by Sam Hull, CFP®, ACC
OK, admit it-you're starting to feel that maybe it's time to explore new horizons, move on, retire, regenerate. It happens to all of us; that time in life when you start to think about selling your business. One of the key factors in this decision will be answering the question, "How much is my financial advisory business worth?" And there are two sides to that question: what's it worth to someone else, and what's it worth to you?
How much would a disinterested third party pay if you were to sell your business and cash out? How much of your future personal happiness and financial peace of mind is wrapped up in the practice you've dedicated your heart and soul to building? What's your timeline? What will change? These are big questions!
What Are You Selling?
In a relationship-based business such as financial planning or wealth management, the coin of the realm is trust. You have built trusting relationships with your valued clients and the degree of certainty that trust gives for continuity of the income generated from those relationships is what gives value to your business. Now you are putting plans in place that will-over a fairly short period-take you, the cornerstone, out of those relationships and replace it with someone else.
So if business value is essentially measured by the risk that client trust may be ruptured, yielding a lower future income stream or less business vision and vitality, then the type and duration of the current client income stream are major factors in valuing your business. A revenue stream built on an annuity-like, income-generation business model (from planning retainers, fees or AUM) is more predictable than one built on commissions or transactions, and thus less risky. Client demographics and marketing factors are also risk elements that influence the character and value of the client base.
The wise business seller will devote major time and energy in the years before the sell date to aggressively "high-grading" the business and client demographics. It is vital to develop a plan to slowly transfer that wonderfully intangible yet crucial quality-client trust-from the seller to the buyer. Since each client relationship is unique, so too will be the transfer process. Most sellers will have "skin in the game" for years after the execution date, since as much as 60 percent to 70 percent of total payout is generally tied to client retention.
What's It Worth?
Many factors must be considered in the valuation of a closely held business. IRS Revenue Ruling 59-60 still is the best guide to what's involved in a valuation. Even so, recognize that valuation of a small, closely held business is an art, not a science, since any valuation is based on recent history as well as forecasts about the future. The primary valuation methods are:
- Book value of capital stock and the financial condition of the business (the basis for the asset approach)
- Forecast earnings capacity of the business (the basis of the income approach)
- Open market price paid for acquisition of similar size companies engaged in the same line of business (the basis of the market approach)
For most financial advisory businesses, the asset approach is not particularly relevant. Except for the very largest firms, advisory firms generally don't own real estate or a lot of equipment or inventory.
The income or discounted cash flow method is generally regarded as the most substantial approach. It estimates fair market value by considering the future ownership benefits forecast to be generated by the business over a discrete period of time (usually five years) plus a terminal value to pull in the greater uncertainty of values beyond that. This method is based on the principle that the value of a business is equal to the present worth of the future benefits of ownership.
In the income approach, ownership benefits are first normalized to account for significant salary or benefit anomalies as well as any perks that may be unique to the current owners. Examples are club dues, car allowances or leases, excessively high salaries, etc. This method discounts future ownership benefits to a present value, reflecting an appropriate rate of return also known as the discount rate.
Determining the Discount Rate
The first step is to determine the discount rate to be applied to future cash flows. The required rate of return is derived from the sum of the following components:
- A "risk-free" investment rate: The long-term Treasury bond yield serves this purpose. The yield as of the date of valuation can be used. Recently (April 30), that rate was 4.56 percent.
- A basic equity risk premium: This is the expected premium over the risk-free rate that investors expect to receive by investing in the large-cap stock market. This premium can be found in the annual Ibbotson Stocks, Bonds, Bills, and Inflation (SBBI) Classic Yearbook. For 2009 (the most recent data available) it was 5.7 percent.
- An additional small capitalization equity risk premium for very small companies: This premium was 5.8 percent for companies with an average market capitalization of around $80 million, according to Ibbotson.
- A specific risk premium for your company relative to comparable companies: In determining the specific risk premium, many factors may apply including:
- Company size and location
- Historic revenue growth rates
- Industry-relative profitability and expense comparisons
- Practice standards, technology adaptation and marketing costs
- Management strength and stability
- Client demographics (age, average fees, etc.)
- Revenue-generation model (fee structures)
Discount rates thus calculated can range from 15 percent to 25 percent or even higher. Here's an example for a hypothetical small practice:
Risk-free rate: 4.6%
Equity risk premium: 5.7%
Small capitalization risk premium: 5.8 %
Specific risk premium: 3.0 %
Equity discount rate = 19.1%
Determining the Enterprise Value
The second step is to determine the enterprise value by calculating the present value of the future cash stream to be generated by the company, discounted at a rate of return appropriate for the level of investment risk presented to the potential buyer of the company-the equity discount rate. The procedure is as follows:
- A projected stream of cash flows for the forecast five-year period is discounted at the equity discount rate to determine the present value.
