Developing your advice business

Part 2: How to determine the value of your business

Getting your business valued is an important step towards planning for succession. Tyrone Brand, Allan Gray distribution development specialist, unpacks the ways advice businesses are typically valued and discusses what potential buyers find attractive. 

A business valuation is important for two reasons. Firstly, it provides you with an assessment of the general state of your business. Secondly, a valuation strips a business bare to reveal where the true value lies: Is it in your book of clients and the revenue they generate? Is it in the practice – in the value created through services delivered? Or is it in the business – where value is derived from client revenue and an organised equity structure, where earnings are reinvested to improve operations, and grow the business?

It is important to understand exactly what it is that makes your business attractive to buyers because they typically approach an acquisition through one of these three lenses.

There are several ways to determine the value of an advice business, but for the purposes of this succession planning series, we will focus on the two most common industry approaches: the market-based approach and the income-based approach.

The market-based approach

As its name suggests, this method of valuation considers how much similar practices have recently sold for or are currently selling for in the marketplace, as a means to determine a price. In the residential property industry, the value of a home is largely determined by the fundamentals of the house and market value, and the same principles of valuation apply to advice businesses. The market-based approach generally applies to the sale of books of businesses and practices, and multiples of revenue or multiples of cash flow are the most widely applied methods of valuing a business.

While the market-based approach is the simplest way to calculate a value, there is a drawback to this approach – it does not forecast future cash flow. 

The income-based approach

The income-based approach is a more sophisticated, and often complicated, means of determining the value of a business, as it is based on future estimates over a set period of time and the ability of the practice to generate income for the buyers. This approach is best suited for internal succession and for sales to established firms.

What do buyers look for?

While the price tag is an important consideration, potential buyers also want to know that a business has the longevity to exist beyond the departure of an owner. Buyers also typically want to know whether the business has a recurring base of clients, what the value of their repeat investments is, where future revenue growth will likely come from – organic versus market growth – and how the business makes an income, whether it is commission or fee-based.

From a buyer’s perspective, size really does matter and the higher the value of assets under management, the more attractive the business is. Of equal concern is the makeup of the client base; ranging from age and the quality of service, to the length of time an adviser has been servicing this base and the ratio of existing to new clients. Longer periods of service demonstrate an adviser’s ability to retain clients, which is a key consideration for potential buyers.

If one applies the Pareto Principle, which is the idea that 80% of results that we achieve are driven by 20% of our efforts, in the context of an adviser’s client book, it goes to say that 80% of the revenue earned is generated from 20% of the clients. Any potential buyer will have this model in mind and will be assessing the value of your client base to determine which clients are more valuable in revenue than others. In addition, an adviser with an older client base runs the risk of being perceived as less desirable. This is because, as the assets of older clients decline over time, the income distributed across clients will make the tail end of the client base appear less attractive and this could have implications on a valuation. Businesses with a more diverse client base made up of younger clients with a growing portfolio of assets offer greater value in the long term.

A business is nothing without the people behind it, and so human capital is another critical area buyers will examine when looking for value in a practice. They will also consider employee tenure and the value-add the employees will bring in an acquisition. 

In Part 3 of the series, we delve into how to find a like-minded successor or buyer. 

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