Exit planning: How much is your practice worth?

Market or comparable (revenue) based

For this method to be effective, most practices must be identical or have comparable revenue, service models, pricing models, product offerings, business models, etc. With so many variables — the factors that tend to make an advisor’s practice unique — it is difficult to establish a comparable market price for a practice.

Income-based

Ultimately, valuation is influenced by three key variables: cash flow, growth and risk. Of the three business valuation models, an income-based approach is most appropriate for valuing a financial services practice. The income-based or discounted cash flow method involves estimating your annual cash flows (net profit) for the next five to seven years, to determine present and terminal value.

The most difficult part is determining the rates for converting income streams into value. The rate is determined by risk, to a great extent, and takes into consideration the following:

• Business organizational structure and employee longevity

  Your ability to demonstrate that you have “institutionalized” your business is essential. Buyers want to see that your practice will continue to prosper even if you are not there. This means creating an environment that encourages skilled staff to participate and use established systems and processes to run the practice efficiently. The more systemic your operation is when it comes to decision-making, client contact, follow-through and back-office systems, the greater the saleability of your practice.

• Growth rate

  Steady growth in profits, assets under management and clients are all important variables. Your ability to show a track record of organizational growth and using a clear business plan are key elements.

• Client type

  This takes into consideration client ages, assets, liquidity, turnover and the proportion that each client represents within the advisor’s book.

• Competition in the geographic area

  If the area happens to have a large number of planners and investment advisors, more risk will be added to the value equation.

• Buyer type

  The practice will be worth more to a buyer that has similar values, offerings, services and investments because client transition will be less volatile. This type of partnership is strategic and the commonalities between the buyer and seller help reduce some of the costs associated with a merger of incompatible practices.

• More Exit Planning

  • Exit planning: Building your own retirement plans (Part 1)
  • Transitioning best practices
  • Knowing what you want
  • Successfully reaching qualified buyers
  • Doing your due diligence

  Seller involvement

  When a service business changes hands, a certain amount of client attrition is expected and will occur. To minimize this effect, the seller’s continued involvement in the transition phase is a key factor. The timeline is one that must be mutually agreed upon by both parties and can range from one to five years. Regardless, seller involvement after the sale is critical for the business to continue to flourish with minimal disruption.

• Deal structure

  Deal structures can have a tremendous impact on the amount of risk both the buyer and seller assume and ultimately affects valuation. Consider a typical deal in which the buyer provides a 20-30% down payment with a five-year earn-out period. In this situation, the seller may receive as much as five times cash flow. However, if the deal structure is altered, for example the buyer offers 100% of the cash upfront, the seller will probably agree to a lower valuation to reduce the risk of not being paid. Furthermore, the ability of potential buyers to obtain financing will impact business value since lenders look at a business’s value differently than accountants.

When thinking about the sale and establishing your approach to facilitate the process, these guidelines can help you achieve a more realistic view and set of financial expectations.

Similarly, a buyer should look at the purchase of a practice in the same way an advisor would look at an investment for a client, understand the risks associated with achieving specific income streams and how the risks measure up against risk tolerance and investment objectives.

It’s true that proper business valuation takes time and effort but the risk of taking a simplistic approach will almost certainly leave you with less money in the end than if you approach business valuation the right way.