Do-It-Yourself Practice Valuations
There was a lot of discussion about regulatory issues at the recent MarketCounsel conference in Las Vegas, which is not surprising since MarketCounsel is a compliance consultant and law firm. But, interestingly, the biggest buzz had nothing to do with legal issues; from the podium, and in the audience, we heard that merger and succession activity has picked up dramatically in the RIA space.
"We have seen it in two contexts," Cory Kupfer, MarketCounsel's director of entrepreneurial services, told the audience. "A growing number of firms are looking to grow through acquisition, and there are a lot of succession deals that are starting to happen after many years of a lot of talk and not a lot happening. The last 12 months has seen the most active interest from our client base in acquiring or being acquired. The market is as hot as I've ever seen it."
Later, he added that the biggest impediment to this trend was "unrealistic expectations and valuations."
A spreadsheet born of necessity
Roger Pine, a principal with Briaud Financial Advisors in College Station, TX, has created a tool that addresses some of these valuation challenges – and it may have come at exactly the right time for the profession. "A lot of times, in these [succession or purchase] negotiations, you find that one side or another anchors on a final number of what the firm is worth," Pine says. "Suddenly, the negotiations become very emotional around that number."
The alternative, he says, is to bring in an investment bank – which not everybody can afford, and which may provide a number without giving both sides a clear understanding of the assumptions behind it. And there are times when the valuation happens to produce the exact number that the firm principal – who is writing the check – believes is correct.
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Pine experienced this dynamic personally when he and his wife Natalie purchased a majority interest in their advisory firm from Natalie's mother, who founded the company. Both sides wanted an objective purchase price that would be fair to both sides, and they were surprised at how poorly the rule-of-thumb metrics (i.e.: 2.1-times recurring revenues or 10-times profits) satisfied either side.
So Pine decided to dig deeper, and ideally analyze the purchase of shares the way he would evaluate any investment that he was recommending to clients. "I'm an engineer by training," Pine says. "So I'm drawn to getting into the numbers."
He put his skills to work and created a spreadsheet with multiple inputs, which is now an open-source document that any advisor can download and apply to his/her succession or acquisition situation. (You can find the spreadsheet here; look for the "Generic Valuation Model" file about halfway down the page.)
The spreadsheet is ideal for a founder and successor to work on together, but it is interesting that the successor can come up with some pretty good revenue numbers even without the help or cooperation of the owner, since most of the inputs don't require the owner to open up his/her books and records. "If you work at the firm, chances are you know the fee structure and how many dollars the firm has under management," says Pine. "You can see most of the revenue side of the equation, and create reasonable ways to project it out based on the firm's past history."
The spreadsheet lists the individual clients, their assets under management, the fee structure (retainer and AUM rate) and their ages. The spreadsheet asks you to make assumptions about the number of new clients that the firm will bring in each year, average assets per new client, average annual investment returns and annual assets lost through client attrition. The total-retainer-revenue-per-year calculations can extend as far into the future as you want, although Pine says that the distant out years don't make a lot of difference to the final valuation. A life expectancy calculation for each client is pulled directly from mortality tables that are included in another page of the spreadsheet, and there are assumptions about when clients will start de-accumulating their assets in retirement.
The numbers can be different for each client, which allows the spreadsheet to account for clients who are grandfathered under old fee structures, or children of clients who may fall under a different pay schedule.
The first output is an estimate of the total annual revenues for the firm going out 25 years (if you want to forecast that far into the future). On the expense side, you can look at the current numbers and extrapolate an annual growth rate.
Of course, when you start digging into the expenses, the selling advisor would have to trust the process enough to open his/her books. The key number here is how much the selling advisor is taking out of the business, which could become a negotiating point when shares are sold and purchased.
Couple the revenues and expenses, and you get the gross profit margin or cash flow for the business projected forward, which is the key metric to creating a valuation. Using that number, you use a discount rate – the annualized return the buyer would ask for on the investment given the risk associated with it – to calculate the present value of the firm. "Given the fact that the ownership shares are illiquid, what kind of yearly return would I want to expect?" says Pine.