By Guy Holwill, Chief Executive, Fairbairn Consult & Mandy Murphy, Practice Management, Fairbairn Consult
The first article, published last month, explained the more familiar but relatively complex ‘Discounted Cashflow’ method. Our third article will help you understand what you should do to increase the value of your financial planning practice.
Before we start, it’s important to make the distinction between price and value. Warren Buffett famously said that “Price is what you pay; and value is what you get”. So, for the purpose of a valuation, price is what a buyer is willing to pay in exchange for a business or client book. Value is what he or she gets out of that ownership; and the two are often not closely aligned.
Often, buyers and sellers go into negotiations, each with their own perception of the ‘book’ or business value. Sellers aim for as much as they can reasonably get for their years of hard work, whereas buyers want to pay the least amount possible so that they can generate the best return on their investment.
Whether you’re using a formal valuation calculation or simply settling on a multiple of revenue or profit to establish a value, you’re still going to be making assumptions about the future revenue that is being purchased.
It’s also important to understand that valuations are about future revenue, and that no method is 100% accurate because nobody knows exactly what the future will bring. Whether you’re using a formal valuation calculation or simply settling on a multiple of revenue or profit to establish a value, you’re still going to be making assumptions about the future revenue that is being purchased – you cannot know for sure whether this will actually materialise. As a result, the resulting value will always be higher if the buyer has more certainty about what they can realistically expect to get out.
Let’s consider the simple calculations you can apply:
- The Revenue Multiple calculation is based on the business’s revenue over the last 12 months and an agreed multiple. While this is relatively straightforward, easy to understand, and effortless to apply, it usually doesn’t distinguish between upfront and ongoing income, nor does it take profitability into account. Since buyers are looking to purchase future flows earned but not yet paid on the transferring clients, the uncertainty about the future flows means that the valuation will use a lower multiple.
Sale Value = (Upfront income p/a + Recurring income p/a) x market-related multiple
- The Profit Multiple calculation is much like the revenue multiple calculation, except that you multiply the bottom line by an accepted multiple. The challenge here is that the costs in the sellers business are unlikely to be the same as the costs in the buyers business, which means that the profit realized by the buyer will be different to that realised by the seller. You can compensate for this by adjusting the multiple, but it makes it harder and harder to objectively justify the valuation, and you need to be comfortable to live with some uncertainty.
Sale Value = Profit p/a x market-related multiple
- The final option is Referral Fee calculation that avoids the risks inherent in making assumptions about future cashflows entirely. In this approach, the seller gives the practice to the buyer in exchange for a % of future revenue or profit. There are a number of permutations, but typical arrangements are 50% of gross or net (after lapses) revenue for five to ten years or 30% for the remainder of the seller’s life. In many cases, the seller will remain in the practice in a relationship role, which has advantages for both the buyer and seller as well as for the clients.
Annuity income = X% of gross or net revenue or profit for Y years
As you can see, there are a number of different methods to arrive at a ‘fair’ value for a practice or client base. For the buyer and seller to reach an amount that is agreeable to both, you must first agree on the approach and then on the relevant variables.
Guy Holwill is the Chief Executive of Fairbairn Consult. He is a qualified Civil Engineer and Chartered Account and has worked in financial services for more than two decades. Guy is passionate about creating business models that thrive in the changing worlds of regulation and customer experience.
Mandy Murphy is the Practice Management Consultant for Fairbairn Consult. She joined the financial services industry in 1998, is a Registered Financial Planner™ (FPI), and has achieved many accolades since. Mandy was a Director in an IFA until 2007, which led her to her passion for business coaching and practice management which she has been doing since 2008, and since 2010 she has been conducting ‘book-sale’ valuations too.
Fairbairn Consult is a firm of Registered Financial Advisers. We are a licensed FSP and a member of the Old Mutual Group.