-proverb

There is little doubt that this axiom resonates with many financial advisors.  Financial advisors understand that careful planning is key to helping their clients meet their financial and retirement goals. Yet, many financial advisors still fail to heed this advice when it comes to preparing for their own retirement. Sadly, since many of the industry-leading periodicals began to highlight the importance of succession planning, few advisors have taken the time to develop a written succession plan. Some broker-dealers have even takengreat measures to assist their advisors by developing dedicated succession planning platforms.

Surveys and studies, however, only tell one side of the story. What can get lost in the facts and figures are the real-world consequences of failing to implement a succession strategy. For example, what if you were only able to sell your practice for $250,000 rather than $500,000?  What if you were only able to pass on 25% of the value of your practice to your family or loved ones? What if you were forced to sell your practice to an advisor who viewed your clients as merely a commodity? Stories like these occur more often than you think, simply because financial advisors fail to plan.

There are a number of reasons why implementing a succession plan is critical. However, failing to develop and implement a succession plan most significantly impacts four important goals that most financial advisors hope to achieve upon their exit from the business.

Increasing Business Value

It is only in recent years that financial advisors have begun to truly understand business value. However, most advisors still do not fully appreciate the difference between merely generating income and building business value. Beginning to think about your succession plan sooner, rather than later, can help you set goals and implement initiatives that will allow you not only to increase compensation but to create additional business value in your practice.  This additional value translates directly into receiving more money for the sale of your practice.

Financial Security for Family and Loved Ones

For many financial advisors, one of the main reasons for extracting as much business value out of their practice as possible is to ensure the financial security of their family and loved ones. However, without a succession plan you will not only miss out on the opportunity to increase your business value, but you may unknowingly leave your family in a situation where they are unable to extract little, if any, business value from your practice.

The main reason for this limitation is the nature of the financial advisory world. Because of the strict regulatory and compliance issues involved with securities, FINRA limits who may receive payment of fees and commissions. NASD regulation has interpreted NASD Rule 2420 to prohibit a member (i.e.. broker/dealer) from paying fees or commissions to a non-member (i.e., unlicensed spouse, child, beneficiary).

in other words an advisor’s broker/dealer cannot directly pay any of an advisor’s revenues to his family or loved ones, unless they are a licensed individual with FINRA.

NASD Rule IM-2420-2 (“Continuing Commissions Policy”) provides a limited exception to this rule. NASD Rule IM-2420-2 holds that a brokerdealer member may pay continuing commissions to a retired registered representative, widow, or beneficiary, if, among other things, a bona fide contract between the member and the registered representative calling for the payments was entered into in good faith while the person was a registered representative of the employing member.

Unfortunately the express language of this Rule only allows for the payment of continuing commissions and not fees.

Thus unless you implement a succession plan that allows for the transfer and sale of your assets (i.e.. book of business) as opposed to the sharing of revenues generated from your book of business, you will likely cause your family and loved ones to receive very little of the equity that you have built in your practice.

Clients Well Being

Many advisors that I have spoken with have developed long-standing and trusted relationships with their clients. With many advisor-client relationships approaching twenty-plus years, it is hard not to. Thus, it is not surprising that when a financial advisor begins to think about exiting the business, one of the first considerations that comes to mind is, “How will this affect my clients?” In fact, in a 2005 survey conducted by Succession Planning Consultants, almost one-third of all respondents that the most important reason for choosing a succession strategy was to ensure their “clients’ well-being,” which was the second most popular answer, only behind, “staying in the business as long as possible.”

Implementing a succession plan allows you to handpick a successor, who shares your values, philosophy, and business culture. It allows you to ensure the skills, experience, and qualifications of your successor. But most importantly, a succession plan will allow you to breathe more easily knowing that your clients will be cared for into the future for generations to come.

Measure of Security for Employees

The cornerstone of any small business is its employees. This is especially true in a financial advisory firm, where the client relationships are the core asset. Many financial advisors realize that the nurturing of these client relationships and overall success of their practice is due in large part to their loyal and dedicated staff. Thus, many financial advisors feel a sense of responsibility to their employees upon exiting from their practice.

Developing a written succession plan allows you to provide a measure of protection for any trusted employees by allowing them to share in the monetization of your practice or ensure their continued employment with your successor.  As the aging financial advisor population begins to look towards retirement, the importance of succession planning will only increase. The bad news is that many financial advisors have been slow to answer the call. The good news is that today, more than ever, there is an abundance of information and resources available to assist financial advisors as they begin the process of implementing their own succession plan. By beginning to work on your succession plan today, you can ensure that you will not be among those who failed to plan and, ultimately, planned to fail.

If you’d like to learn more please feel free to email or call David Kassir at info@mannacapitalmanagement.com or call us at 703 533 0030. 

