Financial Advisors

www.brownstonecap.com

Succession Strategies for Financial Advisors

Paul R. Brown, M.A. Managing Principal

BROWNSTONE Capital Advisors LLC

What is a successful transition?

Value and Liquidity Continuation of the Advisor Client Transition Loyal Staff is Protected Business Legacy


Four Critical Pieces

1.What Does My Practice Look Like?

2.How Do I Create Transferable Value?

3.What Determines the Value?

4.How Do I Make the Transition?


First Piece: What Does it Look Like?

Look

First Piece: Seller’s View

Someone must recognize the value

How dependent is the practice on ME?

There are many exit strategies

Selling a practice = transferring opportunity

A buyer weighs time, cost, and risk


Seven Factors Driving Value

1.Transferable book of business

2.Consistent growth

3.Future investable assets

4.Not entirely dependent on the owner

5.Fair level of compensation

6.Recurring income

7.Financial planning retainers


Questions to Ask

1. Why do I want to sell?

Retirement

Bored, tired, distracted

Unsatisfied with the results

Unsolicited purchase offer

Merge with a larger practice

Other non-business reason


Questions to Ask


2. What is being sold?

A book of business

Future earnings and cash flow

The practice identity

Tangible assets


Questions to Ask



3. Who might be interested in purchasing?

Another financial advisor

An associate

Someone you share office space with


Questions to Ask



3. Who might be interested in purchasing?

4. How long will the process take?

Taking more time can increase value


Two Critical Elements

1. Is there fair compensation for labor?

2. Is there fair reward for ownership?


First Piece: The Buyer’s View

1. Why are they buying?

Just starting out

Expanding their practice

Economies of scale

Financial and operating leverage

Building value

Ego




2. What are they buying?

A book of business

Future earnings and distributions

Market share and/or position

Existing staff

Assets

Unique processes





3. Is this a right fit?

Where is its life cycle?






Where is its life cycle?

Does it compliment my existing practice?






4. Can I manage a larger practice?


Final Considerations for the Buyer

1. Recognize the “personal” nature

2. Scrutinize the revenue mix

Fees may not be transferable

Commission income (trails) may transfer

Goodwill typically will not count


Second Piece: How do I Create Value?

Look Build

Key Elements of a Transferable Practice

1.Customer Succession

2. Management Succession

3. Ownership Succession


Customer Succession

Definition of Client Succession:

The transition of clients from one advisor to another in a manner that increases their investment and fee based activity.


Customer Succession

1.Build experienced continuity Team based client relationships

Client-focused practice


Customer Succession

The Client Audit What do your best clients need?

What do your clients want?

What skills and services do you need to offer?

Which clients are at risk of leaving?

Which clients can you replicate?


Management Succession

Definition of Management Succession:

Creating an advisory practice model in which the ownership of the practice will naturally and predictably be transferred to others sharing the client management responsibilities.



Design the Right Organization

Which organization

creates the most value?



The SOLO Practice



The ENSEMBLE Practice



The LEVERAGED Practice

Assoc. Assoc.

Assoc.

Assoc. Assoc.

Assoc.

Lead Advisor

Lead Advisor



The Median Income Per Owner

$384,900

$762,287

$-

$250,000

$500,000

$750,000

$1,000,000

Solos Ensembles



Build the Right Team



Above the line issues: Demonstrated Knowledge

Demonstrated Skills

Demonstrated Abilities


Below the Line Issues

10% - Limited information:

Skills, experience and company match

90% - Essence of the total person:

• Thinking style• Occupational interests• Behavioral traits• Job fit


Ownership Succession

Done correctly …

Clients are cared for

Goals are realize

Value is achieved

Successor is in place

Timing is on your terms


Third Piece: How Is Value Determined?

Look Build

Value


Standards of Value

“Investment Value” or “Worth” is the standard of value when discussing the transfer of ownership.

“Fair Market Value” is the standard used in the context of gift and estate tax. A Revenue Ruling defines fair market value as a hypothetical value at which an asset or business would change hands between a willing buyer and willing seller, neither party being under any compulsion and both parties being fully informed of all the facts.


“Fair Value” is typically used in divorce, and partner and shareholder disputes, and sometimes in buy/sell agreements. It is a standard usually defined by state law.

