VALUING A FINANCIAL PLANNING PRACTICE

The Dover team spends a large part of its day liaising with accountants and financial planning practices and this gives us insight into how they can improve their financial performance and how their practices are valued.

On 26 April 2010 Mr Christopher Bowen, the Minister for Financial Services, Superannuation and Corporate Law released the “Future of Financial Advice” paper setting out the government’s views on necessary reforms. First and foremost was the announcement that commissions and similar volume based payments would be banned on all retail investment products including managed investments, superannuation and margin loans from 1 July 2012.

This move against commissions is partly driven by the union movement and is now supported by industry organisations such as the FPA and various large institutions.

Financial planning practice values are a function of their expected future income. If expected future income, such as commission income, drops, so will practice values. This means financial planners need to act before 1 July 2012 to introduce compensatory income streams to maintain or hopefully increase the market value of their practices under the new no commissions regime.

The big drop in the worldwide share markets during and since the GFC has depressed financial planning practice valuations even further: if FUM falls, so does everything else, including practice values.

Dover sees this is the big issue for all financial planners as 1 July 2012 approaches, and we are working with our representatives to help them maintain and increase the value of their practices over the next few years.

Who is buying financial planning practices?

Most sales are to other financial planning practices. There is little happening on the institutional front although many firms are still able to rely on “buyer of last resort” clauses in their representative contracts.

The sale price if often deferred in whole or part, and this reduces the need for external borrowings and makes it easier to get the desired price. Some of the major banks will proceed with practice acquisition loans on cash flow lending only basis but the reality is finance is easier and cheaper if its secured by property.

The market is in risky state at the moment: some would be sellers are presenting their practices for sale highlighting their historical commission income and keeping their fingers crossed that the purchaser will not mark that income down post 1 July 2012. The ruse is generally not working and most sales are being frustrated by the uncertainty in forecasting future maintainable earnings after 1 July 2012.

How are practices valued?

There are two main ways of valuing a financial planning practice. These are:

the “multiple of gross earnings” method; and
the “multiple of net earnings” method, commonly measured by “earnings before interest and taxation” or EBIT.

Discounted cash flow valuation techniques may be used to support these main valuation methodologies.

Funds under management, or FUM, methodologies are often used to double check the results of the main valuation methodologies, although for obvious reasons the importance of FUM is now very much down-graded. In a 2006 paper titled "Valuing Professional Practices" prepared for the Institute of Chartered Accountants in Australia, Mr Bill Jansen, a former partner with Ernst & Young observed:

"The values of FUA businesses which changed hands in the Australian Market between 1999 to date have ranged from 1.8% of FUA to a high of 5.8% with an average of 3.3% over 15 acquisitions. Values have comes down to the lower end of this range in the last 2 to 3 years with the majority currently falling in the range of 2% to 4% for larger transactions. "Bolt on" smaller transactions where FUA is in the range $30-$100 million have yielded values from 1% to 2% of FUA. However, this "rule of thumb" approach should only be used as a crosscheck after undertaking the traditional EBIT/EBITDA valuation approaches." (emphasis added)

The multiple of gross earnings method

The “multiple of gross earnings” method was common up to a few years ago, but is usually only seen these days in institutional purchases. This is because it ignores costs, which does not make much sense if you continue to run the business on a stand-alone basis, but may make sense if the business is to be integrated into an existing business, or if the income stream does not create much in the way of extra costs, such as a secure portfolio of trailer or service commissions.

The multiple of gross earnings method usually deployed a multiple of between 2 and 3. So, a practice with gross earnings of say $1,000,000 may have been valued at somewhere between $2,000,000 and $3,000,000. The selection of the final multiple ultimate reflects the valuer’s assessment of risk, and this is connected to the specific circumstances of each sale. These specific circumstances are discussed further below.

We do not expect to see any sales on this basis going forward, due to the obvious concerns about the certainty of commission income after 1 July 2012.

The multiple of net earnings method

The multiple of net earnings method is the more common method. It involves the purchaser measuring the expected future maintainable earnings of the practice, adjusted for costs connected to the owners, and adjusted for interest and tax, and then applying a multiple to estimate the value of the practice.

