The Importance of a Practice Valuation

October 14, 2021 Oak Street Funding

Importance of Practice Valuation

Many financial advisors assume a valuation is only useful when one is selling their practice. But a practice valuation serves many uses, especially for advisors who are actively growing and managing a practice. In fact, a valuation is a strategic tool that can provide a great deal of insight and information needed to drive practice growth.

A Valuation as a Decision-Making Tool

A professional valuation provides advisors with data about how the practice is performing, benchmarks for comparison, and recommendations on what an advisor can do to improve the performance of the practice. This is because a professional valuation looks at several key factors, what we call the drivers of value. This includes client composition, operational performance, profitability, growth and risk assumptions, and other key factors.

We take a unique approach that combines the commonly used financial services industry standard “market approach” with a more established mergers and acquisition “income approach” (discounted earnings). By establishing a value based upon the average of these two methods, we can be assured that it represents the fair market value.  

Our Market-Based Calculation methodology looks at the key performance metrics of the practice (i.e. recurring revenue, profitability, client age, and client segmentation) and compares them to our benchmarks. By doing so we determine if you practice falls above or below the market in overall quality. We then compare your practice to the sales of similar quality practices and arrive at a market value.

Our Discounted Earnings methodology uses a discount or “hurdle” rate by combining a Risk Free Rate of Return (Long-term U.S. Treasury Bills), Equity Risk Premia, Size Premia, Industry Risk and Revenue Volatility Factor. By using a net revenue (after operating expenses) benchmark, our analysis provides an advisor with a solid earnings based Calculation of Value (Net Present Value).

With this information, advisors can determine what changes to make in their practice to improve the financial performance of the practice. Because of this, many advisors seek new valuations each year and use them as a foundation for their annual business planning. They can compare valuations from year to year and gauge their progress in the areas that matter most. Namely, client composition and operational performance.

A Valuation as a Tool to Incentivize Ownership

Because valuations serve as a barometer for how the practice is performing, it can communicate to staff the value of taking an ownership stake in the practice. Advisors and support staff will invest in a practice that is not only growing, but profitable. The valuation can communicate clearly how the practice is performing, often better than traditional financial statements. This is because it looks at all factors that impact performance, not just profit and losses.

Staff who have an ownership interest in the practice will work harder, as well as help retain clients and attract new clients, which further drives growth and increases the value of the practice over time. In several cases, we have seen practices grow by 50% or more after partner buy-in, especially if those partners are advisors with active client relationships.

Not only does this grow the practice, but phased successions also often result in a higher overall payout to the founder, versus a straight acquisition/succession.

A Valuation as a Tool for Securing Financing

Many lenders require a practice valuation to secure financing for acquisitions, lines of credit, or other needs. Because financial advisory practices are built on client goodwill and operate largely based on cash flow, they do not have tangible assets to serve as collateral for a loan. A valuation communicates the financial strength of a practice and the relationship assets it brings to the table.

For acquisitions, it is critical to secure a valuation and loan before engaging with the seller. This is because loan terms can affect deal structure. If you negotiate a deal with a seller, only to find out certain terms of the agreement are not permitted by the lender, you frustrate a seller or even lose a deal.

Many lenders that cater to the financial advisor space are well-versed in M&A deals and can help inform you of the process. By working with the lender and the valuation team, you can go into a deal with greater confidence, knowing you have the capital in hand and the team there to guide you along the way.

A valuation of both your practice and the selling practice can also help you determine if a potential acquisition is a good fit, especially as it relates to client composition and obligations that impact the bottom line, such as staff. Many advisors make acquisitions only to find that it created unnecessary overhead expenses or contained client groups that did not enhance or complement the existing practice. It’s better to find that out before making the purchase, rather than after.

Overall, the power and usefulness of a practice valuation is not limited to a practice sale. It serves as a strategic planning tool, guiding leadership toward critical decisions that impact the growth and direction of a firm. It incentivizes ownership and investment in the practice by key staff.

Above all, it is essential to securing capital for funding both organic and inorganic growth activities, especially acquisitions. For these reasons, smart advisors keep valuations in their practice management toolbox, updating them regularly and using them to guide the practice forward.

By Todd Doherty, M&A Consultant, Advisor Legacy

Disclaimer: Please note, Oak Street Funding does not provide legal or tax advice. This blog is for informational purposes only. It is not a statement of fact or recommendation, does not constitute an offer for a loan, professional or legal or tax advice or legal opinion and should not be used as a substitute for obtaining valuation services or professional, legal or tax advice.

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