Tags: Valuation

Financial Advisors need valuations for a host of reasons, but they are typically related to some desire to improve the business, plan for succession, monitor growth, or attract and retain the next generation of bright advisors. The valuation itself is almost never the “end game” but rather a starting point by which decisions can be made. If you are interested in selling your firm, the valuation might start as a baseline for negotiations. If you want to admit a new partner or embed ownership through stock grants to key employees, the valuation is a foundational brick in the process.

The problem that’s almost never addressed though is that a valuation itself is in fact a variable-dependent process and the outcome depends on the inputs used. If you use stock grants to fine-tune your compensation plan, the impact of altering that comp plan needs to be factored into the price of your stock. If you amend a deal term to increase contingency payments or expand the term in which a buyer can pay, the implication for value is significant. What benefit is a valuation process that relies on stale, dated, historical inputs? Yet that is precisely what a historical valuation report is: A published, dated, unyielding document that is valid for a short period of time and never provides the flexibility needed to answer serious management questions.

The sad answer is that you often see traditional valuation engagements fail to address the very factors for which they are being prepared to deal with. Valuations are contingent on the assumptions that underlie them and should therefore be dynamic. But a valuation report is anything but dynamic. It is a “point in time” report card that measures everything that’s known as of a particular point in time. Even the AICPA and other authoritative professional sources go to great lengths to define “shelf life” when addressing the non-responsiveness of traditional business valuations.

The idea behind dynamic valuation analysis is that measuring performance across all relevant business drivers, predicting the future, and understanding the strengths and weaknesses of every unique firm derive a valuation. To see the impact of client demographics on revenue performance is a powerful insight itself, but to see the implication for value allows users who care to make more informed decisions about hiring, about acquiring, and about planning. To make a decision about expansion can be a scary ordeal, with daunting fixed overhead costs causing anyone to pause. How does one even begin the task of measuring, monitoring, and analyzing options? We believe the answer is elegantly simple: By understanding the implication of a business decision on that business’s current and future earnings, an informed decision maker will be equipped to make informed decisions that improve the probability for success.

Value itself is a confusing and often nebulous concept. There are multitudes of definitional challenges that arise when the term is used, and many governing entities take great pains to spell out some of the core concepts. The concept most aligned to the idea of fair value or fair market value is those originally expressed by Benjamin Graham. If you aren’t aware of Mr. Graham’s contributions to the academia of finance, he was the mentor to Warren Buffet and both gentlemen advocate(d) the ideals of intrinsic value.

Very elegantly, intrinsic value represents the core value attributed to owning an asset or entity for the purpose of collecting the income that is generated by the asset or entity. In a business, these rights equate to the revenue earned from selling a good or service, less the expenses associated with running the business, less any reinvestment necessary to maintain the operating assets required of the business. This may seem more daunting than simply “swagging” a value by multiplying your annual revenue by a multiple, but it really isn’t. Given the right tools and examining the right questions, we are confident that every business owner can be a master financial modeling wizard in mere minutes.

Why should you care about intrinsic value? Very simply because informed buyers do and informed buyers are increasingly carrying sway as market makers in the financial services industry. Informed buyers have recognized through trial and error that no two clients are alike, that no two books of business are alike, and that no two firms are alike. By extension then, no one revenue multiple actually exists as a fair assessment of value.

In fact, pricing data for the industry clearly indicates the vast disparity in deal price. Revenue multiples observed in the market range by 300 percent. There is no central tendency around, for example, a 2.2X multiple and even if it did, wouldn’t you be interested in knowing how you can move the needle on value? Unless dealmakers start reporting better statistics tying value to the factors that matter, no market data can even answer the root question: WHAT DRIVES VALUE? There is only one way to answer the question, and that’s by investigating, understanding, and managing your practice with a keen eye towards the lessons taught by Messrs. Graham and Buffet: Intrinsic value matters. 

There is truth in data. When we analyze the financial characteristics of successful advisory firms, we can isolate several factors that make them attractive. We know that firm longevity requires advisory firms with multiple generations of advisors. Look around your office and ask yourself if all principals intend to retire within a five-year period of each other. Are you racing each other for the door? We are not pointing fingers but we can report that if you’re nodding in agreement, you’re not alone. What is the implication? For a buyer the implication is severe: Client turnover rates will spike during succession events and will be drawn out and more severe if multiple succession events happen in short order.

When then is the right time to bring in second or third generation advisors, and what investment in professional staff development today will generate positive returns at retirement by increasing value? These are some of the important questions that don’t get properly addressed in traditional appraisals that can only measure, typically, a single outcome. The challenge is even worse when applying revenue multiples because such observances say nothing about the prospects facing a business or the implications of change today on operationstomorrow. The ability to track and isolate the characteristics of success where it matters – at the client level – is of critical importance and one of the things we’ve developed in our Truelytics platform. 

The ability to allow owners to make the right decisions for the right reasons while maintaining firm accountability and decision making is the hallmark of good practice management and best practices for proactive business owners. In one example,  a firm that had previously hired an organization to help them with their valuation process. The end-result after spending a fair bit of money was a 2.5x revenue multiplier and a 40-page report that really said nothing about the value characteristics that were meaningful to the practice. The owners had multiple options, including internal succession and a bona-fide offer to sell to a third party and needed to understand the options better while building a roadmap forward.

The challenge then was that neither the internal succession candidate nor the third party buyer had any faith in the numbers. They didn’t correlate with what the people who were in the firm knew to be true about the transition opportunity, and the report provided no meaningful way forward. On the Truelytics Platform, we analyzed nearly 40 components of the business such as advisor age, succession plans, AUM weighted by distance and age, recurring revenue sources, client addition/departure rates, institutional AUM, earnings before owner’s compensation, and many more. As we took into account all those variables, we were able to provide a plan forward that worked not only with the seller to meet their retirement needs, but also provided independence and structure to the negotiating process. Once advisors get away from believing there is “just one number” and start to appreciate the intricate relationship “value” and “price”, there is a far better chance of putting meaningful plans in place that affirm their values as a firm, protect their clients, and maximize personal wealth. And that’s what effective, dynamic, real-time valuation is all about. 

Here’s another pitfall that we’ve seen time and again. Let’s say you make the hard decision to hire an advisor employee with the intention of monitoring performance over five years and, if all goes well, you will begin to make the advisor an equity partner. To make this work, you believe the junior advisor will take on functional duties for your practice freeing you up to grow, and at the same time there is a requirement that junior begin their own external marketing program. We have seen this scenario played out all too many times. At the end of five years, the junior advisor has a small book of business, has never really functionally grown into the roles expected, and the firm is as reliant on the senior advisor group as ever. What’s worse, is that now when they seek outside buyers, the junior advisor is in the way, with an inconsequential book of business to which the firm itself has a marginal claim, if any to, and the senior group is five years closer to retirement without a plan!

With a real-time valuation process that incorporates all key business drivers, goal setting is made simple and focused where it matters: On client numbers, on client demographic targets, and on client income contribution. A roadmap to success can be built that tracks client development and rewards behavior that attracts valuable clients only. Better yet, advisors who get sidetracked from their own roadmaps can be isolated, coached up, or coached out before its too late.

Intrinsic valuation is inherently superior. Try it today and see how data and technology have come to help you be smarter.

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The above article is meant for information purposes only and is not intended in any way to provide legal or other advice for any specific situation.  Readers always should consult their own tax, accounting and legal advisors before taking any action related to the above article or subject matter.

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