- The terminal value (the expected value of future cash flows beyond the five-year period used in step 1) is determined, assuming a fixed growth rate discounted at an appropriate rate (capitalization rate) to determine a present value.
- The values calculated in steps 1 and 2 are added together to determine the value of the company.
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Any non-operating assets to be sold are then added on top to determine an indicated total company market value. Examples are real estate, art work or significant goodwill.
Using the Market Approach
The other primary valuation method, the market approach, estimates the value of a closely held business (like most financial services firms) by conducting an analysis of recent prices paid by investors in private or public transactions for other companies in the same or very similar business. A correlation is developed between comparative companies' market values and some measure of the subject company's operating results or financial position. The two most frequently used measures are ratios or multiples of AUM or operating revenue (net of broker-dealer fees or overrides). Multiples can range from a low 1.0 times revenue for a small, transaction-based practice to 2.5 or 3.0 times annual revenue for a large, high-quality, fee- or retainer-based business.
The financial services industry often uses such revenue ratios or AUM numbers as a shorthand approach to indicating business values, but the market approach can often ignore significant valuation factors that would be picked up in the income approach. The market approach can also suffer from distortion through forced application to the micro businesses that are most financial advisory firms with annual revenues of less than $5 million. Lack of calculation transparency can also make it difficult for either side to support valuations during negotiations or if subsequently queried by a third party, such as the IRS. Most professional valuation firms will therefore use multiple valuation methods and develop a weighted average when arriving at their final business valuation recommendation.
What's Your Timeline?
According to a recent industry survey, more than half of the financial advisory business owners queried say they don't plan to sell their business for at least 10 years, yet the average age of that same group is over 55. The survey also indicated that for more than 40 percent of owners, business life today is more complicated, more stressful and less enjoyable than is was 10 years ago. If you are in that over-55 group that likes what they do less and still hasn't committed to a program to change your life by selling your business, it's time to think about putting a date on your timeline.
If just thinking about selling makes you anxious, step back and stand in the perspective of your life plan, not your business plan. As you think about family, dreams and the passage of time, when would be a good time for the sale to take place? Even if that milestone is beyond what you generally think of as your planning horizon, lock it in by committing to it now. Tell your family and friends about your plans and make it real, otherwise it's easy to postpone that big day. You may actually find it a relief to have the date calendared.
What Will Change?
The outcome of the successful sale of your financial advisory business has two sides. Some outcomes are positive and what we naturally tend to focus on in the process; others are perhaps not so obvious:
You may gain:
- Time to spend with family and on giving back
- Energy to try new ideas and start new activities
- Opportunity to gain new knowledge and friends
- Freedom from the daily routine and job pressures
- Financial security with peace of mind
- A fresh start to go exploring and try new things
You may lose:
- Sense of purpose (What do I do now?)
- Meaning of life (Who am I?)
- Business relationships with clients, peers and friends
- Financial security (Where's my paycheck?)
- Sense of direction (Where do I go from here?)
- Energy (the couch potato syndrome)
This is one of those life experiences where just reading about what will happen is a woefully inadequate preparation for what you will actually experience and how you will feel. The loss of a really big and personal chunk of your life-and financial planning is nothing if not personal-can leave a huge hole that is hard to fill. There is no "right way" to approach what will happen.
The best advice I can offer-gained the hard way over the past four years during and after my own transition-is to be aware of the critical difference between a change and a transition. William Bridges puts it this way in his book, Transitions: Making Sense of Life's Changes, "Change is situational. Transitions are psychological. It is not the events, but rather the inner re-orientation and self-definition that you have to go through to incorporate those changes into your life. Without a transition, change is just a rearrangement of the furniture of life."
So the short answer to the question "What will change?" is "everything." How you deal with your own transition process will largely determine whether selling your business leads you to a time of renewed vitality or gets you stuck in a cycle of stale reruns of what and who you used to be. It's your future and your choice.
Sam Hull, CFP®, ACC, of Riverbank Consultants LLC, is a certified professional life and business coach and a former financial planner who sold his business in 2008. He now helps other financial advisers build enriching lives and navigate their own transition issues. Contact him at sam@riverbank33.com.
