A very rough rule of thumb often quoted for the business value of an RIA/Broker Dealer is two times revenues. However, rules of thumb can be tricky and are commonly misused.
For instance consider this scenario: RIA “A” and RIA “B” both have $5 million in annual revenue, when looking at most recent TTM (Twelve Trailing Months). However, the average age of the clients in RIA “A” is 70, and there has been a 5% annual attrition rate of clients over the last several years. Additionally RIA “A” pays much higher rent expense and has higher overhead in general, and the owner can only afford to pay himself $150,000 from the business, with nothing left over. Finally the assets under management (AUM) are spread out over many clients with an average portfolio size of $400,000.
RIA “B” has been growing clients 5% a year over the last several years, the average age of the client base is 49, and the owner is making a salary of $300,000 a year with cash left over to reinvest back in the business. Additionally the average AUM per client is $1,000,000. So which RIA would you rather own, and should both be worth the same amount since they have the same revenues? Most people will agree RIA “B” would be much more attractive to a potential buyer, but using a simple multiple of revenues does not actually measure the real business value. A revenue multiple would value both businesses at the same amount.
One of the biggest mistakes from the seller we see is unrealistic expectations on what the business is worth. The other mistake we see is when business owners don’t take the steps to maximize the value of their business, so that they can extract the highest price possible from the marketplace. Below are some steps investment advisors can take to maximize the value of their RIA/Broker Dealer and decrease the risk for a potential buyer.
- If the firm is named after you, consider changing the name of your firm to a generic name. This might seem like a drastic step, but if done long before a potential exit, this will make the firm more attractive to outside buyers.
- Can the firm successfully operate without you for an extended period of time? If the answer is no, then the amount of transferrable goodwill in the business decreases, making your business less attractive. Start making changes now to make the firm less reliant on you. Invest in people and train them to be confident advisors for your clients. Be sure your clients all have multiple touch points within the firm beyond the primary advisor. It is important for a potential buyer to regard these employees as revenue-generators and supporters, as opposed to overhead.
- If the client base average age has steadily increased over the last several years, work toward bringing in younger clients. A firm that has mostly retired clients who will begin drawing down on assets is not as attractive to an outside buyer.
- Invest free cash flow back in the business. If you are taking all of the profits of the business for yourself and not reinvesting in people and infrastructure, you are not maximizing its value.
- Work hard to continue to grow the firm. If a potential buyer sees a downward revenue trend, you are adding risk to the business and decreasing the valuation multiple.
- Start the selling process earlier, thereby committing to stay with the business longer to ensure a smooth transition, and decrease the risk for the purchaser. If an advisor waits too long and for personal reasons can only commit to a transition period of 6 months or less, there is more risk to the buyer that clients will not be transitioned properly and will leave when the primary advisor retires.
In addition to working with a business advisor or consultant to maximize the value of your business, it is equally important to work with an experienced appraiser to value your RIA/Broker Dealer, rather than relying on a simple rule of thumb. An experienced appraiser will do a more detailed analysis, considering at a minimum both a market approach and an income approach. A market approach may consider not only multiples of revenue, but also multiples of earnings, after these earnings have been normalized. A careful benchmark analysis is done of overhead expenses, and cash flows are normalized to remove any non-operating or one-time expenses. Other normalizing adjustments commonly made are adjustments to the owner’s compensation. In an income approach a valuation analyst develops a discount rate based on the perceived riskiness of future cash flow streams and will use either a capitalization of earnings or discounted cash flow analysis to estimate the fair market value of the business.
It is tempting to want to cut corners, and using a simple revenue multiple is easy and straight forward. However, if you are truly committed to getting the most from your business in a transaction, take the time up front to maximize its value and to get a proper valuation. Otherwise, you run the risk of having unrealistic expectations and wasting a lot of time on a transaction that does not close. Also make sure that your exit is planned out well in advance to allow you to take the proper steps to maximize its value.
Pros and Cons of Different Valuation Methodologies:
| Method | Revenue Multiple | Cash Flow Multiple | Discounted Cash Flow |
|---|---|---|---|
| Description | Values business based on a multiple of twelve trailing months (TTM) revenue or an average of the last few years | Values business based on a multiple of TTM cash flow or a weighted average of multiple years | Predicts future cash flows and discounts to a present value to arrive at a business valuation |
| Pros | Easy to understand and implement. Can act as a sanity check to ultimate value | Considers expenses and so helps differentiate efficient from non-efficient firms | Theoretically the most accurate way to value a business, as a buyer is mostly concerned with future cash flows, not historical earnings |
| Cons | Ignores expenses. Can often times create unrealistic expectations for seller | Ignores forecasted earnings, which may be lower or higher than historically. In most cases must normalize cash flows by making adjustments to owner’s salary and other expenses | Future cash flow is difficult to forecast. Must also determine the proper discount rate |
Jeff Plank, MBA, CVA, CEPA is Director of Consulting Services for HLB Gross Collins, a full-service Certified Public Accounting firm, and is an expert in the appraisal of businesses and business interests for financial reporting purposes, as well as transaction and trust and estate matters. Jeff is also a Certified Exit Planning Advisor (CEPA) and works with business owners who are transitioning to maximize the value of their business. You can contact Jeff at [email protected] or 678-306-1406 .