Rethinking Your End-Game Strategy

Conventional wisdom suggests that an independent financial professional should choose, at some point in his or her career, between an internal succession plan and an external sale to a third party or a merger with a third party (as in a peer, a competitor, a bank, or a CPA firm). That’s wrong. Forget it.

The smart plan includes both options right out of the gate, but always starts with the internal ownership transition strategy—even if you have only two people, including yourself. The task is to design and develop a plan to guide your journey. If your internal plan doesn’t work out to your satisfaction (and that is always a possibility), an external sale to a third party becomes your fallback strategy.

As you’re now aware, more than 90 percent of advisors will never sell their practices—at least not in the conventional sense—because the value they covet is not that offered or paid for by an outside, third-party buyer; the value most advisors are after is cash flow, the money they take home every year from work that is rewarding, as well as a client base that is more appreciative than not. Advisors would simply rather keep working, and keep earning the income that supports their lifestyle; the truth is, most advisors need to keep working because their lifestyles demand it. And even if they didn’t, the stream of income multiplied by “five more years of working” is a more powerful incentive than selling for a lump sum and living off those proceeds.

So make selling your practice plan B, and face the music—there is less than a one-in-10 chance this is going to happen. You’re not helpless in this matter, of course; plan B is mostly within your control unless and until it is triggered by death or disability (the purpose of a continuity plan) or you choose the attrition route and there is nothing left when you’re done with it. Later in this book we’ll help you better prepare for these possibilities. In the meantime, let’s shift to plan A and start to figure out what that might look like for you and your stakeholders.

Setting up an internal ownership track (which is what powers a succession plan) provides for a stronger and more stable business, which in turn provides higher value in the future regardless of your exit strategy. It can also provide excellent protection against the founder’s short-term or temporary disability. Attracting, retaining, and properly rewarding next-generation talent is an essential step in moving beyond a typical practice to a more valuable business model and solving these problems.

As a business owner with a succession plan in place, you can lead and continue to participate in the business you’ve founded for decades to come if you build an enduring and transferable foundation. In addition, the effective value received can be upwards of six times the trailing 12 months gross revenue, based on the starting point for the plan (including equity and profit distributions)—a fair return on your investment of time and leadership. The final, effective value derived by selling equity incrementally in a growing business is significantly higher than a sale to a third party, but only if you build the foundation to support this process—something to consider as you formulate your goals. Do you want to do this? Are you up for it? It is okay if the answer is “Maybe not,” because honest answers provide for better goal setting and more accurate planning. Just understand that most plans can be designed around your preferences if there are sufficient time and resources.

We ask every one of our planning clients what “retirement” means to them. The answers are mostly the same. Retirement for an entrepreneur rarely means a hard stop; usually it is a gradual, on-the-job retirement from five or six days a week down to four days, down to three days, and so on. But that works only if there is next-generation talent to back you up, and a plan to tie it all together; otherwise, it is called attrition and any value other than cash flow will evaporate by the time most advisors call it a day. Worse, if a health condition or an accident cuts your plan short but doesn’t kill you, the cash flow is gone, too, even when you need it most, and there probably won’t be any funding to cover the equity value.

In the end, it all comes down to what you want and need from your business, and how much time there is to build the foundations and to implement and adjust the plan. That’s why figuring out when to start is so important.

Determining a Precise Starting Point

Most advisors who do embark on designing and implementing a succession plan are starting about 10 years too late. Every year, we work with several hundred advisors to set up formal, long-term succession plans, and these founding owners tend to be around age 60 when they start the planning process—not too late for a successful plan to be designed and implemented, but not optimum in terms of maximizing results and having the broadest array of options.

So when should you start developing your succession plan? The short answer is, start the succession planning process by age 50, plus or minus five years. The longer answer is that it depends on what you want your business to do for you in the future. For the one advisor in 10 who actually will sell and walk away, start the planning process about three to five years before you think you’re ready to pull the plug, and monitor your equity value annually to make sure you’re not already in attrition mode and bleeding off value before you sell; at some point, practices do become unsalable.

One of the best ways to determine when to start your succession planning process is to first plan your “workweek trajectory.” In other words, instead of focusing on either how much money you need from the business, who might possibly comprise your succession team of next-generation talent, or how much ownership you’re willing to part with during the initial stages of your plan, look instead to something much simpler and closer to home—forecast the amount of time you would like to physically spend in the business in the years to come. We use a graph like that in Figure 2.1 to determine an advisor’s current workweek trajectory and goals for the future.

Start the trajectory with an accurate assessment of the average number of hours you now spend in the office or working diligently on office-related matters from home. Then plot how many hours you’d like to be working in five years, 10 years, and so on. What is your goal and what would you like your business to do for you? Just to provide you with a level of comfort before we proceed, we tend to assume that perpetuating your current income level is a part of the succession planning process, even as you slow down and reduce hours in the office, so this important consideration isn’t being ignored. We plan for it every time.

Some workweek trajectories bottom out in future years, which signifies a hard stop at some point in a career, and an end to at least the income stream for the founder, but most don’t. Most advisors plot a gradually descending workweek plan but level it out at about half time based on what they’re used to as full time. One of the benefits from a well-structured succession plan is the ability to elongate your career by reducing the hours and the stress, and by shifting the things you don’t like to do to your up-and-coming succession team. Extending the length of your plan means a longer period of income and profit distributions along the way—in other words, a more lucrative retirement whenever and however that event might unfold, by working less. But to make that all happen, you need a good plan.

You’ll notice that there is a horizontal dashed line drawn at the 30 hours per week level. We call this the “30-hour threshold.” The 30-hour threshold provides an important lesson for founders and succession planners: There are more ways to shift control, or to lose control, of a small business than just selling shares of stock in your corporation, or membership interests in your limited liability company (LLC). Independently owned financial services or advisory practices are notoriously intolerant of absentee ownership, especially when the compensation systems in place are revenue-sharing arrangements or any form of an eat-what-you-kill system.

Working less and less as you get older makes sense and to some extent is inevitable; in fact, plan on that happening. But at a certain point, about 30 hours per week on average over the course of several years, attrition will begin to take its toll. Here is what happens.

Over time, the equity value of your business, specifically the value of your ownership and shares of stock, can be reduced to the value of the assets, namely the client relationships. As you work fewer and fewer hours but remain the owner of 100 percent of a practice, especially one with a revenue-sharing or other eat-what-you-kill compensation structure, the very portable assets of the business can factually transfer to the advisor who regularly sits in front of the clients and helps them. The result is that, at some point, the assets and client relationships take on more value than the founder’s stock (or ownership interests in an LLC), and the next-generation advisors suddenly have something to negotiate with—something powerful and valuable that they control without having to purchase anything. In other words, the clients will follow the junior advisor across the street if he or she elects to go that way.

Accordingly, you should start your formal succession planning process five to 10 years before you break the 30-hour threshold. If you do, there is no reason why you can’t enjoy the lifestyle the business provides, perhaps for the rest of your life, along with the cash flow and the gratitude of your clients and your family.

The Persistence of a Job Mentality

Correctly structuring compensation at the ownership level is a critical element to building a valuable and enduring business. Ownership-level compensation cannot be determined by a chart or a survey or even benchmarking data; at this level, the common mistake is to focus on the question of how much an owner should be paid, instead of how an owner should be paid. Independent advisors start this part of the planning process by seeking answers to the wrong question.

The compensation system most commonly utilized by independent financial professionals in this industry is some form of a revenue-sharing or commission-splitting arrangement. Revenue sharing is an easy and seemingly low-risk payment system to implement—certainly, on the surface, easier than hiring a bookkeeper and setting up a payroll service to generate a W-2 wage and withholding system. But the risk and true cost of a revenue-sharing arrangement become increasingly apparent the more successful the younger advisor becomes; any value other than the share of revenue typically belongs to the individual advisor responsible for building the book.

Instead of building businesses that evolve and improve from one generation to the next, advisors in this industry build one-generational practices, and subsequently rebuild them from scratch with each new generation of owners largely because of these eat-what-you-kill compensation systems. For that reason, jobs and practices that last for just one generation of ownership are plentiful; multigenerational businesses and firms are rare. The goal of a practice owner is one of production, and production equates more directly with cash flow than it does with equity.

In the independent sector, if your goal is to build a valuable and enduring business, then your focus should be on a team of advisors working together, compensated for contributing to and supporting a single enterprise, rather than building individual books and subsequently leaving with the clients and related cash flow they generate when the time is right.

Revenue Sharing: Heads They Win, Tails You Lose

Let’s examine this premise. You hire a 32-year-old advisor (we’ll call him Bob) with a newly minted certified financial planner (CFP) designation and a small book that may or may not follow him, but he is fully licensed (or registered as an IAR) and ready to go. You agree to a small base salary for one year, credited toward the payout structure, which is a 50/50 revenue-sharing arrangement. Bob turns out to be a complete and total failure. He couldn’t sell a space heater to an Eskimo or create a financial plan that looks out past the end of the week. You let him go. You saved the costs and complexities of setting up a payroll, and you didn’t pay for what you didn’t get; but did you win? What exactly did you gain in this arrangement?

The best argument is that you cut your losses and on that point we’ll concede. You definitely did that. But you lost a year or more in the effort, you’re a little older and thinking about slowing down yourself, and now you have to start over with a new hire. So let’s rewrite history and explore this from a different angle.

Bob instead turns out to be one of the best professionals you could have hoped for. He comes in early, he stays late, your clients love him, and most of his clients followed him. He produces $250,000 in gross revenue (or gross dealer concession [GDC] under Financial Industry Regulatory Authority [FINRA] rules) by the end of his second year, and all indications are that he’ll double that by the time he has five years in with you. What exactly have you gained in this scenario?

Well, you get 50 percent of everything Bob produces, so that’s $125,000 a year by the end of year two. That’s a good thing. Bob takes the same amount of money home as his reward, a good payday for him as well. Of course, Bob hasn’t had to spend any money on desks or chairs, a computer or a customer relationship management (CRM) system, a phone system, the office space, or a computer network or the staff to make all these aspects of a business come to life, but you did. So you take your half and you pay the rent, the staff, the light bill, and other expenses, and then you take home what’s left. You own half the cash flow, halved again after expenses, but what about the equity—the value of the book?

After year five, Bob does indeed reach his goal and now produces almost $500,000 in top-line revenue per year. About 70 percent of this revenue is recurring. You decide to make Bob a partner in your business and offer him the opportunity to buy in, but Bob astutely asks, “What about my book? Do you want to buy what I’ve built or exchange it for an equivalent amount of stock?” Those are really good questions, and we hear them almost every day. You own part of the cash flow, while Bob owns all the equity. Bob controls the assets, and those assets (the client relationships) are portable. They may not all follow Bob as he walks across the street and hangs out his own shingle, but they could, and therein lies the strength of Bob’s negotiating position.

This example illustrates the concept that, as independent advisors, there are two kinds of value: cash flow and equity. This is a critical distinction that separates an independent practice from a captive or wirehouse practice.

The point is that setting up a revenue-sharing arrangement or any form of an eat-what-you-kill payment structure is a losing proposition for the founder or actual owner, unless you own your own independent broker-dealer or custodian, a wirehouse, or an office of supervisory jurisdiction (OSJ); don’t emulate these models for any other reason. Remember that most of those models are worth far less, per dollar of revenue generated, than your own enterprise. If the next-generation advisor fails, you lose. If the next-generation advisor succeeds, you have to buy what he or she has built and pay for it with the stock or ownership interests of your own business, or risk creating a competitor, and you lose again. Is cash flow alone, after expenses, worth that cost?

Think about this from the eyes of the next generation. When younger advisors are hired into a practice with no future of its own, a practice that is tied to the life or the career of its single owner, the very natural tendency is for them to build their own practices or books. Said differently, if there is no single enterprise to invest in, they start building their own practices and that is exactly what is happening in this industry. Acknowledging that is the first step toward building a business of your own that works for you.

Fracture Lines!

Revenue-sharing arrangements and other eat-what-you-kill compensation structures seriously undermine the effort to build a valuable and enduring business. Practices with more than one producer or advisor are being built with fracture lines from day one. Consider the diagram in Figure 2.3. In this example, Advisor A, who is 62 years old, is the 100 percent owner of an S corporation. He hires and mentors Advisor B, who is 42 years old, and years later, Advisor C, who is 36 years old. Advisor A provides his younger associates the bottom half of his client base and all new client referrals that are below his minimums or who are just not a good personal fit. This fee-based practice has a value of just over $1,000,000.

Four years later, when Advisor A is nearing retirement and is faced with a sudden and serious health condition, he decides to sell the business and turns to Advisor B. Advisor B is interested in being the buyer, but doesn’t want to pay for his own book, and certainly won’t pay anything for Advisor C’s book. When Advisor A looks outside the firm, a third-party buyer materializes and offers $1.6 million for the practice, but there’s a catch. Advisors B and C must sign noncompete, nonsolicitation, and no service agreements, and/or formal employment agreements with restrictive covenants so that the buyer knows they won’t interfere with or impede the buyer’s ability to control and retain the acquired client base—except that they won’t cooperate. And why would they?

All of a sudden, Advisors B and C’s zero ownership positions are worth something—quite a lot, actually, as the junior advisors now have veto power over the value of their own books, cumulatively about $500,000 to $600,000 in value. The mistake most founders make is that they ask us to value the combined cash flows and think that they own and control 100 percent of the equity. How could they control 100 percent of the equity value when they or their practices don’t control 100 percent of the asset base? This isn’t one business; it is three separate practices. The fracture lines were built in from the first day Advisor A hired each junior advisor and paid him using the industry standard revenue-sharing arrangement.

This common example provides the junior, nonshareholder advisors with control over the assets (the client relationships) even though they haven’t invested anything into building their own businesses: no lease of office space, no phone system or computer network, no employee payroll. All these things are provided through a revenue-sharing arrangement from Advisor A, who was willing to accept cash flow in exchange for the control and value of the assets in each junior advisor’s book. This is not an anomaly; this is why there are so few sustainable businesses in this industry.

The junior advisors, in turn, enjoy cash flow with minimal investment and risk—what we describe as “owning a job.” But what happens if Advisor B or Advisor C gets hit by the proverbial bus as he steps off the curb at the end of a hard day? He owns nothing that is transferable. His family receives little or no value even with the typical revenue-sharing continuity agreement, and, with no infrastructure, the relationships he controls are gone in a heartbeat.

These built-in fracture lines take a single practice with multiple advisors and create multiple books that, cumulatively, are unsalable and therefore end up somewhere between worthless and worth less (than they should be). Creating a competitor is never the goal, but unfortunately creating an equity partner and investor, at least for 99 percent of advisors, hasn’t been one of the goals, either. It’s time to change that, and as an independent owner, you have the perfect tool for the job—equity.

Recurring versus Nonrecurring Revenue

Because the value of a business is based on the assumption of a continuing stream of revenue into the future, it is important that the analysis take into account the revenue sources—specifically, what proportion of the revenue is recurring versus transaction based. Fee income is the most important contributor to cash flow quality, as it represents recurring cash flow, which, in turn, is among the most predictable and durable of the revenue streams produced by a financial services practice. Recurring revenues also are the most important revenue streams to a potential acquirer or successor, and hence these fee-based revenues usually generate the highest interest and value. From a valuation perspective, these revenue categories form an important starting point for determining value.

Recurring revenue is one of the most important single determinants of value of a financial services practice. Revenue produced through management fees or trails is ongoing and reasonably predictable, and highly sought after by buyers. In the case of insurance renewal commissions, or trails, these are considered only to the extent that they can be transferred to a buyer. Most insurance trails are restrictive in terms of their transfer. While the assessments used in the FP Transitions’ Comprehensive Valuation system are applied to both recurring and nonrecurring revenue, more weight is placed on the recurring revenue component.

Transactional revenue is more elusive and difficult to predict. Transactional revenue does have a value, but it is essential to be able to show the propensity for additional revenue in the future and during the buyout period. Factors like the practice’s historical revenue, rate of revenue growth, length of surrender periods, and quality of the relationship are instrumental in predicting this potential from transactional revenue. Due to FINRA/Securities and Exchange Commission (SEC) regulations, there are certain inherent limitations on the transfer and payment for transactional securities revenue streams from a buyer’s perspective. For the insurance portion of a business, the client relationship index and client wealth index are used to predict the propensity for future sales from the existing client base.

Cash Flow Quality Factors

The quality of the revenue stream produced by an independent’s practice or business is one of the key components of value. The cash flow quality index, introduced and used exclusively by FP Transitions, indicates the strength and durability of the revenue stream of a practice. These factors, addressed in the following paragraphs, include:

• Client demographics
• Asset concentration
• Revenue growth and new client growth
• Expenses

In looking at client demographics, statistically it is desirable from a value or equity standpoint to have the largest proportion of the clients in the 50 to 70 years of age bracket, while at the same time not having a large percentage of clients in the 70 years or older age group. This is a recurring trait we see in the largest and best-run financial services practices. The 50 to 70 years of age demographic is desirable because this group, in general, is not only at the top of their earning cycle, but also at the top of the saving cycle as well. Event drawdowns, such as purchasing a home, paying for college tuition, or making business investments, are less frequent in this age group, while the urgency of saving as retirement approaches becomes more salient.

The demographics of those clients in the 30 to 50 years of age bracket are also important, contributing to a developing revenue base. In our benchmark studies, this age group does not represent the majority or largest group of clients, at least in the most valuable practice models. The demographic group represented by those clients 70 years of age and older is often the wealthiest segment in a financial services practice or business. This group, however, is a less stable and less predictable source of long-term revenue as this group is subject to event drawdowns for trust disbursements, gifting, living expenses, health issues, and, of course, mortality. In practices where the majority of the clients fall into the 70-plus age group, the result would be a lower cash flow quality rating, and, depending on other related factors, usually a lower value.

Asset concentration is another consideration in calculating the cash flow quality rating; it is measured by assessing the total percentage of assets under management owned by the largest top 10 percent of a practice’s clients (ranked in order of fees paid).

Revenue growth and net new client growth are significant contributing factors to cash flow quality as well and are measured separately. In our analysis, computed from information we collect from our clients, average annual revenue growth over the 2002–2011 period was 13 percent (evaluated as 5-year compound annual growth rates over the 2002–2011 period), with the middle 50 percent of the distribution growing by between 5 percent and 16 percent annually. The rate of revenue growth, however, is strongly influenced by market performance and therefore, by itself, is not a reliable indicator of the long-term strength of the cash flow. Net client growth, however, provides an excellent proxy for determining the future growth potential of the practice, as well as helping to determine the quality and strength of the referral channels and the client development systems that the practice has in place.

Practice expenses are taken into account as well in determining cash flow quality. Practice expenses are defined by the valuation model as (1) occupancy cost; (2) office overhead; (3) employee salaries, wages, and benefits; (4) marketing expenses; and (5) other or miscellaneous expenses. While the Comprehensive Valuation system does not use expenses to calculate net cash flows due to the variation in how expenses are classified and the difficulty of obtaining comparable statistics, the system does take into account expenses with regard to their impact on cash flow quality.

Transition Risk Factors

Transition risk is defined as the risk associated with transferring the clients, and hence the revenue stream, to a new owner or successor. A number of factors are involved in accurately assessing transition risk, including:

• Client tenure
• The tenure of the practice
• The willingness of the departing advisor to offer postclosing assistance
• The use of noncompete/nonsolicitation agreements
• Other factors such as remaining with the same broker-dealer or custodian, and a number of related continuity issues

The effect on valuation of the assessment of transition risk is to discount anticipated revenue transfer by the risk factor associated with the transition to a subsequent owner or successor. On average, experience dictates that in a well-structured, well-documented transaction, the level of transition risk is in the range of 5 percent, meaning that 95 percent of the clients and revenue will make the transition to the new owner. This number, however, has wide variation depending on the factors cited earlier, and therefore requires careful consideration in ascertaining the level of risk associated with a particular practice.

In general, the longer the client has been with a given independent practice or business, the less likely it is that the client will leave following an ownership transition without significant cause. Long-term clients are much more likely to stay through an ownership transition (whether to a third party or internally to other partners, managers, or employees); this is particularly true if the assistance of the selling owner has been structured into the transaction, or is part of an internal succession plan. This is a case of inertia working to the advantage of the transition.

A corollary determining factor for transition risk is the tenure of the financial advisory practice itself. The longer and better established the practice is, the less likely the clients are to leave the firm in the event of an ownership transition. A number of reasons may be attributed to this observation. In longer-tenured practices, the clients may associate the services more with the firm and less with any one individual, thereby making a change in ownership easier and more natural; longer-tenured firms also have acquired a marketplace reputation and position (often referred to as goodwill) that carries through in the event of a well-structured and professionally executed transaction.