Many solo Advisors have stated they do not favor selling their business to “an outsider” as the ideal succession plan. In fact, the results of a recent survey performed by Succession Planning Consultants showed that less than 20% of Advisors favored this method as their top choice.

Selling Advisory Practice

Given the freedom to choose any succession method, Advisors overwhelmingly, by a margin of over 60%, favored the internal succession model. It is apparent that the Advisors have a clear understanding of the many benefits the model offers over the choice of selling to an outsider who has not ever been involved with their firm. Upon further questioning, the Advisors were asked to rank their opinion to the importance of the various types of internal succession strategies .. Of the options given, Advisors understandably chose selling to a current non-owner associate in their firm as first, and then the strategy of adding an associate to their firm to first mentor and then create a succession plan as second.

Third in importance was the unique strategy of having a younger associate, in early or mid­career, merge their business into the Advisor’s business in return for a stake of equity in the new enterprise. This paper focuses on this last strategy primarily because many solo NEXT Advisors have requested more information on those creative solutions that help to address and solve the dilemma of not currently having an internal succession candidate. Such is the nature of the Equity in Return for a Merged Book of Business strategy.

While putting out feelers for candidates in your succession plan, some of you will happen upon a younger Advisor who is looking for an opportunity to acquire a retiring Advisor’s business. At first glance, it may seem as if this opportunity is ideal. Yet, a closer inspection of the circumstances usually reveals the typical “deal-killer” often seen in the industry: the associate’s financial  inability to make an outright purchase of the business. This is where the strategy of merging in return for an equity stake can benefit both parties.

The Equity in Return for a Merged Book of Business strategy has a simple premise as its foundation; recruit a younger candidate who owns a small book of business and is willing to merge into your firm with the expectation that he or she will become an integral part of your future succession plans. In return the Jr. Advisor is given a stake in the business equal to the contribution the revenues generated by his client base bring to the bottom line. Then, over time, the Jr. Advisor begins a buyout of the senior Advisor using financing terms typical to a.ll Advisor practice transitions such as the earn-out method.

Be aware, though., that this approach is very different from your average practice merger between two equally experienced partners. In essence, the strategy’s advantage is the ability to get past the concept of starting from scratch by adding a moderately experienced associate rather than one fresh out of college. Secondly, the book of business the junior advisor brings to the firm not only will help to grow the business, but the revenues it generates help to pay for the Advisor’s position in your firm. Certain early or mid-career practitioners will leap at the right opportunity to join a veteran Advisor in such an arrangement.

Addressing the Risks

Solo Advisors are sole owners of their firms for a reason – they value their independence. That decision is fine through most of your career, but what impact will it have when it comes to extracting your business value? Large, it can be argued. If the solo Advisor doesn’t have access to strategies that allow for an internal succession they are pretty much stuck with only one option – selling to an outsider. Anyone reading the industry press of late knows that those deals hold significant risks that internal successions tend to diminish. The most important is the risk of high client attrition.

Selling to an outsider is very much like selling your home to another person. When the papers are signed, the keys are handed over, and the previous owners pack up and leave. That might be fine with a home, but with a client base it is often too much of a shock for someone to be suddenly introduced to them as the “new owner-Advisor” on a late Friday afternoon.

Although this may be a bit of an exaggeration, selling to an outsider always has to be kept secret until the deal is done for the seller’s sake. And because the buyer has agreed to pay good money for the business, the seller will have little or no say-so in how things are run. In fact, all outside Advisory sales include non-solicitation and non-compete agreements on the seller to protect the buyer’s interest. So other than an agreed upon and needed involvement of the seller to help transition the client base over a typical 3-6 month period, the former owner has restrictions on contacting clients. Because the investment advisory business is all about relationships, these realities can put clients into a very uncomfortable position, and for some, it is the opportunity to move their accounts elsewhere. It is for these reasons that business sales to outsiders have such a high attrition rate, which ultimately can affect the total value received by the seller, since payments are based on the number of clients transferred and that stay with the new Advisor.

Conversely, because a new Advisor is introduced to clients more slowly and allowed to develop relationships over time in virtually all internal succession plans, the risks of any clients leaving during the transition are significantly lower. Yet, with the Equity in Return for a Merged Book of Business strategy, we are still stuck with a major risk that many solo Advisors do not want to take. That is, giving any equity to another Advisor in return for merging their client base and therefore creating someone to whom they have to answer. If they miss their mark in judging the match of this person, the whole deal can be difficult, if not impossible, to unwind. You may also be concerned about how well the junior Advisor’s clients will transfer into the programs and services your firm currently offers, how profitable the new relationships will become, and how the relationship with the new associate (and new minority owner/partner) will work out.

So the question becomes, how can you mitigate the risks associated with bringing in an associate to whom you immediately convey some percentage of ownership in return for merging their clients into your firm?

