Ways to value a practice have changed

Too many financial advisers mistakenly rely on past notions of growth to measure the value of their businesses.

The explosive equity market of the 1990s, which was interrupted by the technology bubble meltdown, was followed by a five-year bull market that fooled advisers into thinking that their profits and resulting business value would always grow merely by their showing up for work.

Moreover, an over-reliance on growth from passive client referrals and growth of assets under management is a surefire recipe for suffering a decline in your business value.

For every new dollar that comes into a well-managed advisory firm, a healthy percentage is profit.

The industry defines this as the firm’s gross revenue minus its expenses, including all adviser and owner salaries, resulting in what is called earnings before depreciation, interest, taxes and amortization; net operating profit or, by some, owner’s compensation. This is the reward to the owners or a future buyer for the risk of being in business.

Using recent industry multiples for practice value, every dollar in net profit equates roughly to $4 to $5 of business value for the portion attributed to non-recurring net profits and $8 to $9 of business value for the portion attributed to recurring net profits.

For instance, if ABC Financial Advisors Inc. generates $1 million exclusively in recurring gross revenue and has $700,000 in total expenses, that leaves a net profit margin of 30%, or $300,000.

One way to determine the value of ABC Financial is to apply an eight-times-recurring valuation multiple on the net profit for a value of $2.4 million.

However, most net-profit valuation models used in adviser buy-sell agreements, or for acquisitions, call for averaging net profits over a two- to four-year period to moderate any short-term aberrations in profitability.

But here is the rub on market cycles: Since the highs of last October, the Standard & Poor’s 500 stock index suffered a double-digit dip in value. During that period, many firms that relied on fees to generate revenue averaged a 10% to 17% drop in gross revenue, reflecting the decrease in the value of assets under management.

If the firm in the previous example lost 15% in gross revenue for the year, it would bring the total down to $850,000 for the year. But the loss of revenue also would reduce its business value.

Here is why.

The firm’s fixed expenses would stay the same at $700,000. This minus the decreased gross revenue of $850,000 would result in just $150,000 of net profit.

When applying the same recurring multiple of eight as discussed above, the business value for 2008 would be reduced to $1.2 million. If the valuation model called for a three-year average and over the first two years, we used a steady $300,000 of net profits, this would result in a business value of $2 million, or a reduction of $400,000 from the previous year.

Yikes.

What are the firms that employ best practices doing to offset any prolonged period of market correction or loss of clients that might reduce revenue and business value?

They are creating a defined-growth plan, and here are the steps you can take to do the same:

• Create a spreadsheet to determine the gross profit a new client with $250,000, $500,000 or $1 million in investible assets would generate. Using a 1% fee, this would work out to $2,500, $5,000 and $10,000, respectively, a year.

• On the same spreadsheet, determine the firm’s profit margins (revenue versus all expenses). From that, establish a percentage of net profit from each new dollar of revenue. Using $10,000 in gross profit and a 30% profit margin, the client account would net the firm $3,000 a year.

• Develop a rolling five-year growth plan by deciding how much you would like the firm to grow each year — say, 15%. Then determine how many clients the firm would need to add to meet those targets based on the size of the client’s assets and the firm’s profit margins.

The result is a valuable quarterly tracking tool for not only growing during the good times but also giving the firm’s owners the means to know exactly how many new clients the firm will need to replace any decreases in gross revenue or lost clients during down-market cycles.

As important, a defined-growth plan will serve as a critical tool for those advisers who want to be ahead of the curve in addressing the need for growth during the soon-to-come “distribution” cycle that the baby boomers are about to create.

David Goad is president of Succession Planning Consultants of Newport Beach, Calif. He can be reached at [email protected].

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