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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
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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?
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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
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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
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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
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Questions to Ask
1. Why do I want to sell?
2. What is being sold?
A book of business
Future earnings and cash flow
The practice identity
Tangible assets
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Questions to Ask
1. Why do I want to sell?
2. What is being sold?
3. Who might be interested in purchasing?
Another financial advisor
An associate
Someone you share office space with
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Questions to Ask
1. Why do I want to sell?
2. What is being sold?
3. Who might be interested in purchasing?
4. How long will the process take?
Taking more time can increase value
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Two Critical Elements
1. Is there fair compensation for labor?
2. Is there fair reward for ownership?
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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
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First Piece: The Buyer’s View
1. Why are they buying?
2. What are they buying?
A book of business
Future earnings and distributions
Market share and/or position
Existing staff
Assets
Unique processes
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First Piece: The Buyer’s View
1. Why are they buying?
2. What are they buying?
3. Is this a right fit?
Where is its life cycle?
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First Piece: The Buyer’s View
1. Why are they buying?
2. What are they buying?
3. Is this a right fit?
Where is its life cycle?
Does it compliment my existing practice?
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First Piece: The Buyer’s View
1. Why are they buying?
2. What are they buying?
3. Is this a right fit?
4. Can I manage a larger practice?
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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
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Second Piece: How do I Create Value?
Look Build
Key Elements of a Transferable Practice
1.Customer Succession
2. Management Succession
3. Ownership Succession
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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.
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Customer Succession
1.Build experienced continuity Team based client relationships
Client-focused practice
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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?
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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.
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Management Succession
Design the Right Organization
Which organization
creates the most value?
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Management Succession
The SOLO Practice
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Management Succession
The ENSEMBLE Practice
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Management Succession
The LEVERAGED Practice
Assoc. Assoc.
Assoc.
Assoc. Assoc.
Assoc.
Lead Advisor
Lead Advisor
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Management Succession
The Median Income Per Owner
$384,900
$762,287
$-
$250,000
$500,000
$750,000
$1,000,000
Solos Ensembles
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Management Succession
Build the Right Team
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Management Succession
Above the line issues: Demonstrated Knowledge
Demonstrated Skills
Demonstrated Abilities
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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
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Ownership Succession
Done correctly …
Clients are cared for
Goals are realize
Value is achieved
Successor is in place
Timing is on your terms
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Third Piece: How Is Value Determined?
Look Build
Value
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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.
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“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
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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.
Special Industry Approach
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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.
Special Industry Approach
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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.
Special Industry Approach
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Valuation Approaches
Asset-Based Approach
Income Approach
Market Approach
Asset Approach: Book Value
Assets- Liabilities
VALUE
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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
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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.
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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
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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)
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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
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Adjusted Free Cash Flow
As a guideline, overhead expenses should rarely exceed 40% of practice revenue, and preferably considerably less.
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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)
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Determining a Capitalization Rate
Divide – One year adjusted cash flow by the Capitalization rate.
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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
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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%
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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
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Critical Factors : Terms of the Sale
1. Asset Purchase or Consulting Agreement
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Asset Purchase vs. Consulting Purchase
Assets Consulting Agreement
Seller Capital gains Ordinary income
Buyer Amortize over 15 years Expense when incurred
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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
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