One answer is to fall back on an old favorite of financial Advisors. That is, put into operation a joint venture agreement that allows for the deliberate testing of the relationship. Advisors are partial to and comfortable with these agreements because they generally don’t require substantial resources or financial commitments to try out a business arrangement. Examples of traditional joint venture agreements include referral arrangements with professionals such as CPAs, lawyers, or insurance professionals that are to provide unique services for your clients and vice-versa with you providing advisory services to their clients. In other cases, the agreement is with another Advisor who has a complementary skill, such as investment analysis or creating financial plans, which you choose not to perform. For purposes of this section though,let’s think of the joint venture in specific terms as a means to test a business arrangement with a potential junior partner of the firm before officially bringing them in.

For example, the associate could be brought in to share office space and certain expenses for a period of six months to a year while the merger prospect is examined further. If, at the end of the period, the arrangement does not work out, the younger associate would be free to leave with his or her clients and you would have no further obligations. (Keep in mind that it would be reasonable to agree in advance to some sort of financial consideration or reimbursement for the cost of the Advisor relocating their business under this contingency.)

Never should this trial period be used arbitrarily by an owner who isn’t serious about wanting the venture to turn into an actual merger and an eventual succession plan. This would foster bad feelings and be a waste of time, money, and effort for all parties.
This “trial period” does allow you to significantly decrease the risk of prematurely exchanging part of the firm’s ownership shares in exchange for the merged client base only to find out that the arrangement wasn’t working well. Given that compensating an outsider with equity before you know them is considered risky anyway, it only makes sense to have this safety net for both parties. This quasi version of a joint venture agreement will also allow both sides the time to discover their strengths and weaknesses and to identify those skills that can be best put to use when the actual merger is carried out.

THE BENEFITS OF A “TRIAL JOINT VENTURE” WITH A MERGER CANDIDATE

• Both parties are allowed time to get to know and adapt to each other’s style
• It allows time to get processes in place and for roles to develop before a more permanent agreement is decided upon
• It allows time for the strategic planning of goals and development of the direction the firm will take after a merger
• The arrangement allows for the associate to have time to experience and evaluate the responsibilities and expectations they would have under a longer-term arrangement
• It allows for the clients, employees of the firm, and the new associate to become accustomed to the change
• It allows the owner and the junior advisor time to build the trust and communication
• The trial period gives both parties time to develop the details of the agreement that will be used for the merger of the book of business and for future compensation strategies

One note of caution that should be apparent: It is even more important that you do your homework on the profile and personality required for this type of business arrangement and the specific circumstances in your firm than if you were simply looking to employ an Advisor without a book of business. In the former case your intent is to, at some point, transfer a portion of your ownership to secure the merger bargain, which will make the Advisor a minority owner. In the latter case, if a junior advisor was hired as an employee and it didn’t work out, the separation would be less difficult (which is why you want to use the trial joint venture as a safety net).

Also, keep in mind that you shouldn’t overlook the synergies of searching for a candidate whose client base isn’t offered your current core services (such as asset management) and that can conversely offer your clients services you don’t currently provide. Under this scenario, cross­selling each other’s services will create more profitabtllty for both parties during the trial period, and possibly allow more room for the financial aspects of the deal to work themselves out when moving into the actual merger.

There is one final point regarding the boundaries you should set when establishing the trial joint venture. They should have specific time limitations and triggering events attached to them. For example, if several years have passed and you have not offered to merge the junior advisor’s book into the firm in exchange for ownership shares, you’re likely to lose the associate to another opportunity outside your firm. They may even take clients of the firm with them, unless of course you’ve followed the advice to have all employees or associates sign a Non-Solicitation/Non-Disclosure Agreement.

The associate who was specifically attracted to the future ownership/partner aspects of your offer will be disappointed if no timeframes are set in the beginning to give target dates for decision-making. Before the arrangement is seeded, determine the responsibilities of both parties, develop benchmarks for measuring progress in the budding relationship, and select the timelines for the trial period to evolve into a more permanent association.

Valuing the Soon-To-Be-Merged Book of Business

There are many approaches Advisors can take in valuing a junior associate’s book of business that you’re considering merging into your firm. You could use the “open marker’ or fair market value, which is what the book would bring from an informed buyer outside the firm. But most experts would not suggest its use for these Circumstances, since this value is based primarily on an earn-out composition in which the real value is not determined until after all payments are made.

Another method that some have used to value merged books of business is the “rule of thumb” approach, which involves applying a simple multiple to the assets under management or the gross revenues generated. This, too, has many drawbacks, Which include not taking into consideration any potential attrition the book may experience during a merger or how profitable or not the book may be in the framework of the new firm. Rules of thumb also ignore the synergies that a junior advisor may be bringing to the firm.

It is  possible that a good percentage of the value of the partnership with the associate may rest In the non-financial aspects of the arrangement. This could include the associate possessing skills or business acumen that add to the firm’s welfare or positive relationships and contacts the junior advisor has already developed within the community.