The multiple reflects the valuer’s estimate of risk, and the higher the multiple the lower the valuer’s estimate of risk.

The multiple of net earnings method usually deploys a multiple of between 2 and 5. So a practice with an EBIT of say $500,000 will be worth between $1,000,000 and $2,500,000.

Hybrid models

In some cases the actual valuation may comprise a hybrid of these two measures. For example, a firm buying another firm on a high multiple under the multiple of net earnings approach, with a view to tucking it in to its existing practice and eliminating many of the costs, may be influenced by the multiple of gross earnings model, with this influence manifesting in a higher than usual multiple, say 3.5 rather than 3.

The buyer is prepared to pay more than someone else because they will not experience the same costs once the sale is completed. The final price is a more a negotiated figure than the product of a disciplined valuation model, achieving market value in the sense of the price the proverbial "willing but not anxious" buyer and seller would agree on.

What trends can be discerned?

With commissions starting to disappear from 1 July 2012 on, it is clear than FUM based models will become less relevant, and that commission income streams have to be seriously discounted in every valuation model. We think you will see financial planning practices valued more and more like accounting practices, under the net earnings model, and with some smaller practices changing hands on a "cents in the dollar" basis (of up to 80 cents in the dollar) assuming they can be successfully belted on to an existing practice without significant extra overheads.

Recurring fees for advice from committed long term clients, plus commissions on insurance products, will drive practice values.

The multiple will be between 2.5 and 5 times, and future maintainable earnings will be adjusted for notional owner salaries of at least $150,000 a year, of not $200,000 a year.

Practices which do not plan for the new no commission regime could see their value fall significantly, if not disappear altogether.

Which valuation model is best?

The multiple of net of earnings method is more sensible from a practice valuation model. Particularly if supported by a basic discounted cash flow valuation model. However, the multiple of gross earnings method has its supporters. But ultimately costs are real and have to be considered closely and any method which ignores costs, such as the multiple of gross earnings method, is fundamentally flawed and if followed slavishly will lead to incorrect decisions.

As indicated above, the multiple of net earnings method will become more dominant as commissions disappear from the financial planning landscape and practice are valued more like other professional service firms, particularly accounting firms.

What are “specific circumstances”?

Wayne Lonergan in his landmark book “The Valuation of Businesses, Shares and Other Equity” explains (at page 443) that “the valuation of a professional practice ... is a function of its free cash flows and the risk of achieving those free cash flows”. We observe that calculating free cash flow, or the practice’s EBIT, is science, not art, and most accountants will eventually come to (pretty much) the same conclusion (assuming they are being objective and not pushing their clients’ barrow). But assessing risk, ie determining the appropriate multiple, is art, not science, and is inherently subjective and often not able to be explained or articulated completely. Risk is very much in the eyes of the beholder and two valuers can come to completely different conclusions about risk, and hence what multiple should be used, and both may be right.

Lonergan further explains, in the context of accounting and legal firms, that to identify risks associated with a practice you need to consider:

• the nature of the practice, specialised or general, and its client base;
• the age and influence of the partners;
• the tangible asset level and the level of debt;
• leasing commitments, including, in particular, the terms of the premises lease;
• the level of fixed costs and the break even level of income;
• the expected growth in expenses and outgoings compared with anticipated income growth and margins;
• any particular strengths or weaknesses in the practice;
• staff loyalty, retention rates and skills;
• changes in dynamics of the market (for example here changes in the rules for commissions after 30 June 2012);
• the level of investment in technology, training and research and development;
• the business name and client list;
• location and whether there is any site goodwill.

As a general proposition the larger the practice, the more diversified its income stream and the less reliant it is on one key individual the higher the multiple.

