Merger and acquisition (M&A) activity in the investment advisory space has been very active in recent years, and this, along with the increasing age of many firm founders, has prompted many owners to explore the potential sale or merger of their firms. Invariably, one of the first questions that comes to mind is “What price can I get when selling my practice?”
Unfortunately, there is no single, definitive answer to this question as the ultimate sale price depends on a variety of factors and often varies depending on who desires to purchase the firm. Nonetheless, sellers can position themselves to negotiate for purchase price terms that best suit their goals; provided that they possess information necessary to effectively negotiate such terms.
This article aims to arm investment advisers with some of the most important information they need in order to effectively negotiate the best purchase price terms for the sale of their businesses. Among other things, this article describes some of the most important factors that influence the valuation of an advisory firm, some of the most widely-used valuation metrics, and other deal terms that can influence the ultimate purchase price realized by sellers.
What Are Some of the Most Important Factors Utilized in Valuing Advisory Firms?
The valuation of investment adviser firms is influenced by a multitude of factors, both internal and external. These factors can significantly impact the purchase price in M&A transactions. Here are some key factors to consider:
• Assets Under Management (AUM). AUM is often a primary driver of valuation for investment adviser firms. The higher the AUM of a firm, the higher valuation the firm is likely to receive. This is generally because larger practices are seen as growing faster and easier to scale. Trends in AUM growth or decline, however, may also influence valuation of a firm. Sources of AUM growth may also influence valuation as AUM growth due to organic growth is more attractive than AUM growth due to enhanced market performance.
• Revenue Streams. The characteristics of revenue streams matters. Recurring revenue, such as management fees, is typically more highly valued than transactional or one-time revenue sources. Firms with a stable and predictable revenue stream are generally more attractive to buyers.
• Client Base. The composition and loyalty of the client base are crucial factors in firm valuation. The longer clients have been with the firm, the more valuable the firm is perceived to be. Firms with a concentrated client base where few clients generate the most revenues for the firm can depress the valuation of a firm. Other client characteristics that impact firm valuation include the average wealth, age, and income of a firm’s client base.
• Profitability. Although revenues are vital, expenses matter, too. Therefore, advisory firms that operate at higher operating margins tend to receive a higher valuation than other firms.
• Services. Firms that offer services that are in high demand or that are specialized can often realize a higher valuation, especially where an acquiror seeks to offer such specialized services and to cross-sell them to their existing clients.
• Regulatory History. Firms with a clean regulatory bill of health and record tend to be more valuable than other firms because of the perception of lower regulatory risk from acquiring such firms.
• Growth Prospects. The growth potential of the firm is a significant consideration. Factors such as the ability to expand into new markets, launch new products, or increase AUM can positively impact valuation.
• Technology and Infrastructure. Investment in technology and infrastructure can enhance a firm’s efficiency and competitiveness, positively influencing its value. A modernized technology stack can make the firm more attractive to acquirers.
• Attractive Location. Firms that have a physical presence in desirable locations can garner a higher valuation because of the opportunity for an acquiring firm to establish a physical footprint in such areas through acquisition.
• Brand and Reputation. A strong brand and a positive reputation in the industry can contribute to a higher valuation. Trust and credibility are crucial in the financial services industry.
• Economic and Market Conditions. External factors like economic conditions and market trends can affect the valuation of investment adviser firms, particularly since firm revenues are typically tied to a percentage of AUM. A favorable economic climate can result in higher valuations, while a downturn may lead to lower offers.
• Talented Personnel. Firms with employees with highly-demanded knowledge or skills can help increase the value of an advisory firm as long as the acquiring firm can convince such personnel to remain with the firm after the transaction.
Firm owners that understand these and other factors can position their firms to be most attractive to acquirors and to negotiate the best terms when selling the firm by emphasizing the most attractive features of the firm.
What Are the Most Widely-Used Metrics for Valuing Advisory Firms?
Once the factors that influence the valuation of the firm have been evaluated, parties typically must still determine how they will be applied in valuing the firm. When it comes to M&A transactions involving advisory firms, there are several popular metrics utilized in valuing firms (which are used to provide easy comparisons among different firms), and firm valuations are typically based on a multiple of such metrics based on the valuation factors highlighted above.
Below we will highlight some of the most widely-used metrics in valuing advisory firms including the use of gross revenues, earnings before interest, depreciation, taxes, and amortization (EBITDA), and earnings before owners compensation (EBOC) as well as the pros and cons of using each metric.
The first commonly used metric utilized is based on the gross revenues of the target firm. Valuation utilizing this metric (as well as the ones outlined below) is based on a multiple over a delineated time period (for example, two times gross revenues of the target firm over the preceding 12 months prior to closing). Gross revenues represent the total income generated
by the firm, reflecting its ability to attract and retain clients. Using this metric allows investors and buyers to assess the firm’s growth potential and market positioning. A multiple of gross revenues encapsulates all these income sources into a single, comprehensive valuation figure. Perhaps the most appealing reasons for using a multiple of gross revenues for valuing an advisory firm is that it provides a clear and transparent valuation methodology that is easy to understand for all parties involved, which can facilitate smoother negotiations. Nonetheless, there are numerous drawbacks of using a multiple of gross revenues to value an advisory firm. First, using gross revenues as a baseline for valuing a firm Ignores expenses and does not provide a view of the overall profitability of a firm. A firm with high gross revenues but low profitability may not be as valuable as the multiple suggests. Conversely, a highly profitable firm with lower revenues might be undervalued.