A better and more appropriate method of valuation in these circumstances is to use a modified version of the “net cash flow” approach. This process first involves determining the net cash flow (or profits) that the book will generate after the associate’s business is merged into the new firm, times a multiple that takes several factors into consideration and then, if warranted, applies certain premiums or discounts for special circumstances benefiting or jeopardizing the firm. The more complete formula steps are as follows:

1. Determine the new total gross cash-flow for your firm;
2. Average your firm’s gross expenses for the last two years (in terms of a percentage);
3. Subtract this gross expense ratio and then subtotal for the net cash flow of the revenues when under your firm’s expense ratio;
4. Multiply the result by the market norm of four-seven times net cash flow. In those circumstances where the associate is bringing value beyond the net cash flow generated, it would move the multiple up the scale. These could include certain premiums that benefit the firm and that didn’t exist before, such as tax/accounting skills, marketing skills, technology skills, etc. A higher multiple may also be required if the associate’s client accounts will generate new revenues by buying services or products not previously offered them. This, in essence, would create two income streams (the old and the new) for increased profitability.
5. Subtotal for the gross value for the book of business;
6. If appropriate, subtract a minority interest discount, which is standard for small ownership posltlons.;
7. Subtotal to arrive at the net value for the book of business;
8. Determine your firm’s stock per-share-value and divide the amount by the net value for the book of business;
9. This is the total number of shares (or percent of shares) due the associate for the merged book of business.

For example, on a book of business with $10 million of AUM, generating $110,000 of gross revenues to the new firm, the formula could be as follows:

Step 1: Determine gross cash flow into your business $110,000 Gross Revenues
Step 2: Subtract your firm’s gross expense ratio -71 ,500 Gross expenses (65%)
Step 3: Subtotal for net cash flow to your firm $ 38,500 Net cash flow
Step 4: Times multiple (associate has marketing skills)
Step 5: Gross value result for book of business $154,000 Gross Value of Book
Step 6: Apply discount for minority ownership* -38,500 Minority Discount (25%)
Step 7: Net value result for book of business $115,500.00 Net value of book
Step 8: Divide by company share price** + 280.00 ABC stock unit price

Total number of shares exchanged for the book 412.5 ABC shares or 6% ownership due associate in return for merging their book of business

*If you apply the discount here, be cautious not to apply the same discount twice when formulating a buy-sell agreement. **There are many methods used to determine the share price of a closely-held business. Be careful to use a method or formula that is congruent with existing buy-sell agreements.

The most important and most subjective part of the formula is Step 4, which calls for applying a multiple to the net cash flow to determine the gross value of the book of business to your firm. As stated in the example, jf the junior advisor is bringing to the table certain skills or synergies that did not previously exist in your firm, this added value should be considered in the total appraisal of the ownership percentage to be offered the candidate. Also, where the addition of the partner might bring certain cost savings or a reduction of the firm’s overall expenses, these too should be considered as added value in the formula.

Where warranted, you could consider applying other discounts in addition to the minority discount taken in Step 6 of the formula. For example, jf you determine that the client base is at risk to experience some attrition through the merger and will not therefore produce the same revenues in your firm that it did for the associate, a proper “client attrition risk discount” should be applied. In addition, when you as the current sole owner and controller of the company’s stock change to fractional ownership, you are giving up the ability to be the sole decision maker in selling to an outside willing buyer. Although your plans may have been to sell the total shares to your junior associate in the future, circumstances could change and an outside buyer may be more appropriate. In that Situation, the buyer would have to deal with two separate owners. Therefore a “lack of control discount” of 10-25 percent could also apply for your forfeiting complete control of the firm’s shares.

Another reason for discounting is where the associate’s book of business will not support the necessary income required to cover the salary paid to them by your firm. In this case, the owner can compute the value of the additional income required for the first year or two of the arrangement and reduce the number of shares by the same dollar amount to even out the requirements of the junior advisor’s compensation. Lastly, in some situations it may be appropriate to offer a combination of cash plus a percentage of ownership to the merging associate. Generally, this strategy is used where the candidate has a smaller value in their book of business. If you offer a small percentage of the total exchange value in cash, it may be the very enticement you need to bring in the type of qualified talent you’re looking for.

It is critically important to note that merger valuations can be very subjective, which can often drive firms to devise their own formulas that better address the particular circumstances at hand. It is highly advised that anyone valuing either a book of business for merger purposes or their own business, enlist the help of a qualified tax or valuation specialist.

