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How much is that business in the window?

01 June 2010 Esm? Davies, Celestis

Ready to retire or sell your practice? In response to the inevitable question: “What’s your asking price?, do you umm and ah, quote a figure and watch the reactions, or suggest that the price is negotiable depending on the conditions of sale?

A survey by Celestis amongst local financial advisors found that 85% or those contemplating selling their practice or client book expressed a need for assistance with business valuations. And more than 75% of potential buyers would also like assistance with valuations to ensure realistic offer prices.

When it comes to valuing a financial advisory practice, the price is just one of a number of important criteria both the buyer and seller need to consider. To begin with, what will be changing hands – the entire business, the client base or part of a client base? Is there a cultural fit between the buyer and the practice’s staff and clients? Will the clients stay with the practice after the takeover? For today’s article, let’s focus on the value of the practice.

Multiple of recurring revenue

The common valuation method applied in our industry is a rule of thumb known as the multiple of recurring revenue. It involves taking the potential ongoing income of a business and multiplying it by a factor, say, two. Why not four times? At one stage, in Australia, it was as high as eight times.

This approach has three major drawbacks. Based on “ongoing income” it does not return a fair value in respect of predominately risk-orientated practices whose income is largely “first year commission”. It also does not take the cost of generating ongoing income into account, and the multiple factor is highly subjective and difficult to substantiate.

Discounted cash flow

Another popular valuation method is the discounted cash flow method which discounts the practice’s potential future income stream and, again, favours investment business over risk business. Applied correctly, the method should account for expenses incurred in generating revenue, which few models do. There is also an element of subjectivity in determining the discount rate. This model is best suited to the disposal of a client book or part thereof, rather than of the business as a whole.

Multiple of profit method

The multiple of profit method is one of the more appropriate models when valuing the practice as a whole. The practice’s net profit is multiplied by a factor to generate a value. In arriving at the value using this method, it is important to aggregate profits over a period (at least three years) taking inflation into account. Profits may have to be normalised because it is common in smaller practices for the owner to increase drawings rather than pay himself a salary and dividends. The drawings, therefore, include an element of profits which should be added back to the net profit. Again, the multiplier factor is also subjective and should be substantiated by evidence of sound business practices.

What is a practice worth?

There is no simple solution to business valuations. Quite clearly the quantitative measures can be reduced to formulas but it is the qualitative factors that will reduce the subjectivity of the variable factors, such as the multipliers.

Your practice is worth precisely what a willing buyer is prepared to pay for it. And that amount is going to be persuaded by hard facts including a defendable business valuation, demonstrable client loyalty and evidence of effective, efficient business management. The very kind of things you should be talking to your business or practice consultant about.

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