To properly value your financial services practice, there are several key drivers that can deem your business profitable to potential acquirers. Service organizations can be difficult to value since much of the value is derived from intangible assets. An alternate valuation approach that can address specific retention and continuity issues could be the key to building a business with significant equity value.
What Determines Value?
In order to build equity value into your business, you first must understand what determines value and how it is calculated. A financial planning or investment advisory practice would be considered a professional practice for valuation purposes. Here are several characteristics that set a professional practice apart from other small businesses:
- A professional practice is a service business with few tangible assets.
- The professional develops a trusted relationship with clients.
- New clients are usually generated from referrals from existing clients.
- Professionals must meet regulatory, licensing, and education requirements.
- Majority of the value of the practice is tied to the professional and goodwill they create.
It’s also important to be aware of how value is calculated. Popular valuation methods include:
- Income method- Expected or projected future cash flow is discounted to present value at an appropriate rate of return for the investment an acquirer will make in the company.
- Market value method– Compares other market-based transactions involving companies that are similar to financial planning/investment advisory businesses, then adjusts for size and material factors that are dissimilar.
- Asset-based method- Restates the assets and liabilities of the business from historical cost (book value) to fair market value.
These traditional methods can sometimes fail to address continuity issues that make a business sustainable, thereby valuing the business too conservatively to ever affect a transaction. Valuation experts need to focus on the ability of a business to generate predictable cash flow and therefore, profit, which is dependent on recurring revenue streams and client and employee retention.
Recurring Revenue Streams
Recurring revenue is of much greater value than commission-based income. Potential business partners may evaluate recurring revenue in the form of advisory fees, planning fees, insurance renewals, mutual fund trails, group insurance, or group retirement plan fees/commissions. The aspects of valuation depend on the potential partner’s business model. For many financial planners, the greatest recurring revenue gain will likely come from converting to fee-based investment programs.
Looking at historical financial performance only gives potential partners a picture of the organization under the current owners and principals. The ultimate question any acquirer must answer is how much of the current revenue streams will remain post-transition. For your business to offer significant value, you have to ensure your clients are comfortable and confident that they will receive the same valuable advice and service after you’re gone and someone else takes over. As discussed in previous business-building articles, you have to institutionalize your business. Ensure that anyone in your organization can provide quality value-added advice because there are multiple parts to your business success equation.
When it comes to adding value to your business, retaining talented employees is also at the top of the list. You need to show prospective employees and current employees that you can help them achieve their goals and personal vision for their lives, just as you would look to establish for your own personal well-being. Develop incentive plans that will entice your employees to stay the course and push your business to further success. Profit and equity sharing is a good place to start, the sooner you implement this, the better.
The DFCF Valuation Approach
Let’s turn our attention to something you may not have heard of before, the DFCF valuation approach. At the moment, you may be scratching your head and asking yourself what exactly this valuation method means for you and your business. This approach represents discounted future cash flow, and has two potential advantages over traditional valuation methods: it focuses on key drivers of goodwill, and establishes an empirical method for arriving at fair value for buyer and seller.
Drivers of Goodwill include:
- Expected future revenue
- Historical revenues, expenses, profits, and cash flow
- Quality of balance sheet
- Types of revenue streams
- Level of competition in area
- Employment agreement
Some Items a Valuation Model Must Quantify are:
- What services are being provided?
- How well are these services being delivered?
- What are the demographics of the client base?
- How are new clients gathered?
- What are total recurring revenue sources?
- Are their standard operating procedures in writing?
For a full list of goodwill drivers and valuation model components, check out Building a World-Class Financial Services Business by Don Schreiber, Jr.
Generating predictable cash flow to produce recurring revenue, institutionalizing your business, and attracting and tying key employees to your company are ways to add value to your business. It doesn’t matter how small or large your firm is, your value will reflect your actions. The ultimate goal to attract buyers is to make your business profitable, sustainable, and scalable.
Past performance does not guarantee future results. The views presented are those of Don Schreiber, Jr., and should not be construed as investment advice or trade recommendations.