Taxation Consequences for Mergers

A last issue that is important to consider in any merger transaction is the possible tax consequences for either party from the business transaction. Usually, when structured properly, the merger can be a tax-free business transformation for both parties, since the junior advisor is merging his or her business value into another form of business value. But since this paper is not intended to give tax advice and every circumstance is different, it is critical that both parties enlist the help of their tax and legal professionals to ensure the proper structuring of the transaction to minimize or eliminate any tax consequences.
A second, and often overlooked, aspect of possible tax consequences related to mergers is the sales tax statutes some states levy on transfers of business assets. Particularly of late, states are looking for increased revenues and in some cases, are reinterpreting past regulations regarding business transfers, which could give rise to sales tax due. There are 50 different states with 50 different systems for taxing transfers of property. It is critical that you work with your tax professionals to identify whether this is even an issue for your Circumstances, and if so, to structure any merger plans to minimize its effects or to eliminate the concern.

The Take-Away: Many solo Advtsors have looked for an efficient means by which to diversify their companies’ revenue streams and client services for years. For some, instead of developing the expertise themselves, they’ve acquired a practice and its key employees where these dissimilar product lines were already developed. The junior advisor merger option discussed above is similar in concept, but usually more financially feasible and less convoluted to set in motion. More importantly, the strategy can be an excellent means of developing a two-to-five­year succession strategy for the solo Advisor who is concerned with giving up ownership too quickly to the wrong party.

Written by: Succession Planning Consultants

How profits are generated can be as crucial as having profits in your business. It is
common acceptance In this industry that recurring revenues tend to be more predictable and consistent than non-recurring revenues. Therefore, these types of revenue streams have a propensity to attract more successors and bring greater prices for their owners, than nonrecurring revenue streams. Another critical non-financial aspect of your business is the transferability of your business assets. If what helps to produce profits in your business is not transferable or assumable, then you must take action to reconstruct your business assets to make them transferable. It is the combination of profits or cash flows, the transferability of clientele and the business assets, and the probability of future growth that set the foundation for the value of your practice.

After the quality and transferability of client relationships and the firm’s free-cash flow, there is an equally important measure of value: the “secondary assets” that bring value to your enterprise. These assets may be tangible or intangible, but the key to unearthing their value is jf they can be transferred to a successor.

So what are some of the secondary assets that can increase the worth of an advisory firm?

There are many considered as value drivers, including the following examples:

• Where you are In the business Ufe cycle-If your business is in its infancy, that factor may have a different impact on value, than if it is a mature business.

• How revenues are produced-Are the revenues recurring or non-recurring? Have you focused expense and time investing in the latest technology to maximize your firm’s efficiency? Have you developed a broad offering of services for clients that will generate a diversity of revenues?

• Transferability of clientele, processes, and systems – The transferability of your business assets is essential in most succession plans, even more so when transferring ownership to an outside party and possibly less with an internal transfer.

• Entity type and tax considerations-How the proceeds from the transfer will be treated for tax purposes will vary as to the type of entity sold and the tax allocations. Work with a qualified tax professional, to explore if you should be selling assets or stock.

• How the transfer is paid for-The risk of using an earn-out financing arrangement may demand a price premium over what a deal financed with promissory notes would bring. Also, internal succession plans usually offer more assurance of payment, and therefore may increase the business value due to lower risk: factors.

• Structure of agreements- Terms in an agreement will either add or reduce value.

For example, agreeing to a non-compete with the successor may call for a price premium, whereas not staying on through a reasonable transition period may call for a reduction.

• Location, location, location-Adjustments can be made for the geographic location.

If the business is in an area without many potential buyers, the price may need to be reduced.

Conversely, jf the business is in a high population area, it could bring a premium.

• Goodwill, reputation, and the intangibles-Some firms have significant goodwill built into their business, including the business’ “on-going concern”, the firm’s involvement in the community, and reputation in the industry or locally could add additional value. Also, certain firms have other intangibles that help generate revenue, such as brand names, a highly productive staff, which could add value to an appraisal.

Valuation Premiums and Discounts

A somewhat subjective, but very important aspect in determining the value of an advisory firm, is the use of premiums and discounts. These adjustments are frequently used to help narrow the value range of both the book of business (defined as selling only the client accounts and not the entire business itself). and an advisor selling all of the business’ assets. Premiums and discounts help to account for the inconsistencies found among firms, which are difficult to flush
out when using just mathematical computations based on the financial aspects of a subject firm.

Added value may also be derived from a client base that is from a certain niche, such as within the medical community Of from large corporations, whereby consistent client referrals are sent into the firm. Location, average lower age of clients, and diversity of services offered may also add premiums to the value of the business. A case-in-point is that a business for sale in a large metropolitan area with plenty of affluent population as potential clientele can be considered in
general somewhat more valuable than one in an area with a very low population (unless of course the later firm has other special attributes to offset this detraction).