Examples of valuation calculations

Examples are dangerous, but may help give you a feel for the current state of the market:

A practice with only one fee earner, aged 61, a relatively low gross income (say $500,000 a year) a relatively low net income, say $150,000 a year (allow $100,000 for the owners’ salaries), an ageing and therefore dwindling client base, a heavy reliance on FUM and no new services in the pipeline, is likely to be valued on a low multiple (probably by everyone except the owner!), of 2, or even less, say 1.5.

This equates to a value of $75,000.

On the other hand, a 1/3 interest in a three fee earner partnership, with a high gross income (say $3,000,000 a year, a high net income, say $500,000 a year per partners, a young and growing client base, a low reliance on FUM and a history of new services being successfully introduced is likely to be valued on a high multiple (probably by everyone except the purchaser!) of 3, 4 or even 5 depending on the circumstances.

This equates to a value of $1,200,000 on a multiple of 3 [ie ($500,000 less $100,000) times 3].

In both examples the key variable is the perceived certainty of the expected future cash flow, and the size of that cash flow, this is inherently connected to client transition, and the first example has low client transition prospects because of the strong personal connection with the owner. Buyers are more and more paying attention to the perceived certainty of the future cash flow, and this is the key focus in all due diligence exercises.

Generally the more the seller can reassure the buyer, even demonstrate to the buyer, that he or she will get what she pays for, the easier the sale. The successful transfer of the client relationships, in all or part, to the new owner is the key. Paying attention to this key requirement often means the price part of the transaction takes care of itself. It’s better to buy a good business at a good price, than it is to buy a poor business at a good price. Both parties focussing on the buyer getting a good business at a good price is the best way to make sure the sale is completed satisfactorily for all concerned.

Part interest in practices

Part interests in practices are interesting propositions. Generally they work out well, provided client relations are maintained and the on-going owners are happy with the purchaser.

A buyer gives up control and autonomy, and needs the protection of a co-ownership agreement (and must be sure there is good faith and confidence amongst all concerned), but the continuum created by only a fractional interest changing hands and the certainty of having the other owners on deck, business as usual, may more than compensate for this lack of control and autonomy.

The essential goal of a successful client transition (ie lower, or no, client attrition) will be easier to achieve in a sale of a part interest in a practice.

Choice of platform

The popular platforms will have some effect on practice values. The more popular and widely used your platform the easier it will be to transfer FUM to the buyer.

It’s not a deal breaker but a common platform certainly expedites the sale process and helps achieve cost advantages in a bolt on acquisition process.

The due diligence process

“Due diligence” is not a defined term but generally describes the process in which a potential buyer evaluates the financial position of a business before it is sold. Increasingly the process includes confirmation of compliance with relevant regulatory rules, including town planning, leases/occupancy, human resources, taxation and ASIC/Corporations Law.

Unfortunately you cannot believe everything you are told, or shown, about a business for sale. Every sale must be approached with a healthy scepticism, and a preparedness to be surprised.

In some cases there is little need for extensive due diligence. For example, the buyer may have worked in the practice as an employee for five years, know and trust the owners, and only be buying a part interest, with the vendors staying on as co-owners for many years to come. Here, basic checks and investigations are needed, but there is no need for significant external audit style investigations.

In other cases it’s not so simple. The bigger the transaction, the less the continuing relationship with the seller and/or ongoing owners, and the less the prior knowledge of the practice, the greater the need for extensive verification of information. And the greater the likelihood this should be done by someone else, so you get an independent assessment of the business you are buying.

A good rule of thumb: ask for everything, and if the practice is not an open book, and something is being withheld, stop there and buy something else. A lack of preparedness to let you see everything is a sure sign something is wrong. And as we always say “no deal is better than a bad deal”. There can be a psychological urge to complete a deal once you have started the buy process. Fight this and be prepared to walk away at any time if your intuition tells you something is not right.

Due diligence should always cover ASIC audit issues, complaints to the Financial Services Ombudsman and similar forums. On the positive side, good systems, good software and good ASIC compliance track record will improve the practice’s valuation multiple.

The content of FUM needs to be considered. Agri-products are particularly problematic, and may also indicate an unhappy client base.

Restrictive covenants

Restrictive covenants are contractual clauses that reduce or limit the ability of the seller to offer similar services within a specified area for a specified period of time after the sale is completed.

