Should I stay or should I go – more on succession planning and selling your practice

Information about selling an advisory or broker business is surprisingly difficult to find in the South African market. Buyers are rife, but sellers are not keen to openly announce their intentions.

There are quite a few obvious reasons for that but this makes life difficult for those who are keen to buy. Regulatory changes also steer a few brokers and advisers in a direction where they either want to merge, become tied or bank brokers or just get out of the industry after they have built their businesses over many years. So what is the first step and how much is your practice really worth?

FAnews asked a few industry experts some relevant questions in this regard so that we can get the conversation around this topic going.

Succession planning has not always been top priority; but to be without one is not an option anymore. What do we see in practice lately?

ALEX COOK - The Financial Services Board (FSB) (through RDR) and external compliance officers are starting to become more insistent on there being an executable succession plan in place in order to protect the client base. Whilst we find that most still do not have an executable plan, the hunt for viable solutions is increasing.

DANNY JOFFE - Corporate brokers and larger independents have larger staff compliments and larger skills bases so they are far more geared to have succession plans in place. The smaller owner managed brokerages are very reliant on the top management of the company for all activities performed and have almost no succession plans in place should those owner managers ever decide to leave the business or take more of a back seat.

PAUL KRUGER - It forms part of the annual FSB FAIS report, so those not complying are playing Russian Roulette. Treating Customers Fairly (TCF), as the foundation on which all future market conduct regulation will be built, adds another dimension to this requirement.

What is the most important part of a succession plan?

ALEX COOK - The three parties in a succession plan is the existing adviser, the potential successor and, most importantly, the client. All three have the same goal, which is to ensure that the client receives the same (or an improved) level of service. In so doing, both the existing adviser and the potential adviser will also achieve their business goals. The existing adviser will obviously maximise the business’s value, while the potential adviser will be purchasing a solid foundation on which to build. As always, agreeing on the appropriate sale price of the business will be difficult.

As a rule of thumb, businesses with established annuity revenue and strong existing relationships in place could expect to negotiate a price in the region of ten times their annual revenue. These businesses would typically be in the investment, medical, employee benefit and short-term sectors.

The picture is somewhat different for those companies that rely on large initial fees from life insurers. These could be considered as two year loans because if the client cancels during that period, the adviser’s fee would be clawed back by the insurer. Life is thus a more risky type of business, and crafting a succession plan that works for all parties is harder. The potential successor needs a large force of hungry wealth managers who are motivated to develop long-term relationships with clients in order to develop a stream of annuity revenue from the existing clients.

DANNY JOFFE - The main issue around succession planning in the short-term industry is having skilled experienced individuals willing to step into the shoes of the previous leadership of the brokerage once that leadership exits the business. The new leadership must be skilled to manage the company strategically as well as run the important client accounts from a FAIS and relationship perspective.

PAUL KRUGER - Succession planning is all about the client, not the adviser. It seeks to ensure service continuity in case the adviser dies, becomes seriously ill or wants to sell his business, so the nature of the business does not really matter.

The decision has been made to sell. Which methods are used to value a business?

ALEX COOK - With RDR and the increased cost of being in business, the frequency of outright sales or exits is increasing. These are often the most successful successions as the existing adviser is in a position to be involved for a period of time making the transition smooth and maximising client retention. The higher the client retention, the higher the eventual price the business will realise.

There are a number of ways to value a business, some of them include:

• A payment equivalent to a multiple of the annual revenue. This would usually be in the order of 1.5 to 3 times, and only annuity revenue would be used in the calculation. The payment is usually staggered over a period of time. The capital raised would not generate enough income to replace the income generated by the business.
• Larger, more-developed businesses could be valued using a true price-to-earnings multiple, which looks at the true profitability of the business after all expenses. Importantly one of these expenses includes the revenue paid to the actual adviser.
• A percentage of assets under advice, where the purchaser takes into account the assets on which the current adviser is advising, and multiplies those assets by a percentage to arrive at a value.
• Future annuity income in order to provide the seller with annuity revenue for life. The concept is that the seller participates actively in the transition to ensure that client retention is maximised. Typically, this sort of annuity works out to around ten times the annual revenue. The big advantage is that the seller can replace the income he or she used to get while being an independent, something that is not possible when using the other methods.

DANNY JOFFE - Currently the value is calculated based on a multiple of annual income of the brokerage being fees and commission. The multiple varies on the growth of the business as well as success. If the owners value it highly, they will use a higher multiple. As stated above there will be a price adjustment based on the number of clients committed and the number of clients that are still there after a full year. This is to make sure the old owner works hard in that year to make sure the business remains and that the value is fair.