Usually, any adjustments applicable to the value of an advisory business, is applied after determining the “foundational value” of the business. Regardless of which valuation approach is used (the capitalization-of-earnings approach or the free-cash-flow approach), the value range can be considerable. For example, today’s market norm for multiples in these models runs from three to eight times net operating profits (before taxes and interest). It is accepted that net profits generated from commissioned revenues bring the lower end of the scale (three to five multiple) while those generated from fees bring the upper end of the scale (six to eight multiple). The result is considered the foundational value of an advisory firm.

What method is used to further narrow value? In an acquisition, typically it comes down to the negotiations between a buyer and seller. Financial buyers tend to focus on the bottom-line profits, where strategic buyers may better appreciate the non-financial value drivers of the business. Therefore, strategic buyers often pay more for a business with these attributes, than a financial buyer does.

Usually, premiums, discounts, or not used in partnership buy/sell agreements, or internal successions. There are several exceptions to the rule. Take for example the circumstance where a merger candidate will bring to the business certain skills or synergies that did not previously exist. A premium may be expressed either through the value of the stock they receive in return for the merged assets, or they may be given more total shares than otherwise would be justified.

Conversely, discounting may apply to some buy/sell agreements to account for the fact that not everyone should have the same share value. This may include the use of a traditional valuation concept called the “lack of control discount”.

Lack of Control Discount. This refers to the concept that a minority business interest should be worthless than a majority business interest. Though sometimes referred to as a “minority discount”, this valuation adjustment has less to do with minority ownership itself and more with the non-controlling aspect of having the minority ownership in a business.

This discount is applicable in the profession in those circumstances where a transition of a minority ownership position exists. For example, it could apply in situations such as the partial sale of a business, or in a merger of two businesses of different sizes, or where a majority partner is buying back a minority ownership from a departing partner. All of these occurrences may call for applying a lack. of control discount.

For example, let’s assume that Sam has 70 percent voting stock ownership of a firm and Dave has 30 percent voting stock ownership. If Dave voluntary leaves the business, the buy-sell agreement might have a provision for a lack of control discount to recognize that Dave’s ownership interest is non-controlling. Lack of control discounts tend to range from 10-25 percent in the profession.

Where warranted, one could also consider applying other discounts in addition to the lack of control discount. For example, if you as a buyer determine that the after acquiring the client base, you’re likely to experience the loss of Clients, a client attrition discount should be applied.

Again, most premiums and discounts are subject to negotiation. Suffice it to say that who your buyer is or what succession option you’re focusing on, will ultimately determine whether these or any other premiums/discounts are applicable.

Important note: Generally, in the financial services field, each premium Of discount run from about 5 to 10 above the base foundational value produced from the Asset-Based Approach, the Free-Cash Flow Approach or the Capitalization-of-Earnings Approach. Certain assets or deficiencies may, in specific cases, warrant a premium or discount of more than 10 above the base business appraisal. For any premium or discount to apply, it should be of either higher than average quality, or less than average quality than what is seen in the average advisory firm.

There are a few additional critical aspects to be aware of when unearthing the value in your firm. The following three categories are characteristics that can affect value, which should be of concern to all owners of an advisory business:

Thinning Margins
Margin compression is of concern in most financial firms today. The ability to control gross and net margins has been a struggle for most advisors. The recent increase of competition and inconsistent stock markets has made creating profits a challenge. It is also clear that some are not charging clients enough for the services they render and therefore are experiencing thinning margins. In other firms, it could be that the advisor(s} are spending time on the wrong projects and not enough time with the clients to generate new revenues.

All advisors should keep a watchful eye on the ebb and flow of the profit margins in their business. ff you are not currently tracking the business’ margins on a monthly basis using the Profit & Loss statement, you should consider doing so starting now. It is the best way to be nagged of changes in the firm’s profitability early and correct them before too much time has passed.

The Importance of Client Persistency and Asset Weightings

Without client relationships, your business would have no cash flow. Without cash flows, you will not have a business that you will be able to sell. Two value drivers that aren’t usually unearthed in the valuation process, but can truly help to show a buyer hidden value, are the persistency weightings and asset weightings of your client base.

Client Persistenct Weightings. Simply put, the greater the loyalty and the lower the client turnover, the more attractive your firm will be to a successor of any type.

High levels of client satisfaction can translate into significant added value, when you have taken the time to document it for a potential buyer. The process is straightforward and uncomplicated, but it will require time to sort through all of your client files to determine certain data. What you are determining is how long clients have done business with you, and what percentage fall into what category of years, as in the example below:

This simple but powerful information will also: 1) help an appraiser better understand the stability of your business, 2) puts on paper what you already knew about you business that others don’t, and, 3) provides any potential successor a quick snapshot of your clientele’s loyalty.

Clearly J you want any buyer of your business to know the loyalty of your clientele. Very often buyers will be open to paying a higher-level multiple for high client persistency, or in some cases, a premium over the business’ foundational value.

