Four Ways to Increase Your Firm’s Value

As the independent wealth management industry sees further consolidation, sources of capital will continue to transform to meet the needs of the evolving advisory firm. Investors may include individuals, lenders, acquiring firms, private equity firms and other institutions. Although these investors look at wealth management firms through varying lenses, they determine enterprise value similarly. Knowing how investors calculate value can help you choose the most productive strategies for managing your firm. Here are four ways that you can increase your firm’s value, while making it more attractive to potential investors.

 

1. Know your ratios.

When analyzing and valuing a business based on cash flow or goodwill, there are several ways stakeholders will make decisions around value and their ability to provide capital. For instance, valuation companies will use multiple avenues to come up with a value—they will look at multiples of earnings, the market value of comparable firms and a discounted cash flow analysis, to name a few. But there are several other numbers investors and lenders look at as well.

In addition to looking at the value of the firm, lenders will want to understand a business’s ability to repay a loan. This is often called the debt service coverage ratio or cash flow coverage ratio. The debt service coverage ratio measures a firm’s cash flow and compares it to the principal and interest payments of the note, plus a buffer (annual cash flow/annual debt service). Most lenders calculate this ratio on a historical basis, but they will also consider projections to see how a firm expects to perform in the future. Private equity firms, in contrast, will often look at a firm’s historical and projected return on investment and will focus on its prospects for growth to determine whether there is value in investing in or purchasing the business. This means there will be a focus on revenue and earnings growth and whether certain investments can bring economies of scale to the business. If the investment provides capital for the purpose of an acquisition, both lenders and other providers of capital will take into consideration the future economies of scale that the acquisition brings.

Other ratios that lenders will consider include leverage ratios, such as funded debt to EBITDA or funded debt to revenue, the net worth of the business and the owners’ personal debt to income ratios (if they require a personal guarantee). These are good indications of whether the business has too much debt relative to its size and profitability. Taking on too much debt in a short period of time will hurt these ratios and is a red flag that the business could be over-leveraged.

Improvements to the ratios that signal a firm’s profitability could have the best short-term impact on the value of the business. These include profit margin (net income/revenue) and operating profit margin (revenues minus operating expenses other than taxes and interest as a percentage of total revenues). Some of the largest expenses in most advisory firms are occupancy costs (rent) and salaries. By reducing some of these key expenses, businesses become more efficient (assuming the reduction does not have a negative impact on sales), which will improve both the profit margin and the operating profit. Revenue growth is typically characteristic of a healthy growing business but does not stand alone. Watch your profit margin — if it shrinks at a faster pace than the business grows, lenders and investors may see that as a warning about the ability of the business to repay a loan. Make sure your investment in growth is paying off!

Several ongoing benchmarking studies allow advisors to compare their growth and expense ratios to those of their peers. Your broker-dealer or custodian may offer one. If not, Investment News publishes the “Adviser Compensation & Staffing Study” every other year. It’s a valuable investment if you want to see how your firm stacks up.

 

2. Revenue should be predictable and sustainable.

An advisory firm’s value, in most circumstances, is based on intangibles; they do not own many physical assets, such as inventory or factories, that can be used as collateral to secure a loan. Without tangible collateral, lenders and other investors must rely on the cash flow of the business for repayment. For that reason, they will seek out businesses with predictable cash flow. Predictability typically comes in the form of recurring revenue, especially fee- based business. As a result, valuation companies will assign higher multiples to businesses with higher percentages of recurring revenue. What’s more, lenders will typically discount revenue that is not recurring, since additional sales from new or existing clients will be required to remain at the same revenue level.

