So far, we’ve reviewed general tax and legal considerations when selling your book, as well as common questions buyers and sellers will ask. This article will discuss how to value your book, and how to negotiate with buyers to get the best price.
Both buyers and sellers often want to get to “the number” for a book sale—whether that refers to a multiple of commissions, percent of assets under administration or other simple calculations. While fundamentally there must be a book of assets to operate on, the makeup of the book and the efficiency of the practice currently housing it can vary widely. Just as an advisor would not recommend that a client purchase a stock or fund based solely on its current dividend yield, these single-criterion measures may be easy to derive, but are simplistic in terms of arriving at the true value of a practice.
That said, common rules can constrain parties’ negotiations. Simply put, if a suggested price significantly departs from street wisdom, it may be rejected out of hand.
Conversely, a figure that directly mimics one of those quick calculations may be accorded an undeserved air of legitimacy.
It will benefit both parties to establish a negotiating range that reflects the true business proposition. To do that, the usual starting point is to look at free cash flow.
Free cash flow analysis
Free cash flow analysis begins by using the real data of a business to determine its historic gross cash flow. The focus is on the recurring flow, minus the cost to collect it. “Free” cash flow is the net amount in hand that is not required to go back into operations. Armed with this history, you can project the expected future cash flow, as modified by a subjective review of its quality and feasibility.
Once you’ve established the expected stream, the next step is to determine current value. This is done by applying an appropriate discount rate (a percentage) in order to commute the stream into a current figure. The discount rate is essentially what a given buyer requires as compensation for using current money to buy a future (and uncertain) payment stream.
When examining an advisor’s practice, a buyer should distinguish between one-time charges and recurring revenue. The buyer will pay for the latter, again based on an expectation of its continuation. Relevant quality criteria might include the consistency and reliability of particular sources, whether receipts have been smooth or lumpy year to year, and any observed trends.
Where there’s been growth, the source of that growth is important. Organic growth may be considered as more of a built-in feature as compared to client expansion or turnover.
Lastly, a buyer should expect some attrition, as an ownership change may cause clients to go elsewhere.
Even with a thorough cash flow analysis, the buyer must still be able to put resources toward making that cash flow happen.
To see if that’s possible, the buyer should gauge the operational capacity of her current practice, including her own time and attention.
Can the seller’s book be brought in without having to add resources? And if additional resources will be required, what are they, what will they cost and when can they be put in place? This brings attention back to free cash flow, since it factors into the buyer’s cost of realization, influencing the amount the buyer would be willing to pay.
Getting initial guidance from an experienced lawyer can help an advisor get started on the right foot; greater involvement under a formal retainer can follow. Here are some considerations.
Once discussions with a potential buyer have begun in earnest, it’s advisable to have a non-disclosure agreement (NDA). The idea is to preserve confidentiality of any disclosure, and restrict the current and future use of it. Importantly, the agreement should also cover the fact that negotiations are underway, as leaks could unsettle clients and employees. While this obviously serves to protect the seller’s interests, it also benefits the buyer in that it preserves the value the buyer seeks to acquire.
Recitations and terms
It’s common for negotiations to span many months. During the course of those discussions, parties will make statements that may or may not be intended to be relied upon.
A good practice is to jointly build a memorandum of understanding to serve as a continuing check that the parties are seeing eye to eye. This document can feed into the formal contract eventually prepared by a lawyer. Once in that form, the respective and mutual premises can be laid out as recitations that form the foundation for what the parties commit to do under the contract terms.
Just as a seller wishes to preserve the practice’s integrity with an NDA during due diligence, a buyer needs to protect the purchased product post-close. This can be achieved through a restrictive covenant in the contract, also known as a non-competition agreement.
A restrictive covenant has four components: who, what, when and where (e.g., the seller will not provide retail investment advice for two years from closing within the province of Manitoba). This example is illustrative only; careful and detailed drafting is required to assure that it clearly records intentions, and that it is enforceable. The Shafron case provides an example of a poorly drafted covenant (see Shafron v. KRG Insurance Brokers, below).
Differences of interpretation can arise in even the most amicable situations, and taking a dispute to court can be costly. So, include dispute resolution terms in a contract. At the same time, parties should understand that finely drafted contract terms may have little effect on an unscrupulous person; if you do not trust your buyer’s commitment, think carefully before committing yourself by executing the contract.
Shafron v. KRG Insurance Brokers, 2009 SCC 6
Shafron sold his property/casualty insurance practice to KRG, after being an employee of KRG and its predecessors for 14 years. He executed a restrictive covenant not to compete within the “Metropolitan City of Vancouver.” There was no such legal place. KRG invoked the covenant when Shafron accepted work in Richmond, a municipality bordering the City of Vancouver.
The Supreme Court of Canada ruled that term was unreasonably ambiguous. Courts are not there to read down such provisions, as this could invite parties (particularly employers) to draft overly broad provisions, expecting the court to trim them to what is reasonable.
Note that a higher level of scrutiny is applied where the restrictive covenant is a term within an employment contract, as employers usually have more negotiating power.
Part 1: Tax and legal considerations when selling your book
Part 2: Finding the right buyer for your book
Part 3 (this article): Getting the best price for your book