The 3 determinants of practice value

After 19 years in an emergency room, Joe Hollen is an expert in assessing what’s critical and taking care of those things first.
So when the former ER physician started an advisory practice three years ago in Reno, Nev., he concentrated on one important goal: building business value so that he could retire in about a decade.
But what constitutes value, and how does an adviser increase it?
Based on my firm’s work with advisers over the years, I believe that an advisory firm’s value is based largely on cash flow quality, marketplace demand and transition risk. Let’s look at each.
Cash flow quality measures the value of a firm’s revenue. As one might suspect, the higher the percentage of recurring fee-based revenue, as opposed to commissions, the higher the value of an adviser’s cash flow. Operating a fee-only practice, Mr. Hollen scores higher than average in quality of cash flow.
Yet there are several steps he can take to increase his cash flow quality — and hence, overall value — in the years to come.
Almost a quarter of Mr. Hollen’s revenue currently is derived from non-recurring financial planning fees. He is working to reduce that percentage, and over the next few years, he will look to convert one-time revenue into a recurring resource. Mr. Hollen plans to provide some planning services at a slightly lower fee, but in the framework of an agreement that requires an annual plan review.
Marketplace demand is probably the most complex of the factors determining business value. It comprises several components. One is location. There is higher value in being located in a fast-growing metropolitan area than in a declining one, and more value in being in an affluent part of that area. Wealthier, faster-growing locations increase the likelihood of attracting many desirable clients — as well as widening the pool of other advisers who might buy your firm.
Small is better
Practice type and size are other components of marketplace demand. There is higher demand for fee-based businesses, of course, and higher demand for smaller practices.
Practices grossing $300,000, for example, are in high demand because there are many qualified buyers.
Surprisingly, marketplace demand is lower for large firms. Despite the talk of roll-up companies on the hunt for large advisory businesses, demand drops off for firms grossing $3 million and more. The reason is that there simply aren’t many potential buyers for firms of that size.
For a firm of Mr. Hollen’s size, there may be about 100,000 potential buyers.
Finally, there is transition risk, which refers to two types of risk involved with the sale of a financial services practice: client risk, which is associated with the transitioning of the client base to a new adviser, and continuity risk, which is associated with a change in the actual practice, as perceived by the clients.
In Mr. Hollen’s case, he discovered that his transition risk, when compared with his peers’, was higher than average, which reduced his value.
His transition risk was affected by low client tenure, running a one-man shop, having a large portion of his clients nearing the age of 70, his emphasis on personal branding, and his failure to implement a short-term continuity plan and long-term succession plan.
Some of these issues will improve on their own over time, but he is planning to deal actively with others, including hiring an assistant to help when he is away from the office. Mr. Hollen also set up a plan to provide post-closing assistance when he leaves his practice, and is working to attract a slightly younger group of clients.
Ultimately, the measure of the value of an advisory business can be expressed as a multiple of its gross revenue. Taking all three factors — cash flow quality, marketplace demand and transition risk — into account, his business has a current multiple of 2.3 times its trailing-12-month gross recurring revenue.
That’s higher than the average of 2.16 times gross for firms we serve, where multiples typically range from 1.5 to 2.7, with a high of 3.5.
While Hollen Financial Planning Ltd. has grown almost 200% each year, it operates with a higher expense structure than is typical to generate such growth. By normalizing the firm’s expenses over the coming years, stabilizing growth and not directly tying himself to revenue production, Mr. Hollen hopes to increase his multiple to well above where it is today.
David Grau Jr. is president of FP Transitions, a unit of Portland, Ore.-based Business Transitions LLC. His company is involved in financial-practice sales, consulting and valuation.

Related Topics: Practice Management