I have been engaged to help salvage more failed deals involving smaller financial advisory practices than I’d like to remember. The facts and reasons almost invariably involve three categorically similar features:
- Poor pre-transaction due diligence
- Unrealistic faith in the intentions of the buyers and sellers
- Failure to understand the relationship between the structure of the deal and the overall economics
I will start with a story of one of my most disheartening experiences. A son, who genuinely loves his father, told me that what hurt the most about his failed acquisition experience was knowing that he and his father would likely never experience a loving family Thanksgiving dinner again. I hope that he was more wrong about Thanksgiving dinner than he was about the acquisition of his father’s practice.
Plan for Pitfalls
When the parties affected include fathers and their children, husbands and wives, siblings, and great friends the scenarios become systemically problematic. Over the years, I’ve seen many cases that have gone as terribly awry as that first experience, and some that are even worse in terms of acrimony or more expensive in terms of dollars. In every instance, I’ve relayed the story of that first experience, sometimes to fathers, sometimes to sons and occasionally to both. I’ve relayed the scenario to the buyer and I’ve repeated it to the seller. It is truly heartbreaking when I see the interpersonal damage of a failed transaction knowing full well that it could have been a success. While all business partnerships start out for the right reasons (or at least I prefer to believe so), most fail because loyalty in personal friendships often trumps business common sense.
In 2013, 70% of financial advisers were 45-years-old or more, and nearly one-third planned to retire within the next 10 years, according to Cerulli Associates.
But just 25% of financial advisers have a succession plan in place, as found by 2013 study by the FPA Research and Practice Institute, a program of the Financial Planning Association.
Buyers and sellers are naturally opposed in their interests, yet this in itself is not the sole cause of deal failure. Successful deals, after all, do outpace unsuccessful deals and there is ample proof that a happy buyer doesn’t preclude an unhappy seller. The goal for any buyer is to perform adequate due diligence and to pay a fair price for the business. The goal of any seller is to prepare for the due diligence and to be ready to enter negotiations as devoid of emotion as possible. Easier said than done – and sadly harder when unrealistic value expectations have crept in and left an impression on plans for the future. Who doesn’t like to believe their net worth is higher or more liquid than it really is? When you have been falsely led to believe you can cash out and live a privileged retirement, those images can be hard to erase.
Let’s be clear: If you believe the value of your firm is 2.5 or 3.0 times last year’s revenues, put it on the market and see what happens. Firms that sell in these ranges are rare, and rare exceptions are not the norm. Average advisor practices do not sell at an implied value of 2.2 times – regardless of what may have been promised. Those deals are exceptions and if you plan to sell your practice at a high multiple, plan to be exceptional.
What should you expect from a typical sale? This depends on a laundry list of concerns, but here are some of the most important factors:
- Size: A solo advisor rarely sells their business for the same multiple as larger, multi-advisor platform. For the most part, the market understands this and it should be universally intuitive, yet we still see unrealistic value expectations bred deeply into the smallest segments of the market.
- Structure: A deal in which the buyer writes a check for 100 percent of the consideration is exceedingly rare. The “value” of that kind of transaction is easy to discern, but deals typically include a large variable payment that depends on future performance and almost always includes a guaranteed payment over time. It is “guaranteed” by the cash flows of the business, and these are never as guaranteed as one may think.
- Financial statements: Financial statements are the currency by which informed investors make their decisions. When personal and business expenses are commingled, the potential buyer does not have a clear picture of the business and cannot not expect that they can “do better” than their predecessor. If a business is run like a country club, it will sell like a country club. As we all know, country clubs do not sell for much. Well-run businesses with a focus on bottom-line earnings will sell at a much higher price.
- Growth: Businesses often sell when they are deep into their lifecycle, when client attrition rates are high, and the core client roster is whittling away. Is such a business as attractive as a growth-oriented company? In public stock analysis, sustainable growth is a fundamental analytical tool used to value companies. Companies with high-expected growth rates sell at higher multiples. Analysts are polled quarterly in search for consensus on expected growth rates and these forecasts affect market prices, especially when there is a change in growth expectations. Clearly growth matters in the public markets. The same is true of small, private advisory firms.
- Diversification: If a firm relies heavily on a rainmaker who has a demographically concentrated client base of 70 year-old clients, not only will growth projections be lower, but the risk of attrition is high. This is an acute issue when facing the sale of a practice because transition creates uncertainty for clients and often generates a high rate of immediate turnover. How are the buyers going to protect themselves? By adjusting their offering price. If the five largest clients aren’t willing to transition to the buyer, the value of the company will naturally decrease.
- Culture: For many advisors, their clients are an extension of their families. Lifetime milestones have been shared and clients have come to admire and respect the culture of the office. It is often the case that the administrative staff is a core component of the firm’s culture and it is important for that culture to remain intact. For buyers, it is naïve to assume that an acquisition can be effectively “tucked in”, thereby reducing overhead and maximizing profit. A good client is not a commodity and neither is the staff that is potentially being acquired. It is as important to analyze the entire staff’s contribution to the business and how this can affect client retention.
Understand, Plan, Succeed
If you intend to buy or sell an advisory business, the due diligence process is aimed at understanding these issues and ensuring there are clear solutions for any potential problems. The list above is nowhere near exhaustive. It doesn’t begin to describe some of the daunting challenges that can arise either pre-or post-transaction. Litigation risk is often a component of the deal and can take on many forms. Contracts, such as non-compete agreements, performance agreements, employment agreements and contingency agreements need to be developed and reviewed. All of these factors will eventually determine where a firm will fall within the price matrix.
If you are well prepared with a succession plan, you will have time to enjoy the rewards that come to well informed, astute sellers. Firms that are well-run are those that will sell at a premium. Prepare early, focus on growth, retain clean financial records and keep a solid bottom line. Finally, make an exit strategy part of your regular business vernacular. Eventually, a succession plan will be part of your near-term plans and, if the factors above are seriously considered, the demand for your business will most certainly be stronger. And if you’d like to see just how much succession planning affects firm value, ask us about our Truelytics eValuation Index™ tool.
More articles related to: Succession Planning