Thinking about M&A? Keep these three issues in mind

Mergers and acquisitions have the potential to accelerate the growth and profitability of financial advisory firms if they’re properly planned and executed. To improve their likelihood of success, advisers need to ask some tough questions up front of both their counterparties and themselves.

Adviser interest in M&A has recently been rising, and most have their sights set on small transactions. According to a recent FA Insight survey, more than 60% of independent RIAs considering M&A are looking to acquire a solo adviser, while 47% intend to buy a book of business. Big fish are in demand too: 42% anticipate acquiring firms with multiple advisers.

(More: RIA firms ride consolidation wave)

The allure of M&A is easy to understand. Well-executed deals can bring about new revenue, assets and clients at a pace that could take years to cultivate organically. Transactions can be a vital component to succession planning and create a more competitive firm with greater depth and breadth. At the same time, there are roadblocks that can impact the expected benefits of a deal.

Though no two deals are exactly alike, we’ve found there are three key roadblocks that can slow or stop M&A: valuation, negotiation and emotion.

VALUATION: WHAT’S IT WORTH TO YOU?

According to FA Insight, most advisers believe they have a good handle on their firm’s worth, but disagreements on valuation are the norm because buyers and sellers come to the table with different perspectives. A number of factors go into putting a price tag on a firm, and the prioritization of what drives value almost always varies.

When deal discussions turn to valuation, each side should present their rationale for using a specific methodology to help the other understand how they are measuring value. Three of the most commonly methods used are: rule-of-thumb, based on a multiple of revenue, earnings or assets; income, which calculates the net present value of future cash flows discounted for certain risks; and market-based approaches, which rely on sales data from comparable transactions.

Many RIAs do their own analysis, particularly after they have done a few transactions and feel confident in understanding a firm’s key value drivers. A third-party valuation specialist can be helpful to validate estimates and smoothing negotiations — particularly for larger transactions — though occasionally one side may fixate on the third-party number and be unwilling to compromise.

(More: RIA consolidation hits new high in first quarter)

NEGOTIATION: OPENNESS IS KEY

It’s rare to have all sides agree on all terms of a deal, so having an open mind and a sense for which items have more importance and which are open to compromise is key. Equally important for RIAs is an open dialogue, as ensuring a good fit can go a long way for finding consensus on deal terms.

If negotiations stall over valuation, it can be productive to explore where each side’s price comes from. Rather than fixate on the numbers, try discussing the methodologies and assumptions behind them.

Non-financial components can have an impact on negotiations as well. For example, non-compete agreements, buyback provisions and tenure requirements should be considered. Acquiring RIAs should explicitly state non-compete requirements, predefined transition periods and tenure requirements in

their deal terms, as unanticipated departures of key people could significantly impact a buyer’s ability to realize the full anticipated benefits of the transaction.

Other considerations include: payment composition, incentives for seller to facilitate transfer of relationships, personnel integration or displacement, branding, technology integration, compensation plan strategy and organizational structure.

(More: 3 non-traditional methods for acquiring a financial advisory practice or book of business)

ADDRESSING EMOTIONAL TIES

It’s natural for sellers to have emotional ties to their firms, which may represent their life’s work. But once the decision has been made to transact, the seller must acknowledge that things may change and evolve as a deal progresses and ultimately closes.

Indeed, a buyer may need to walk away from a deal if the seller has reservations that cannot be overcome. If wide gaps exist between a prospective and the optimal M&A candidate, particularly around pricing, it also might be time to call the deal off.

Most importantly, if a lack of trust exists between the parties, there may be little reason to move forward with discussions. Decision-makers on either side should not hesitate to walk away from the table.

(More: Smarter sellers, buyers bog down RIA M&A activity)

TAKE THE TIME TO GET IT RIGHT

Courting an M&A prospect is a significant investment of time and resources, and closing the deal is even more so. Don’t rush it. RIAs should take steps to avoid common pitfalls by ensuring that there is compatibility, a shared vision and open and honest communication throughout the process.

Vanessa Oligino is director of business performance solutions at TD Ameritrade Institutional. FA Insight is a product of TD Ameritrade Institutional, Division of TD Ameritrade Inc.