#FASuccess Ep 008: David Grau On Maximizing The Valuation Of A Financial Advisor’s Book, Practice, Or Business

What You’ll Learn In This Podcast Episode

• Why the valuation process makes many independent “book” owners rethink how they can capitalize on and maximize the value of their greatest asset. [12:20]
• How David started out as a securities attorney and a state securities regulator, before launching FP Transitions. [20:58]
• Why books and practices – which together make up about 95% of the financial advisory industry – struggle to remain sustainable businesses once their advisors retire. [29:51]
• The specific definitions for books, practices, businesses, and firms that form the foundation of how to manage and grow what you own. [33:06]
• Why FP Transitions emphasizes building multi-generational practices over third-party sales. [39:01]
• David’s thoughts on why the industry-standard of revenue-based compensation actually destroys equity value and limits the ability to grow from a practice to a true business. [47:43]
• The supply and demand, and overall health, of the merger and acquisition marketplace in the financial advisory industry right now. [1:05:56]
• How a great match between a seller and buyer still necessitates a deal with shared risk and shared reward to maximize the value of the firm for all involved. [1:09:00]
• Why selling your client books to or through your broker-dealer or custodial platform may not be the best deal that you could get for the practice. [1:13:27]
• How predatory buyers force you to essentially take your practice off the market – AND leave most of your hard-won clients hanging. [1:16:04]

Resources Featured In This Episode:

• David Grau - FP Transitions
• The FP Transitions Comprehensive Valuation Report
• Succession Planning for Financial Advisors: Building an Enduring Business by David Grau
• Buying, Selling, and Valuing Financial Practices: The FP Transitions M&A Guide by David Grau
• How Revenue-Based Advisor Compensation Ruins Succession Planning

Full Transcript: David Grau On Maximizing The Valuation Of A Financial Advisor’s Book, Practice, Or Business

Michael: Welcome, everyone. Welcome to the eighth episode of the Financial Advisor Success podcast. My guest on today's podcast is David Grau. David is the founder of FP Transitions, the leading marketplace for financial advisors looking to buy or sell financial advisory firms, in addition to a consultant on advisor mergers and acquisitions, success planning, and valuations. In this episode, David shares his perspective on the four types of financial advisors: books, practices, businesses, and firms.

Advisory firm valuation trends, given that FP Transitions had done almost 9,000 valuations and facilitated over 1,500 purchase and sale transactions. Why a multiple of revenue, rule of thumb for valuation is actually a reasonable way to value a book, but a problematic way to value a practice or a business. And why paying revenue-based compensation to the advisors in your firm ultimately destroys your ability to create enterprise value as a business.

We also talk quite a bit about David's two books, "Succession Planning for Financial Advisors" and "Buying, Selling, and Valuing Financial Practices," both of which I've read and highly recommend, and you can find directly from our show notes for this eighth episode at kitces.com/8. Be certain to listen to the end as well, where David discusses the problem with relying on your custodian or broker-dealer platform to find a seller for your business, and why you should be especially cautious about using the company's standard selling agreement.

And so, with that introduction, I hope you enjoy this episode of the Financial Advisor Success podcast with David Grau.

Welcome, David Grau, to the Financial Advisor Success podcast.

David: Thank you, Michael.

Michael: So, I'm excited to have you joining us today. I've kind of followed your work from afar for, I don't know, I guess almost as long as I've been in the business, is as long as, I think, you've been doing this as well. I started in the business in 2000, so I'm going 17 years. And you've been running this business of helping financial advisors buy and sell advisory firms, and I guess a marketplace for them to meet each other, for almost that long now, I think. So, can you kind of share for our listeners your business and what you do?

David: Sure. Well, FP Transitions started out in 1998. A group of five of us got together and our goal was to use this new thing called the internet to help advisors meet each other and create a match, a method for buyers to find sellers, and for sellers to find buyers. The model has evolved significantly since then, but at the time, that was the goal. So basically, we were going to become, and were, one of the earliest matchmaking services in the industry, for buyers and sellers, and later we added paperwork to it.

