What Are You Worth?

Before you look at multiples, figure out where all your firm's value lies.

- David Goad, President of Succession Planning Consultants.

FEW SUBJECTS ARE AS CONFUSING AS assessing the monetary value of a financial practice. Many advisers believe that they can follow a simple rule of thumb based on gross revenues. Others look at forms of revenues, such as fees versus commissions, to price a firm.

You can't just compare your quantitative data to that of practices some thousand miles away. Two firms that generate similar fee-based revenues don't necessarily have anything like the same value. Every outfit has different clients, services, efficiencies and niches—which combine with revenues to establish its value. Using broad multiples is misleading and may cause sellers to leave substantial value on the table—or risk mismatching a successor to their clients.

To understand your firm's true value, you must analyze it as if you were a potential buyer. It isn't in spreadsheets or rules of thumb. Three main value drivers, in order of importance, that will determine the value of your firm are:

* The quality and transferability of client relationships;
* The "other assets" transferable to a successor;
* Your firm's available free cash flow.

CLIENT RELATIONSHIPS

Your practice's fundamental value lies in the quality and transferability of its client base. Without client relationships, there would be no cash flow and hence no business to sell. Client relationships can affect more than 50% of your price.

The most efficient way to unearth the value in your client base is through client demographic studies. Two industry-specific methods that you can pre- pare yourself are:

Client persistency weighting. The greater the client loyalty and the lower the turnover, the more attractive your firm will be. Take the time to document your clients' loyalty through their positive experiences. The process is straightforward, but it will take time to sort through all of your files to extract the data. You want to show how long clients have done business with you, as shown in Figure 1 at right.

This is a powerful analysis you should perform periodically, even when you have no intention of selling. It helps you grasp the stability of your business while offering potential successors a quick snapshot of your clients' loyalty. Buyers with high confidence in a firm's clients tend to offer higher prices and better acquisition terms.

Client asset weightings. This is a simple way to convey client information to a buyer or potential internal successor. In this study, look for the total invested assets each client has with your firm.

In Figure 2, the top 20 clients generate 64% of the firm's revenue (30.57% plus 33.48%). Losing just a few top clients during a transition could have a big impact. Clearly, maintaining their loyalty is crucial to a sale.

When looking at your own practice, you can arrange data by listing quintiles of client assets, the top 5%, the next 5%, etc. Include footnotes to explain each client category, especially when a few clients generate a disproportionate amount of your revenues.

Some more studies you should per- form to value your client base:

* The percentage of assets under management invested in various products and services;
* Profitability per client;
* Profitability per employee;
* Client age versus asset level.

These exercises also help reveal inadequacies in your business that you should correct before selling.


OTHER TRANSFERABLES

Many owners don't realize the importance of the systems, processes and intangibles that create their firms' revenues and profits. But such elements can increase your firm's value by up to 50%. You may know you have some- thing special to offer, but potential buyers won't unless you tell them. Document the tangibles and intangibles that add value to your practice in a bound manual. A list of suggestions appears in Figure 3 below.

Just one or two of these elements can raise a practice's market value dramatically. For example, firms with exceptional referral systems and well-placed niches can fetch a premium. The more detail you provide, the more useful this document will be in your negotiations.

FREE CASH FLOW

The third major driver of practice value is its free cash flow or net profit. The greater the net profit, the greater the value. This net value is always calculated after the owner's compensation has been deducted (including salaries, bonuses and commissions).

There are significant value differences between a fee-based firm that generates $1,000,000 in gross revenues and $400,000 in net profits, and another firm with the same fee-based revenues that generates only $200,000 in net profits.

Significant free cash flow is always necessary for a buyer to make the payments and still profit from the deal.

COMPUTING VALUE

Only after all this should you calculate how to price the firm. This is where you use multiples of net profits, premiums and discounts.

Market norms for multiples run from 2-7 times net operating profits before taxes.

Generally, net profits from commissions are less valuable (2-5+ times) than those from fees (4-7 times) because recurring revenue tends to be more predictable than nonrecurring revenue. There are some exceptions, owing to processes or systems that give firms superior business platforms. This is where premiums (and discounts) come into play.

Certain tangibles, intangibles and good will warrant a premium over the net profits a firm generates. These include highly skilled employees, advanced technology and a client base that generates higher-than-average revenues.

Similarly, you may have to discount the business to account for flaws such as a shaky client base that may not produce the same revenues once you sell. Then a client-attrition-risk discount may apply. Poor location or lack of diverse services could justify discounts as well.

Additions or subtractions are often in the eye of the beholder. A financial buyer looking for an immediate bottom- line return may ask for a 10% discount on a firm with an aging client base, while a strategic buyer focused on estate-planning services may be willing to pay a premium. Most industry-specific premiums and discounts run from 5% to 10% of the total value and are always subject to negotiations.




Georgetown Investment Company helps with financial practice transitions. We buy financial practices. If you are considering to retire and planning to sell your financial practice, we can help.