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For the past nine years, I have served as a succession planning consultant and valuation expert to financial advisors. During that time, I have seen the key drivers of value that increase or decrease a practice's value, and, as a result, a practice owner's return when they sell their practice.
Specifically, three drivers increase a firm’s value and another three can decrease it.
The drivers that increase a firm’s value are recurring revenue, operating profit and the percentage of high-net worth clients the practice serves. Recurring revenue, versus transactional revenue, provides a predictable and regular income stream for the business. The more stable the business’s income from month-to-month and year-to-year, the more valuable it is to a prospective buyer. Operating profit derives from a firm’s overall efficiency, especially as it relates to expenses. High expenses and narrow margins negatively impact a firm’s profitability and its cash flow. Low expenses and high profit margins improve cash flow and operating income throughout the year.
High-net worth clients drive up a firm’s value largely because of the significant return they provide in relation to the investment it takes to service them. It takes the same amount of resources, if not more, to service low- and middle-range clients as it does to serve high-net worth clients, yet much of the revenue for a firm comes from those high value clients. It’s a prime example of the Pareto Principle, which states that 80% of your return comes from 20% of your effort. In this case, the majority of your income comes from a smaller percentage of your client base. If you increase the number of high-net worth clients you serve, your return per client will increase, as will the value of your practice.
On the other side of the coin are the factors that drive your practice value down. Those drivers are the number of low-value clients you serve, the average age of your clients and the number of professionals you employ to service your clients. As stated earlier, it takes roughly the same amount of resources to service a client of any size. Low-value clients provide the lowest return to the firm. The more low-value clients you have, the more energy you are expending to receive a small rate of return. That negatively impacts the value of your practice.
The average age of your client base is a significant detractor of value. The tipping point at which a client’s value decreases dramatically is age 70. As clients reach retirement age and beyond, they begin to draw down on their assets, or sadly, pass on. In that instance their property transfers to their heirs – who may not be your client. An aging client base puts future revenue at risk. Generational planning can help mitigate that risk and encourage continuity of assets under management.
Operating profit is a key driver of value. Operating profit is largely impacted by expenses. Staff are usually the largest expense for a practice. The number of professionals employed by a firm, especially in relation to the total revenue and AUM of a practice, can significantly drive down a practice’s value, especially if those professionals are largely serving low-value clients or an aging client base.
To highlight how those drivers impact value, I’ve provided a chart that compares two practices, whose names are withheld, that have similar revenue and AUM. Based on those figures alone these practices appear quite similar, but when the drivers of value are considered, you can see that the ultimate valuation of each practice varies significantly. As is evident in the chart, practice 2 has a higher percentage of recurring revenue, a higher profit margin, and higher percentage of high-net worth clients. When it came to the factors that negatively impact value, practice 2 maintains a smaller percentage of low value clients, has a lower average client age, and uses one fewer professional to service the same number of AUM as practice 1. As a result, their practice was valued over $700,000 dollars more than practice 1.
If you are looking to sell your practice in the next one to five years, you still have time to make changes to improve your practice value. Key items to focus on are increasing the number of high-net worth clients, engaging in generational planning and actively reducing operating expenses in order to improve profitability.
Even if you don’t plan on selling anytime soon, knowing these drivers will help you create and manage a practice that is profitable and cash-flow positive year-round. To truly have a clear picture of where your practice stands, get valuations at regular intervals, usually every year or every couple of years. Doing so will identify any weaknesses and improve on your strengths long before you decide to retire and give you the best opportunity to maximize your practice value before you sell.
Todd Doherty serves as M&A expert for Advisor Legacy, a Michigan-based merger and acquisition advisor to wealth managers. With over 15 years of senior leadership experience in financial advisor firms, Doherty knows first-hand what it takes to grow a successful practice and helps advisors with growing practice value, succession and acquisition strategy and planning, business valuation analysis, and operations. To learn more visit
https://www.advisorlegacy.com or email him at [email protected]
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives
