Many of the financial publications today tell the tale of advisors selling their business for two and a half times what their revenue is worth.
But what is not being discussed in many of these reports is what the buyer should expect. Early on in my career as an investment banker, I was trying to sell a retail organization that specialized in kitchen and bathroom tiles. The organization had 23 locations throughout Colorado, New Mexico and Arizona. It was a well-run business for sure. The owners had their mind set on selling the business for $10 million. The annual income received was $1 million on revenues of $8.8 million a year. However, we kept running into the same conversation with potential buyers: “I am only going to pay six times the earnings or $6 million for the business.”
After seven buyers passed on the deal, the owners finally took it off the market. Several years later, I heard one of the seven prospects came back and bought the business. Unfortunately, the sellers never got their asking price.
Outweighing the Risk
So what does a buyer of a financial advisor practice want? Recently, I was writing about investment options in a series I call FLOW. I determined I was looking for a 10% return and was willing to take on some risk. It is likely that the price of the investments could swing by more than 20% in a six-month period, but I believed the investment’s cash flow stream would remain consistent.
To begin, a financial advisor should seek at least a return of 10% on the purchase price of a business. Ensuring this; however, can be difficult as there tends to be risk involved. First, there is risk with stock market uncertainty. Second, there is a level of client anxiety associated with the fear of a trusted advisor leaving. Third, you may encounter an employee risk which occurs when an advisor leaves the firm or has not received proper training. Lastly, you must be prepared for systemic risk, which is the risk of an entire financial system collapsing.
To outweigh such risks, I would look to achieve at least a 15% return on the initial investment. This means that the annual cash flow should be 15% of the price paid to the financial advisor.
Let’s say that a financial advisor has $300,000 in revenue. Using the often-heard “two and a half times’ revenue” equation, the selling advisor may expect a return of $750,000. However, the amount received ultimately depends on how much cash the firm brings in as profit. If the expenses are $200,000, leaving $100,000 in cash flow each year, this represents a return of 13.3% annually, before taxes.
Is Your Return Worth It?
FA Insight indicates that profit margins are about 18% with a range of 15% to 30%. Therefore, if a firm with $300,000 in revenue were generating 15% cash flow or $45,000 a year, this would only represent a return of 6% to the buyer…NO THANKS! A return that low is not worth the market risk, client risk, employee risk and system risk – plain and simple.
Now imagine your profits are more extreme and are closer to the 30% mark. With $300,000 in revenue, you’re looking at $90,000 in cash flow each year. This means the buyer is still only receiving a 12% return on the investment. Consequently, the two and a half times revenue maxim for what a financial advisory practice is worth may not be accurate in terms of what an advisor can actually get for the firm.