Client Asset Weightings. Like client persistency ratings, this second technique for unearthing business value is a simple way to convey information to a business appraiser or a potential successor. It also requires setting aside time to gather data from client files, but why not do both projects at the same Urne? In this task, you’re looking for the total invested income and assets that each client has with your firm. Then categorize clients into how much of the firm’s income and assets each group represents. Think of this as an exercise to determine how the
“80120 rule” applies to your client base. (The 80120 rule states that, on average, 80 of an advisory firm’s revenues are generated by just 20 of the firm’s Clients).

You may decide to arrange your data differently and in a way that will have specific meaning to your particular clientele. For example you may list the top five percent of client assets first, then the next five percent and so on. You should include footnotes to explain each of the client categories, especially when an aberration exists. A case-in-point would be to describe who your largest clients are and how they affect the overall asset weighting. Another is to explain why the percentage of profitability and income generated, differs in the various categories.

Tip: This exercise is also helpful from a practice management perspective to better understand where your revenues and profitability lie within the client base. Some may want to take the process several layers deeper by examining what product assets are invested in and determining the profitability of each client regardless of size.

The Take-Away: Many factors over and above gross revenue streams go into the
process of determining the value of a financial planning firm. These include the size of the client base, client-age demographics, and profitability per client. Others involve the uniqueness that each advisor has applied in building his or her business. Rules of thumb cannot take into consideration the individuality and distinctiveness of each advisor’s firm. That in itself should prod anyone building their business value to set aside those rules and to adopt a more serious
and fruitful approach to unearthing value in their firms.

Written By:  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.           

Written by Succession Planning Consultants.

Some additional important aspects of the due diligence processes are:

Buyer’s Due Diligence Guidelines

+ Understand the financials, including the breakdown of revenues and how they are generated. How much is based on recurring and non-recurring? Have recent anomalies occurred, such as bonuses or other one-time forms of revenue that won’t be available after transference? Obtain and review the last three years’ federal and state tax returns. Perform a Uniform Commercial Code (UCC) and tax lien search to make sure no assets are encumbered.

• Make sure necessary registrations and licenses match between your firm and the seller’s, and that the seller is in current compliance. Ask for and review the seller’s compliance and audit history. Ask for and review carefully any correspondence from federal or self-regulatory agencies regarding actions taken.

+ Ask for copies of any client complaints, lawsuits (pending or historical), and any judgments and decrees to which the advisor has been subject.

+ If the seller has a different broker-dealer than yours, take care to know early on whether that is a deal-breaker If they aren’t willing to move their firm into your broker dealer

• Identify the tangible and intangible aspects of the firm such as brands, market niches, seminar systems, client management programs, and other processes and systems that may bring increased value to the deal.
• Obtain a breakdown of the client list, including how long they have been with the advisor, the forms of revenue generated, products and services used, and the size of their holdings.
• Have the advisor provide a list of service providers including agreements with third parties, such as money managers, the broker-dealer, or other industry product providers.

+ Obtain a copy of all agreements, including property and equipment leases, and any insurance agreements that could affect the business (property, key-man, errors and omissions, etc.) Obtain employee files, personnel manuals, and any agreements regarding employment matters. Require the seller to disclose all labor agreements, disputes and administrative matters.

Step 5) Negotiate the business deal details with your selling candidate using professionals to ensure that all events and issues are addressed. You will need the help of a good attorney to draft the documents for your deal. If possible, use your attorney, who knows your circumstances well. A seller may request that his or her attorney draft the necessary documents, and if you agree, it is still prudent to have yours review all fine points of the documents. Make sure any and all elements of the discussions between the seller and yourself are in writing, including contingency removals to avoid future arguments.

The Take-Away: A carefully structured plan that considers all parties fairly is critical to
an acquisition. Never approach a buyer before you’ve done your homework on what type of acquisition fits your firm’s profile, how it is best financed and the specific elements that are important to you. Always be in the driver seat when considering an acquisition, but be sure to provide a comfortable front passenger seat to your seller and that the backseat that is to carry the clients is clean, pleasant and provides a secure ride.

Let’s look at each of the steps in more detail.

• Financial buyers are mostly focused on the current free cash-flow streams (read: net profits) available to them and tile potential for future earnings growth from tile acquisition. Usually, these buyers are looking for at least a minimum of 10-20 percent annual net return on investment (after owner’s compensation) to reward them for the risk and effort taken.
• With today’s thinning margins, strategic buyers often have the edge over financial buyers because of the value added by the synergies they enjoy. The prudent financial buyer can still find opportunities to purchase a low-expense, l1igh-profit margin firm. But it will take more time to find such a gem in today’s marketplace. Remember, always work off of net profits of the firm, and never gross revenues.