The degree that technology is used in the office also factors into transition risk. In practices where there is a high technology level and where the owners have invested the time, money, and resources into the business component, the common result is that client contacts and tracking are more automated and in many cases more systematic as well. In these practices, the transfer of ownership often experiences less disruption than when the contact, processing, and office systems are not as highly automated.

Other ancillary factors that contribute to the transition risk assessment include the owner’s willingness to grant noncompetition/nonsolicitation/no service agreements upon their retirement or exit, and having similar restrictive covenants in place with licensed employees.

Marketplace Demand Factors

Since value is ultimately determined in the open marketplace by what buyers will pay a seller for an independent financial services practice or business, it is important to consider the market demand factors that influence that value. There are several important factors in determining marketplace demand, including:

• The type of practice
• Geographic location
• Size

The first consideration, practice type, is categorized by whether the practice is transaction based, fee based, or fee only. It can generally be said that the higher the percentage of fee income, the higher the demand for the practice, and this is factored into FP Transitions’ Comprehensive Valuation model. The caveat to this classification is whether the practice has a truly specialized niche, which, while often lucrative (and which may increase cash flow quality), can have the effect of lowering marketplace demand because the practice may appeal to a very narrow range of potential acquirers.

As for geographic demand considerations, it is simply a matter of a buyer’s preference as to location. Practices that are located in highly desirable areas (which almost invariably means strong marketplace demographics) have higher demand than practices in rural or lower demographic profile locations. Geographic location has several other interesting aspects to consider. One is that when we list a fee-based practice for sale in Chicago, for instance, for $900,000, it will draw an average of 30 to 50 interested buyers from the general area. If we list the same practice for sale in Scottsdale, Arizona, we see an average of 30 to 50 interested buyers from the general area, and another 30 to 50 interested buyers from many of the colder-weather states.

Finally, the amount of revenue generated by an independent practice or business is an important consideration in determining market demand. This factor tends to be a matter of supply and demand; since the number of successful larger businesses that come on the market is far smaller than the number of lower-revenue practices, there is an asymmetry in supply, which tilts the demand equation in favor of larger sellers in the current marketplace.

Very small practices, those having revenues of less than $200,000, and businesses that have revenues in excess of $1 million per year also have a higher demand factor than those practices in between those revenue levels; one is easily affordable, and the other is more about quality. These demonstrated preferences over the years are accounted for in the market demand index, though it should be noted that the cash flow quality factors and transition risk factors may offset this advantage.

Addressing Insurance-Based Practices

The valuation of an insurance-based practice is different from any other type of valuation we perform. As a beginning, recall that the valuation of a financial services practice or business must address the following basics in order to provide an accurate assessment and useful business-building tool:

• The quality of the practice’s cash flow
• The ability to transfer the clients and assets to a succeeding advisor
• The marketplace demand for what the practitioner has built

In addition to these basic indexes (cash flow quality, transition risk, and marketplace demand), an insurance-based practice requires further analysis to address the depth and length of client relationships with protection-based clients—issues that directly affect the probability, and profitability, of future revenue events. This additional level of study is referred to and quantified in the FP Transitions’ Comprehensive Valuation system as the client relationship index (CRI).

There are many factors used to accurately establish a practice’s client relationship index, but basically the CRI is divided into three primary subcategories for evaluation:

1. Client adhesion
2. Business systems
3. Client management

Separately, no one of these subcategories of the client relationship index significantly affects the overall adjustment to the valuation results of a financial services practice, but collectively, the sum of these factors provides a reliable guide to the overall quality of the client relationships and therefore the book’s ability to generate future revenue events. Since the client relationship itself is the primary driver for predicted future conversions, a renewed focus on how this relationship is managed—now and in the future—is a critical aspect in establishing and even increasing the value of an insurance-based practice.

Impact on Value of the Payment Terms

The results of the FP Transitions’ Comprehensive Valuation attempt not only to value the practice or business, but also to place the value within the context of commonly utilized deal structures and payment terms. The reason for this is that one of the most important components in a practice valuation in this industry is the structure of the transaction; practice valuations are inextricably linked to the deal terms. Comparing values or developing pricing for a financial services practice or business in the absence of understanding and employing the appropriate deal structure, which includes the tax allocations, can be very misleading.