Michael: So, I mean, I'm trying to think back. So this was the era of, like, match.com and eHarmony. So, the vision was you wanted to be eHarmony for financial advisors buying and selling firms?

David: We honestly didn't. You know, at the time, you think back to those humble beginnings, there was an understanding that the independent industry was obviously here to stay. But people began to ask good questions. So, if we have all these independent advisors who own what they built, what do they do at the end of a career? So the thought was that there would be...and I'm sure you've read this, and I've seen it many times, too, it was going to be just this tsunami of advisors who needed to sell, who would need good buyers. And simply matching them up made all the sense in the world.

Michael: Like the Harry Dent age wave was supposed to plow through our industry and cause mass selling.

David: And this will sound funny now, but I remember as we sat down as a group to lay out the blueprints for what inevitably led into FP Transitions, one of the guys said, "Well, this is internet-based, so all you have to do is build it and it will run itself, and we can all go back and do our day jobs." So, all five us said, "We're in."

Michael: Oh, that's awesome. That's awesome. Yeah, you just turn the website on and you let people buy and sell on your platform, and then you go away. Like eBay have hardly any employees as well, right? You just open the marketplace and you let it run.

David: But sometimes, I think if you really knew what you were getting into, you'd pause and have second or third or fourth thoughts. At the time, this sounded wonderful. Nobody knew any better. So off we went and we gave it everything we had and, obviously, we had to make a few adjustments along the way. But that's what we thought.

Michael: So when did you get started? When did the first site go live?

David: The first site that went live that anybody saw, that actually worked, was late 1999.

Michael: So, wow. So it really was the point I was coming into the industry. I can't even remember how I came across FP Transitions originally. That really was the early days. So, I remember at some point, you had a couple of versions of this as well. There was FP Transitions and there was RIA Transitions, and a couple of others.

David: Correct. So, we still do all of those things. Back in the good old days, it was simpler because of regulatory issues, technology issues, to simply not ask an insurance an agent or not as an RIA to go through an insurance agent's form to fill it out and just fill out the parts that applied to you. So, we tried creating separate interfaces all under one company. And the problem with that was websites, well, if you remember back to those days, you know, they had to speak Netscape, AOL, Internet Explorer. I can't remember all of them, but each one was you literally had to program the website in multiple languages. So, if you had to have each one in four of five different languages, and you've got four or five websites, you need a full-time IT staff to maintain it. And that was just not practical.

Michael: So they got consolidated down to this thing that we now call FP Transitions.

David: Correct. And we still work with RIAs and registered reps and independent insurance agents, but now one site can help identify who it is we're talking to and provide that user the correct interface and information that's pertinent to just them. We got good at it.

Michael: So can you help me understand a little of just what the business, what that service looks like today? I mean, I suspect at least most people now have seen, I guess, match.com or eBay or even Amazon, like, any number of businesses that do, we'll call it online marketplaces. So, help us understand what FP Transitions look like, because as far as I know, I don't just go to the website and browse around and just get match.com profiles when I go there and make a quick login. You got a little bit more involved.

David: Yeah, so here we are, almost 20 years old. We just hired our 39th staff member, so we've got a lot of people here. And we've got a lot of different professionals. So, we still help independent advisors who have a goal of how do I transfer ownership from my generation to the next? Except now, in addition to finding a match, which is what we call exit planning, we do succession planning. We do mergers. We do tax-free exchanges. We do continuity planning. We handle all the specific skillsets that go into that transition: law, taxes, regulatory compliance, cashflow analysis, compensation structuring, profit structuring, documentation, valuation, marketability.

So, we have different specialists who completely surround the advisor. And depending on what their goal is, what they've built, how they've built it, how much time we have, we can help them lay out a plan of action specific for their needs and specific for the regulatory structure that they live in. And we've gotten quite good at it.

Michael: But you're still...I don't mean this negatively, but so you're still built primarily around leading up to either valuations or transactions. This isn't meant to be broad-based practice management consulting. Is that correct?