A second common metric utilized to value advisory firms is based on the earnings before interest, taxes, depreciation, and amortization of the target firm. There are several benefits of utilizing EBITDA as a baseline for valuing an advisory firm. First, EBITDA provides a straightforward and clear representation of a firm’s operating performance. It measures a firm’s earnings before considering the impact of interest, taxes, depreciation, and amortization, making it easier to understand and calculate. Second, EBITDA emphasizes profitability, which is a critical factor in assessing the financial health of any business, including investment advisory firms. It allows buyers and investors to gauge how well a firm generates earnings from its core operations. Third, EBITDA is often used as a proxy for cash flow, as it excludes non-cash expenses like depreciation and amortization. This makes it a useful metric for assessing a firm’s ability to generate cash for future growth and debt service. Fourth, EBITDA allows an acquiring firm to evaluate whether it can increase profitability of the practice being acquired by managing costs and scaling operations efficiently, which can be an attractive proposition for buyers and investors.
However, there are also several drawbacks of using EBITDA as a valuation metric. First, EBITDA excludes Interest and Taxes: EBITDA excludes interest and taxes, which are significant financial obligations for any business. Ignoring these expenses can result in an incomplete picture of a firm’s financial health and the potential impact on its cash flow. Second, EBITDA doesn’t consider capital expenditures (CAPEX), although many advisory firms may not have significant capital expenditures. Nonetheless, ignoring CAPEX can result in underestimating the funds needed for future investments and growth. Third, EBITDA can be manipulated by adjusting for various non-recurring or discretionary expenses, making it susceptible to abuse. Sellers might try to present an inflated EBITDA figure to make the firm appear more valuable than it actually is.
A third commonly-used metric is based on the earnings before owners compensation of the firm being acquired. EBOC represents the firm’s profitability before accounting for the owner’s compensation. This can be particularly useful when evaluating the core financial health of the business, as it separates the business’s success from the owner’s personal income.
EBOC can help investors and buyers assess the firm’s potential for growth. If a firm’s EBOC is strong, it indicates that there is room for the owner to take a larger share of profits in the future, making it an attractive investment opportunity. EBOC is relatively straightforward to calculate, making it accessible for smaller firms or individuals interested in evaluating investment advisory businesses without the need for extensive financial expertise. However, there are also some downsides to using EBOC. One of the most significant drawbacks of EBOC is that it doesn’t account for owner compensation. This means that the valuation may not accurately represent the true financial picture, as some owners may take significant compensation that could impact the firm’s overall value. Owner compensation can vary greatly from one firm to another, and even from year to year within the same firm. EBOC doesn’t consider this variability, which can lead to inaccuracies in the valuation. EBOC may overvalue firms in the growth stage where owners are intentionally reinvesting profits back into the business rather than taking significant compensation. In such cases, using EBOC alone may not reflect the true value of the firm.
Of course, all of the above metrics for valuing an investment advisory firm are all backward-looking and do not provide visibility into the future profitability of the firm being acquired. As such, some firms may choose to supplement these valuation metrics with a discounted cashflow model that incorporates various assumptions designed to project the future prospects for the practice being acquired.
A seller that understands the above metrics can choose the metric that helps put the firm’s best foot forward in order to realize the maximum value for the practice.
What Other Deal Terms Can Influence the Purchase Price for an Advisory Firm Being Merged or Acquired?
The purchase price for an advisory firm is not only based on firm-specific variables – it can also be based on the seller’s willingness to negotiate other terms related to the transaction. As the saying goes, “You tell me your price, and I’ll tell you the terms.” Sellers that are willing to make a portion of the purchase price contingent on satisfaction of future conditions or to extend payment of a portion of the purchase price well into the future may realize a higher price for their firms. Below we highlight some key terms that can impact the overall purchase price realized by the seller.
First, there are purchase price adjustments which can impact the overall purchase price eventually realized by the seller. The most popular purchase price adjustment used in investment adviser M&A transactions is based on client retention following the closing of the transaction. If the practice being acquired loses clients beyond an acceptable threshold, the purchase price may be adjusted downward. Purchase price adjustments help mitigate the risk for both the buyer and the seller. They ensure that the purchase price is fair and accurately reflects the practice’s financial health. A seller’s willingness to subject the overall purchase price to adjustments may realize a higher overall purchase price from the buyer.
A second term often found in M&A transactions is the “earn-out”. An earn-out is a contractual arrangement that allows the seller of an investment advisory practice to receive additional compensation based on the future performance of the practice. Earn-outs can be an attractive option when the seller and the buyer have differing expectations regarding the practice’s future prospects. The earn-out agreement specifies the performance metrics that will trigger additional payments. These metrics can include revenue targets, growth in assets under management, client retention rates, or profitability thresholds. The agreement also outlines when and how the earn-out payments will be made. Payments are typically structured over a specific period, often several years, and are contingent upon the practice meeting the predefined performance criteria. The amount of the earn-out is often expressed as a percentage of the additional revenue or profit generated above the baseline performance. Including an earn-out in the transaction can help the seller realize an overall purchase price for the transaction than it would otherwise receive absent such a provision.
Third, a seller may agree to deferral of a portion of the purchase price as part of a transaction. Sellers may realize a higher purchase price for the sale of their firms if they agree to defer payment of the purchase price into the future. Generally, sellers that agree to a lower upfront payment on the purchase price can expect to receive a higher overall purchase price. This makes sense given that buyers and sellers both realize the time value of money, and buyers can use the funds that would otherwise have been paid to the seller at closing to invest in the business and integration of the acquired practice.
While there is no single metric utilized for valuing an investment advisory practice given the innumerable factors and terms that influence the perception of value, sellers armed with the above information can, with the assistance of experienced legal counsel, position themselves to achieve the financial outcome that best suits their needs and goals.
What questions do you have about selling your advisory practice or buying an advisory practice? Please contact us and we can help you answer those questions.
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