The primary lending or financing source in this industry is the exiting or affected owners themselves or, for larger firms, the business enterprise; this is often referred to as “seller financing.” (This is true for both internal and external transactions.) Seller financing, in turn, means that practice sales and acquisitions require a degree of cooperation and flexibility between the parties before the transaction is completed and for a period of time afterward, what we refer to as an “economic marriage.”

Seller or company financing also means that retiring practice owners look to their successors for more than just the highest purchase price or the largest down payment. In a seller-financed transaction, buyers rely heavily on their own cash reserves or lines of credit for the down payment, and on seller financing to pay for the balance of the purchase price. In sum, it takes buyer and seller, in a cooperative effort, to make most transactions, internal or external, financially viable. This codependence often results in sellers choosing very highly qualified buyers (rather than the highest bidders) who are excellent matches in terms of practice style, business model, investment philosophy, and personality, which, in turn, often results in very high client retention rates, supporting the realization of highest value for the seller.

Deal structuring represents the apportionment of risk in the transaction between buyer and seller. The payment terms that underlie the determined value in our Comprehensive Valuation Report represent the most commonly utilized deal structuring approaches. The basic components used to finance a transaction or to structure a deal include a cash down payment, a basic promissory note, or a performance-based or adjustable note; earn-out arrangements are rarely used anymore and should be avoided by FINRA-regulated practices.

Profitability and Its Impact on Value

The value of an independent financial services or advisory practice has traditionally been driven by top-line revenue, as illustrated in the preceding pages. The ability to access that value in the succession planning process is driven by bottom-line revenue because of the internal ownership buy-in process. In other words, if you cannot consistently generate a reasonable profit, you cannot build a valuable and enduring business.

From the internal buyer’s or investor’s perspective, the business’s profits serve a critical function in almost every case; profit distributions are the primary funding source for their buy-in. Profits are the source of money they will use to make the promissory note payments to purchase stock or an ownership interest from the founder or from the business itself. Profits also serve as a return on investment both for you (the founding owner) and for the incoming partners who are taking on the roles and risks of a formal business relationship. A business that distributes most of the incoming revenue on a revenue-sharing basis tends to have a nominal bottom line. In that common instance, next-generation advisors have little choice but to invest in a job, or building their own book, rather than your business; a paycheck or a share of revenue is the only way to earn a return on investment.

The point is, as a business owner, you have to find a balance between the top line and the bottom line if you’re going to attract and retain collaborative business partners and next-generation advisor/investors. What is that balance? In our experience and based on our study of actual business models, we think the minimum level of profitability to sustain an enduring business model is 20 percent. Said another way, at least 20 percent of the business’s gross revenue needs to make it to the profit line and be distributed to actual owners. In an S corporation, for example, profit distributions are tied to investment and risk, not to production. Profits serve as the return on investment for those who actually take the risk of investing in a business and creating the infrastructure necessary to endure.

The impact on value is this: When profits are lower than 20 percent, equity value, at least in the eyes of an internal advisor/investor, is reduced. As profitability increases, equity value is increased, as is the advisor/investor’s ability to purchase ownership, which brings us full circle—the ability to access value is driven by bottom-line revenue.

Many practices, as they begin to transform into businesses, simply cannot achieve a significant level of profitability, and that is okay. Shifting from a revenue-sharing, one-generational practice is not supposed to be an overnight proposition. But work toward that goal. Succession plans have the added benefit of creating a long-term strategic growth plan for cash flow and equity.

Later in this book, we’ll share an excellent strategy for achieving and even surpassing that 20 percent goal. Eventually, the profit line should be 30 percent or more to reward and attract ownership-level talent and to create a single, enduring business model. In terms of what the right profit level is for your business or firm, think of it as an investor would—after all, that is what you’re trained to do as a financial services professional. As our valuation models become more sophisticated from year to year, as we learn alongside you, the profitability element will become more prominent and serve to provide a more accurate assessment of value from an investor’s point of view.

For the methodology and the actual math on this concept, see the last two sections of Chapter 3, “Remodeling Your Cash Flow” and “Production Model versus Business Model.”