 

The Strategic BuyerLooks to Fill in the Gaps

The Financial BuyerLooks For Hidden Treasure

 

• The next step in developing your objectives and strategies is to ask yourself several important questions to narrow down the focus to what works best for you. Buyers might complain that this exercise will surely cut down on the number of acquisition opportunities that qualify, but that is exactly what you should seek to do. Searching for just any firm can be a significant time-waster for you, and you want to focus only on those opportunities that fit your circumstances.
• Just like the seller who has a written succession plan incorporating some range of flexibility yet knows what his or her successor should look like, you should also know what you’re looking for in advance of looking. Buyers of financial firms often burn out from spending too much time perusing opportunities that don’t match their true objectives. It is not unusual for a buyer to expend months on an acquisition target only to find out during the due diligence phase that it is simply not a match. The best way to avoid wasting your time and the seller’s time is to know in advance what you’re looking for and what your focal points are.

Stay tuned to read more details on the other 5 steps in the upcoming blog posts.

In recent years, buying a financial advisory practice has been discussed as if everyone is
doing it. With the aging of the financial services field and the ever increasing need for late-
career advisors to retire, you’d think that there would be scores of opportunities for buyers.
The truth of the matter is that only a small percentage of buyers are actually acquiring firms,
but that is for reasons that might surprise you. Those who are successful with acquiring firms
seem to know the secret that no one else knows.

One clear hurdle for sellers is that there has been a great deal of misinformation on the subject
matter. Another is that there has been what some would describe as information overload.
Since news articles tend to provide less in how these deals are actually done and more in
“sound-bites”, sellers walk away knowing one thing. Because the generic strategies discussed
in the industry don’t address their customized circumstances, they are more confused than
ever before.

Potential sellers aren’t selling because of the fear of the risks. What risk you ask? The risk of
clients not transitioning or leaving after the buyer is introduced. The fear of not being able to
understand the value of their firm. The fear of not knowing what safeguards are important to
selling their practice, and therefore, not receiving full value from the buyer. Tile risks that are
not discussed virtually anywhere.

How to Acquire a Financial Practice

As it turns out, their concerns are valid. And this leads us back to how some buyers not only
have acquired a firm with relative ease, but in some cases, multiple firms. Their secret:

Educating themselves on the methods that can be structured in the deal that address
the seller’s risk concerns. In doing so, they then can do something hardly anyone else
does: Proactively help the seller find solutions that lead them to feeling comfortable with the
deal. In essence, if the buyer is honest and fair, they can serve as the “teacher” to the seller
by showing a desire for striking a fair and balanced deal for everyone, including the seller’s
clients. That’s just the opposite of how most buyers approach sellers, which is to focus on
their own concerns rather than acting in “mutual capacity” for the deal.

So unlike the early days when many sellers were somewhat haphazard in selling their
businesses’, today an acquisition takes far more thought and pre-planning. The buyer and
seller must work closely together to create a value proposition that works for all the parties
involved in the transition. The earlier deals have proven sellers who are out to get every dollar
over all other considerations or the buyers out to get a “rip” in the deal (read: a steal), only
makes for one party or the other to end up disappointed.

Buyers, here’s the reality of today’s acquisitions: Most of the responsibility of a
successful deal will fall upon your shoulders. It is critical that you know the lay of tile land
and what strategies and options are available for you to help solve problems for the seller and
to guide the process to a smooth landing to “closing land”.

The balance of this paper is dedicated to providing the buyer of a financial services firm with
an approach that is similar to those successfully used by industry consultants. In essence,
step back from your self-interest and view all the aspects of an acquisition from the broader
perspective of aligning everyone’s interest to get the deal done.

The Parties

There are four parties to every financial practice acquisition, and each needs to be considered
separately when structuring a deal. They are:

The Buyer – Who today should consider searching for opportunities that bring more than
financial gains, such as providing added value to the clients acquired from the seller, and to
offer the seller a fair and balanced deal as they leave their livelihood?

The Seller – Who should be focused on balancing a concern for his or her Clients, tile
employees’ well-being, the buyer’s interest, along with receiving reasonable value from the
transaction?

The Client Base – Who will react positively to a well-planned, smooth transition, or who will
not likely survive the transition if they feel uncomfortable with any aspect of the plan.

The Employee(s) or Staff – Who will need assurance about their place in the transition with
the buyer, especially if they are a valuable link in client interactions and are the key to
retaining those relationships? If employees are not to be kept after a sale, an appropriate level
of thought and financial consideration should always be applied to their well-being.

How to Prepare an Acquisition Plan

The best advice to late career advisors is to research all of the exit options available. Choose
a path that best fits their individual circumstances, and then proceed with a written plan as
their primer for taking action. Without a plan that encompasses what is to be achieved under a
certain range of acceptable parameters, too many advisors end up choosing an exit strategy
inappropriate for themselves.

Likewise, you as the buyer should also define your growth or acquisition strategy. Buyers
shouldn’t take acquisitions lightly, or they’re not likely to find the quality firm they are looking
for. The place to start is the same as for sellers: customize a personal plan.