Valuating Your Practice: 2 Costly Mistakes To Avoid

Roughly 37% of financial advisors in the U.S. are expected to retire before this decade is over, according to a Cerulli Associates report. This will account for $7.76 trillion, or 39% of all assets managed by the nation’s financial advisors.

With the industry’s own retirement crisis mounting, the COVID-19 pandemic is pushing advisors to think more urgently about the value of their practices in preparation for an accelerated exit.

This creates an acquisitions atmosphere ripe for mistakes and rushed judgments on both the buy and the sell sides of the equation. Sellers, however, have the most to lose during this frenzy, as their own retirement dreams and legacies are at least partially hinged on a successful sale — and that requires a proper valuation.

To find the value of your practice, it’s important to perform a business valuation that will determine its realistic worth and potential for growth. During this process, be sure to avoid these common, costly mistakes that can create a flawed valuation and derail potential deals.

Mistake #1: Neglecting value-creating factors

First, identify the factors that create value. For example, consider your practice’s position in the marketplace. What is your client base? Where do your new clients come from? Do you have a process that ensures regular meetings with potential clients?

Also consider geography. Does your practice dominate a neighborhood? How about a specific social stratum of a town or city? Are clients predominantly in a certain profession?

Never forget about referrals. Is there a business process that keeps a steady stream of referrals walking through the door?

Next, find the benchmark valuations for each piece of the business that adds value. For example, the industry-accepted benchmark for recurring revenue from advisor fees is 2 to 2.5 times annual income. If your business makes $200,000 in recurring fees annually, this part of the business can be fairly valued at somewhere between $400,000 and $500,000.

Commission income that does not recur has a lower valuation. It is still valuable to the buyer if the business has processes to ensure that opportunities for additional commissioned sales persist. This can be achieved through a referral network, name recognition, an advertising process, a location or a business partnership.

The industry-accepted benchmark is 0.75 to 1 times annual revenue. The more certainty that commission sales revenues will continue, the higher this valuation can be. A business that relies on cold calling and has fluctuating sales has low reliability; therefore, a valuation under 1 times is reasonable. A business with a consistent process for maintaining a referral network deserves a 1 times valuation.

With that said, valuing a business is sometimes more art than science. No two businesses are the same. The previous questions and benchmark valuations provide examples but are far from exhaustive.

Mistake #2: Instigating a valuation gap

Valuation gaps are the No. 1 reason that practice transactions fail to close. A valuation gap opens when the seller believes the business is worth more than the market is willing to pay.

Sometimes this occurs because the market has changed since the seller calculated the value. In other cases, the seller remains unaware of the valuation gap until confronted with it during the sales process. Often sellers are too optimistic, believing that because they worked hard to build their book of business, it should have a higher value. This is irrelevant from the buyer’s perspective, and because the buyer may change processes, the business may be worth less to them.

To avoid the valuation gap, ensure that benchmark valuations are realistic. With a rapidly changing market and so many industry variables at play, it is essential to reevaluate every year so the valuation is up to date. Also, understand that the value is based on what buyers will pay. Even though you may have put your blood, sweat and tears into developing the business, you must remain objective.

Buyers want to invest in a robust practice and an incoming client base that can continue generating powerhouse profits despite the key player, the seller, exiting the business. Many of these practices run on the sole proprietor model, where the owner’s efforts, personality and vision are the main drivers of success. These practices are worth less than those with established processes that are easily transferable to the new owner. For example, valuations can increase when there is a robust email marketing list proven to drive crowds of potential clients to seminars and similar prospecting events.

Building a financial advisory practice is a lucrative and rewarding endeavor. It’s a privilege to help people achieve their financial goals while reaching yours at the same time.

However, in all careers, there comes a time to retire or move into a new sphere. Selling the business for the valuation it warrants takes planning, the same kind of planning that goes into allocating an investment portfolio. By learning to value your business correctly and repeating the process annually until the inevitable sale, you’ll be more confident and at peace when the time comes. The key is understanding benchmark valuations, being realistic and sustaining transferrable business processes that make buyers willing to pay more.

Mike Walters is the CEO of USA Financial. He is also the host of Advisor Skinny, an original podcast for financial advisors aimed at helping them enhance the enterprise value of their firm. Mike may be contacted at [email protected].