Restrictive covenants may in extreme cases be unenforceable as a restraint of trade.

But in most cases they will be enforceable, unless it is not in the public interest to enforce the clause, or the clause is unreasonable in terms of time or geographic area. An unreasonable restrictive covenant may be read down to give it a legal effect, for example, a court may hold that a clause seeking to stop you practising as a financial planner in NSW and Victoria for five years may be read down to mean not practise with the same clients, or in the same local area, for three years.

Restrictive covenants are necessary to give commercial efficacy to sale of practice agreements.

There is no goodwill without a restrictive covenant.

Retention clauses

Most sales will have most of the sale price paid up front, with the balance, say 20%, deferred by between 12 and 24 months and depending on client retention and certain other key indicators. In recent times the deferred amount and the deferment period have increased, reflecting changing market conditions.

Agreeing to a retention clause may help achieve a better price, by displaying your confidence in your practice and your preparedness to work towards a 100% client transfer and no client attrition, ie the outcome best for both the buyer and the seller.

Capital gains tax issues

Capital gains tax on the sale of goodwill and other active assets is an area where specific legal advise from an experienced solicitor is needed before any conclusions are reached. However, in summary, the government generally encourages and supports small and medium sized business by allowing a number of small business CGT concessions and in most cases these concessions will apply to leave any capital gain on the sale of a practice as a tax free capital receipt.

These small business concessions include:

• the small business 15 year exemption;
• the small business 50% active asset reduction;
• the small business retirement exemption; and
• the small business rollover exemption.

You can read more about these concessions at www.ato.gov.au and ATO Small Business Concessions. We stress that expert written legal advice should be sought before applying any of these concessions.

For example, John, who has net assets excluding his home of $2,000,000, sold his financial planning practice for a capital gain of $1,000,000. The practice was owned by his family trust, and started ten years earlier.

The tax treatment of the $1,000,000 capital gain is as follows:

Capital gain                     $1,000,000
Less 50% discount       $   500,000
                                                                  $ 500,000
Less Active Asset discount    $ 250,000
                                                                  $ 250,000
Rolled over to SMSF                             $ 250,000
Taxable amount Nil

In other words, provided John pays $250,000 to his SMSF before he lodges the tax return for the year of the sale, he does not pay tax on the $1,000,000 capital gain.

The need to plan your sale

It’s hard to believe, but it has been estimated that as many as four out of five financial planning practices do not have a succession plan.

You should regard your business as always being for sale, and always make sure your decisions maximise its saleability. This will maximise maintainable future profits and cash flow and create the best possible outcome, even if you never sell.

Your practice’s business plan should include a valuation model, and some comment and thought on when, how and to whom all or part of your practice will be sold, and for how much. Internal sales can work very well. Recruit and mentor a stable of younger advisers, on the understanding that all or part of the practice will pass to them as certain key milestones are achieved. This motivates and rewards them for building up the practice for you.

Selling your practice as a business that has been structured to suit a walk in walk out sale, with 100% successful transition of clients, and hence value, will be much better than a cats and dogs style sale of a client list.

Mergers

Here the concept of culture fit is paramount.

Mergers can be great. Two firms combine with unnecessary costs eliminated and possibly higher revenue achieved by cross-selling and achieving better compensation deals. Higher profits and higher valuation multiple values, from greater size and diversity mean much higher practice values. Everyone wins.

Two separate business may each make $500,000 a year, and be valued on a multiple of 2.

Put them together and total profit jumps to $1,200,000, and the multiple jumps to 3.

So separate, they are valued at $2,000,000. But together they are valued at $3,600,000.

Each firm has increased in value by $800,000 CGT free just by merging.

The theory is simple and excellent. But take great care because it all depends on the culture fit.

You have to do more than just get on over a few meetings. You have to be able to work together through thick and thin and conceptually put each other’s interests ahead of your own. Systems and procedures have to fit, but more importantly philosophy and culture need to combine and even complement each other.

It’s all in the execution.