PAUL KRUGER - There is a number of calculations. Usually the retention of business will determine the real value of the business. Where there is a high lapse/turnover rate, one would not be prepared to spend too much money on shaky business. Short-term books normally have a more constant income flow, based on an as-and-when basis. For life and investment business, upfront commission forms the bulk of the income, followed by trial commission afterwards. Under the new RDR proposals, there may be bigger on-going value in these practices.

How different is the perceived value (of the seller) versus the real value of the business when discussions around this topic start?

ALEX COOK - It can be very different. Some reasons for the gap between real and perceived value could include:

• The seller discounts the value of his or her own input to zero, effectively inflating the business’s profitability because no salary is accounted for;
• Key man risk: the seller underestimates the importance of his or her role in the business;
•Margin: The seller overestimates the net margin that the business generates after all expenses;
• Annuity revenue versus initial revenue: The greater the volume of annuity revenue the greater the value as a rule; and
•Life business: The more life business is written, the lower the value of the business. This is because receipts effectively represent a two-year loan from the life company which may be clawed back if the insured person cancels the policy.

DANNY JOFFE - The value is normally different as the clients are often there because of the current leadership of the brokerage and the relationship. This can change when the leadership leaves as the relationship is often very important. The owner also often has big expectations for the growth of the business which is often unfounded and this affects the multiple used to value the company.

How does the broker-client relationship influence the value of a business?

ALEX COOK - The relationship between the client and adviser is the key to the business’s value, and everything has to be done to transfer that relationship to the new adviser. One of the best ways to achieve this smooth handover is for the seller to join or work alongside the new company for a while. The closer the clients are to the current adviser the more they realise the adviser cares about them and the smoother and more successful the integration.

In cases where the relationship is not that strong, it is often possible for the new adviser/broker with the right approach to uncover a lot of value. This is only possible, of course, if the purchaser has both a strong value proposition, and a strong team with the capacity to take it to the client base. How the purchaser assesses the closeness of the seller’s relationship with his or her clients will always be a grey area, more of an art than a science. As in any transaction of this nature, performing a thorough due diligence is critical.

PAUL KRUGER - My recommendation is always that the buyer contracts with the seller to stay on as a relationship manager for at least a year or two after conclusion of the deal. This is also in the interest of the seller, as his remaining payments will be dependent on business staying on the books. One of the first aspects to consider is how closely the potential buyer resembles the seller’s approach to their clients. Conflicting views on client care is a recipe for disaster.

What should the seller look for in a potential buyer?

ALEX COOK - Sellers should consider the following issues when looking for a suitor: Decide what their current culture is, and what they would want from a merger partner? What would their clients want? How important is independence to them and their clients? Would they be happy to recommend that their clients rely on one company’s products? A few more things to look for in the news company: systems, contracts, licence categories, staff qualifications, RDR readiness, merger experience and technology.

PAUL KRUGER - Sellers should look for compatibility in business approach and business ethics.

An adviser/broker has made the decision to sell. Where do they start?

PAUL KRUGER – A good set of guidelines can be found on Centurion Market Makers’ website, which is an Australian company www.centurionmarketmakers.com.au.

What can we learn from our international counterparts?

ALEX COOK - Margins are likely to remain under sustained pressure as technology is making everything more transparent, and the obligations of the RDR will add further overheads. As a result, consolidation is inevitable.

The final word on a tricky business

ALEX COOK - An all-or-nothing approach often does not work. In most cases, it is ideal for the seller to continue servicing the 20% of his or her clients that represent 80% of their revenue and to hand the 80% over to the new adviser/broker, from whose efforts they would earn revenue. At the same time the administration, compliance, overhead and management burden of the whole client base would have to be reduced in order to maximise time. This is one of the key benefits the purchaser should be able to provide through better systems and processes, along with economies of scale.

PAUL KRUGER - The market conduct authority, which is to replace the FSB, will be more outcomes focused. We recently commented on enforcement action where the potential for poor client outcomes led to a fine of R150 000. Similarly, you do not only need to have a TCF tick list as part of your business – it needs to be a living document which is lived out every day. Succession planning will be tested against his as well. If you only have a succession plan because you are legally required to do so, hard times await you under the new dispensation.

There are many options available. Whilst many advisers still do not have a proper plan in place, it makes sense to think about the future before it is too late.