Sustainability, on the other hand, is more evident in firms with favorable client demographics and strong management. Stakeholders will analyze such client demographics as the average age of the client base, net new asset growth and average revenue per client. They’ll also look at client concentration—that is, whether a small group of clients makes up a large percentage of revenue. Some lenders, for example, will consider it a red flag if the top three clients make up more than 20 percent of the firm’s revenue. In addition, stakeholders will want to know what is the firm’s strategy for communicating with the next generation of clients (sons and daughters of current clients), and how many of them are currently using the firm. Strong metrics in these areas give investors’ confidence in a practice’s long-term sustainability and give buyers confidence that they are not purchasing a business that will start to de-cumulate assets soon. Setting up a firm to be multigenerational, meaning there is a written succession plan in place and a strong management team to implement it, is also a good indicator of sustainability.

 

3. Have a strong executive team.

One aspect of enterprise value that is often overlooked—but is very important to lenders and valuation companies—is the notion of transferability. Transferability is important for a firm’s ability to thrive beyond the current generation of owners. People and processes must be set up to last. For potential buyers, a firm is much more transferable with the existence of a strong executive team and a written succession plan for the C-suite. Think about it: If you were a potential acquirer, would you rather purchase a business with clients who interact with one key owner—who will most likely retire shortly after the acquisition—or with a team that will remain part of the firm after the transition? The inherent risk in the former is much higher and is one of the first characteristics lenders or investors will explore. While there are ways to structure around this (which we will discuss as well), having a team that’s well equipped to manage the client experience and ultimately the transition will increase the market value of the firm.

A strong executive team will help the firm long before you start to think about selling. For many firms, there is a tipping point when the current owners, who are also the rainmakers, cannot manage client relationships, run the day-to-day operations of the business and continue to bring in new clients. Having an executive team that has experience, specifically a COO, will allow the advisors who are driving revenue to continue to focus on engaging new clients. The COO can focus on day-to-day operations, human resources and creating processes that will make the firm more efficient. If the firm is looking to acquire other firms, this will also add capacity and won’t put the current client experience at risk.

Another valuable member of an executive team is an in-house compliance expert. Once you’ve grown sufficient scale to support the role, a full-time compliance officer is a good investment in the future of your firm. You will have a professional at hand who is intimately involved in keeping your practice above reproach, which adds to your firm’s general ability to attract capital—or, at the least, not to repel it.

 

4. Structure transactions properly.

It is rare to see a company sell for the same amount as its valuation. There are as many structures as there are deals out there, and the structure determines the price as much as the value. The valuation is a great place to start; however, the terms of the deal will affect the risk profile for both buyer and seller, which will, in turn, affect the purchase price. Have you ever heard the phrase, “you name the price, and I’ll name the terms?” Consider it your new Golden Rule.

When advisory firms are sold, buyers typically pay a down payment to the seller, followed by subsequent payments over time (usually in the form of a seller-held note or an escrow agreement). The subsequent payments are often subject to a claw-back provision, that is, an adjustment to the purchase price if assets do not stay with the firm. If the down payment is on the lower side, making most of the purchase price contingent on performance through the transition, the seller is taking on the preponderance of risk and may command a premium price for the business. A larger down payment means the seller is monetizing more on the front-end, shifting the risk to the buyer. That, in turn, will call for a discount on the purchase price. Transactions on either side of the spectrum can command premiums or discounts as large as 20 percent. Depending on the risks associated with the transaction, an outside investor or financier may want more of the transaction to be contingent because that protects the buyer.

Other points of negotiation that should be brought to the forefront of conversations are seller transition, consulting or employment agreements, referral agreements and contracts for key employees. Keeping the seller engaged through additional compensation beyond the price of the business is good for the transition, but it changes the economics of the transaction and will be an additional expense that lenders will consider. It is not uncommon to have an employment/compensation agreement for the seller while they are transitioning, but for longer transitions, cash flow coverage ratios can get tight if both new owners and sellers have to be compensated for a longer period of time.

 

At Live Oak Bank, we make a point in helping business owners understand how to position their firms for growth and enhance their value. If you have questions or concerns about building your business or want to learn more about your firm’s potential access to capital, talk to us. Our dedicated investment advisory lending team understands your business.