners to vastly overestimate their value, but more importantly it causes them to misunderstand the actions they can take to improve their overall valuations and business quality.

I suspect the persistence of revenue multiples as a quick and dirty shortcut for valuation comes from the brokerage environment in which many advisers get their start. When you work for broker-dealers, you’re paid on production, while they cover most of the costs. That’s not the case in the RIA world, where efficiency, geography, productivity and client books weigh heavily on a firm’s profitability and longevity.

As the industry evolves and becomes more professional, we need to adopt a more sophisticated approach to firm valuation. We need to break the hold of the rule-of thumb revenue multiple so CEOs of RIAs can learn how to drive value within their firms with strong, educated, strategic and financial decisions.

(More: RIA firm valuations climbing, but not yet back to 2008 levels)​

A true valuation framework reflects the present value of the future free cash flow of your assets. Since RIAs don’t have many noncash expenses or capital equipment purchases, EBITDA or EBOC (earnings before owner compensation) can be a starting point for determining valuation. EBOC in particular is popular with solo and ensemble practices, as it determines the cash that would be available to a buyer after paying all employees at market rates.

Obviously, cash flow improves when revenue goes up or expenses go down. But the total valuation of the firm depends on more than the current cash flow. It’s important to consider how long it will last, how much it is growing, and whether significant investments are required in the future to sustain it.

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So to understand the value of your firm and how to improve it, we like to look at a few key variables. First, how old are the clients? This helps us know how long they could remain revenue generators. Second, what is the state of the firm’s infrastructure, including technology, talent acquisition and training, and client experience (technology and service levels)? This can be a great indicator of how sustainable the firm and the client relationships are without the founder or lead adviser.

Third, we look at client profitability. Many advisers “carry” a lot of clients who are either not profitable or do not receive appropriate levels of service. An adviser who has a very high client/adviser ratio or is not providing great service to their lower-revenue clients is likely to lose those clients in the long term.

Additionally, if an adviser is losing money on many clients, with no path to those clients becoming profitable through growth, it’s a clear sign of a firm whose profit margins are far lower than they ought to be.

When it’s done correctly, valuation is more than a simple formula. It is an undertaking that can provide sobering insights about the source of your success and obstacles to your future growth. Going through the process to gain this level of insight and self-awareness will give your business a real edge in a competitive market.

Once you understand how you can drive value in your business through more than just “more revenue,” you can home in on the resources and partners that can make it possible to grow revenue, profits and total firm value to the next level.

(More: RIA sellers need their own Zillow)​

Lisa Rapuano is chief financial officer at Facet Wealth.