A valuation for tax, divorce or litigation purposes could result in a conclusion different than the value of a practice for purchase or sale.

Standards of Value

Special Industry Approach

Gross Revenue x Multiplier

or

Managed Assets x %= VALUE



Special Industry Approach = “Rule of Thumb.”

The “rule of thumb” for an industry is a multiple of gross revenue or a percentage of assets under management.



For financial planning, insurance and investment advisory practices, you often hear the rule of thumb value is somewhere between 1 and 4 times gross revenue, or between 1 and 2% of assets under management.



Rules of thumb are not reliable! They do not recognize the true economics or characteristics of a particular practice.

The rule of thumb, or “special industry approach,” may serve as a check against the actual value, but should not be relied upon solely.



Valuation Approaches

Asset-Based Approach

Income Approach

Market Approach

Asset Approach: Book Value

Assets- Liabilities

VALUE



The asset approach refers to balance sheet assets not assets under management.

The asset approach is not likely to have much weight in valuing a financial advisory practice because most advisory practices do not have much in the way of tangible assets, accounts receivables or work in process (WIP).

Asset Approach: Book Value

Income Approach

Adjusted Cash Flow

Capitalization Rate= VALUE



Income Approach

The income approach focuses on the income generating capacity of a book of business.

It considers three factors: financial return, risk and growth.


Special Issues

Any other approaches to valuation are variations of one of these three.

When considering the income approach to valuation for the purpose of facilitating the sale of a practice that is for sale, a fourth key element must be factored into the valuation: the transferability of the book of business

Adjusted Profit Before Tax

Revenue (Gross income from the practice)

- Direct Expenses

= Gross Profit

- Overhead Expenses

= Adjusted Profit Before Tax


Adjusted Free Cash Flow

Adjusted Profit Before Tax

+ Non Cash Expenses (Depreciation/Amortization)

+/- Working Capital Changes

- Normalized Capital Expenditures

= Free Cash Flow

+ Interest Expense x Tax Rate

= Adjusted Free Cash Flow (Financial Return)



Adjusted Free Cash Flow - Adjustments

Compensation (reduce owners’ compensation to the market level for a local salaried professional planner)

Travel & Entertainment

Non-business related legal expenses

Certain support staff salaries

Taxes applied to adjusted earnings


Adjusted Free Cash Flow

As a guideline, overhead expenses should rarely exceed 40% of practice revenue, and preferably considerably less.


Determining a Capitalization Rate

Capitalization Rate = the expected return a buyer requires in order to be persuaded to make an investment in a particular practice.

Range: 20% - 40% based on risk. Higher cap-rate for higher risk (e.g. income driven by commissions; elderly client-base)


Determining a Capitalization Rate

Divide – One year adjusted cash flow by the Capitalization rate.


Factors Determining Risk

Return available on alternative investments

Volatility or stability of the Adjusted Free Cash Flow

Amount and quality of competition

Size of the practice

Condition of the local economy

Quality and nature of the book of business

Any synergies present


Growth Rate

The growth rate used in the capitalization rate formula refers to the assumption of growth in free cash flow in perpetuity – not 1 year, or 5 years, or 10 years, but forever!

From 1913: Average annual inflation rate is 3.7%


Growth Rate

The growth rate (perpetual) is subtracted from the rate of expected return to produce the Capitalization Rate.

Example: From an expected return of 30% (average) the growth rate of 5% (perpetual) is subtracted.

30% (Expected return)

- 5% (Perpetual growth rate)

= 25% (Capitalization Rate)

Fourth Piece: How Do I Transition?

Look Build

Value

Transition

Four Things the Seller Must Do

When Negotiating or Closing a Sale the Seller Must Do Four Things:

1. Negotiate the Definitive Purchase Agreement

2. Maintain Momentum

3. Maintain Control of the Process

4. Continue Managing and Growing the Business


Critical Factors : Terms of the Sale

1. Asset Purchase or Consulting Agreement


Asset Purchase vs. Consulting Purchase

Assets Consulting Agreement

Seller Capital gains Ordinary income

Buyer Amortize over 15 years Expense when incurred


Critical Factors : Terms of the Sale

1. Asset Purchase or Consulting Agreement

2. Non-compete Agreements

3. Buy/Back Provisions

4. Representation and Warranties

5. Earn-outs


Documents

Financial Advisors