David: We're definitely not a coach. We always say that to our clients. We assume you're not hiring us to motivate you. So, we're definitely not in that business. Some folks will look at us and call us a consultant, but you know what? We've got half a dozen lawyers here. We have cashflow analysts. We have compensation specialists. We have folks that'll come inside of your entity structure and literally just rebuild the entire structure so that it's designed to last for 40 or 50 years. I don't know any consultants who do all the things that we do.

So, I'm not even sure I'm comfortable with that word. I think we're kind of a one-of-a-kind model and depending on what the client needs, the one thing we never wanted to be was succession planning in a box. We do not do that. No static solutions up on the shelves for every client. And we don't expect the clients to fit in through every square peg in a round hole kind of thing. We custom build and design the plans and we work with about 2,000 clients a year. That's why we have 40 people.

Michael: I was going to ask, so how many firms are you typically involved with through the year, between...so I guess, there are valuation services, there's actual marketplace transactions you support, internal succession plans I guess you help do, valuation and crafting the structure of the plan. So, what's sort of the split across those in terms of the kind of activity that you guys are typically engaged in?

David: Valuation is probably our single most popular item.

Michael: Everybody likes to know what they're worth, right?

David: Yes. You know, not only what are they worth, but a lot of other questions come out of the valuation process. I kind of liken it to the annual physical. It gives the doctor all the baseline measurements. So, the client comes in and wants to be told they're fine, you know, go home. But from the doctor's point of view, you start to amass all the underlying measurements and data points. So when we know all those things, we can actually offer good advice.

Without all of those input pieces of data, the output would be useless to us. It's interesting to the client, but the client usually is saying, "Well, how much value have I built?" But that's followed up real quickly by, "And what do I do with it? How do I protect it? Will anybody really buy it? Would my son or my daughter or my key employees be interested?" So the questions that follow, it isn't the value that really makes the difference. It's all of the other 100 pieces of information that they give us and share with us.

How The Valuation Process Makes "Book" Owners Rethink How They Manage Their Largest Asset [12:20]

Michael: And so how much activity do you see between the channels, between RAs, the brokered dealers, the insurance agents, because you're working across all of them? Are one of those more dominant than others or are they differently focused? Like, RIAs are doing a lot of internal succession plans, but insurance agencies just want a quick marketplace transaction.

David: There is a pretty big difference, and our own staffing level, we've begun to have people who specialize in independent insurance support, who specialize for RIAs, and those who specialize for registered reps. We certainly see some crossover between a registered rep or an RIA or an IAAR. Don't see a whole lot of crossover into the independent insurance sector yet, but I think that's changing.

We're just starting to see the insurance folks who...I'll say this in a nice way. In terms of valuation, practice management's the wrong word, succession planning, exit planning, building sustainability, it's the independent insurance agents are 10 to 15 years behind. It's just never been an issue for them. They've had a very strong mother ship to rely on.

Michael: Well, and the businesses just never grow the same way, right? I mean, when...I mean, this is what struck me, because I started in the insurance side of the business, and then I spent some time in the IBD channel before I ultimately landed at an RIA. And I still remember the driving difference across them, just from the business perspective, to me, was that the insurance business is a transactional business. You know, granted some types of coverage give you some trails, but nominally speaking, you wake up on January 1st. No matter how good you were last year, your income is zero. So you get your backside out there and you meet some people and you do some business.

And because of that, you can only ever build your business and your infrastructure so large, because A, you're always...the more you hire, the more mouths you have to feed, so it becomes kind of terrifying. And because you're only as good as what you did in the current or upcoming year, you know, at some point just there's so much pressure that you create for yourself with more staff that it's just easier to be lean.

And when you flip over to the RIA side, or really just the AUM model, but the RIAs kind of embody it, you get to a point where after you've been doing it for a couple of years, you wake up on January 1st and you look and say, "Wow, I've got 75 clients that have a million dollars each," or whatever my number is. "I've got $75 million under management. Is $600,000 or $700,000 of revenue. And all I have to do is give them good service and all the revenue stays."

And it's pretty easy to start seeing, like, "Wow, if all I had to do to keep $750,000 of revenue was hire some really awesome service people to service my clients well," it gets really, really easy to start justifying a lot of hiring because there's a revenue to pay for it, a natural profit margin. And the truth is, it costs less to get good service people than it does to get new salespeople that bring in business. And so the math just works.

And then, the businesses start getting bigger. And, I mean, you look back over the 15 years of the RIA movement and, to me, that's what's happened. They just accrue bigger because recurring revenue that can be supported by service staff is an amazingly robust model at the end of the day.

David: But one of the things, I think, that we could say that it is a common thread between the registered reps, the RIAs, the IAAR hybrid model, and the independent insurance agents, Michael, is that once these folks go through the process of obtaining a formal valuation, and they spend an entire Saturday, some cold January or February, inputting all of the data we need to do a good job on the outputs, when we give them the results and they look at that number, many of them, for the first time in their life, they're all struck with a kind of a common understanding or result.

This small practice that I own is the single largest, most valuable asset I own and I better do something with it besides going to work on Monday. But what is it? And that's the dialog that begins to start. That's why it's so important that we do a thousand plus valuations a year. That's what begins the dialog.

Michael: Well, and it strikes me. So, when you look at the management of, say, a large business, particularly a publicly traded company. So, there's a natural feedback mechanism when you're the owner and leader of a publicly traded business, which is every possible bit of information about what you're doing, how you're running a business and its trajectory, is factored into your stock price.

And to me, it's the purest form of the ultimate key performance indicator, the ultimate KPI metric about how you're doing and building and executing your business. The challenge in small and closely held businesses, in general, and I think certainly for the advisory world in particular, is that because, historically, most people didn't do valuations, didn't even have a good, affordable means to get a valuation, they never had perspective on...there's no feedback system to let them know, "You are doing the things that actually make a business more valuable as a business."

And otherwise, we just kind of get caught up in whatever gives me current income or whatever gives me less pain, all the things that we normally react to in our day-to-day lives when there's no other feedback or guidance. And just the idea of saying, "I'm going to stop running my business by just reacting to problems or doing what feels right at a gut level, which may or may not be right in the long run.

I'm going to actually get a valuation with an objective marketplace feedback of whether the things I'm doing actually enhance the value of my business in the long run." And I think, in the truest sense, when you change the way you measure the outcome, you'll start changing your own behavior in, hopefully, positive ways, at least if your goal is to enhance the long-term value of your business.

David: Well, and ultimately, Michael, that's why we wrote and published our last two books. You know, we've done now, gosh, upwards of 8,500 formal valuations. So, the clients would ask the questions, as they should, "What's next? What should I do with this? What can I do? What am I not understanding?" So, the first book we wrote was "Succession Planning: Building an Enduring Business." So that was all about sustainability. Do you want, are you capable of building something that will still be here 30 years from now?

Our second book was kind of, we call them the bookends. Our second book was "Sell It, Merge It, Move On." So, those are the folks that, for whatever reason, aren't interested in building something that's still around in 30 years, but they do want to monetize what they've built. They want to make sure that they take their clients and put them in the hands of somebody who's at least as good as they are as a seller.

So we gave people real clear choices and then said, "Okay, with those two choices, which intrigues you the most?" There's still a hundred possibilities with each one, but which one? Are you a builder? Would you rather just sell it and monetize your value and go do something else? Those are both perfectly good answer, but when you have a valuation in your hand to start the exploration process, I think you look at the answers with a completely different set of glasses. And I think that's important for our industry.

David's Experience Before Launching FP Transitions [20:58]

Michael: So, can you give us a little bit of context about how you came to this path? I mean, you started a tech company in 1999, so did you have a tech company background? Did you have a practice management consulting background? Like, how did you actually come to the table as a tech entrepreneur for the financial advisor world?

David: Michael, if my staff could hear that question, they would all be nervously giggling right now, because I am the least tech person you'll probably ever meet. I can barely turn the computers on in the morning. But that's okay. I have lots of really smart people around me. And I learned a long time ago, surround yourself with good people and they'll take care of you. So, I started in, of all places, as a regulator.

So, after I finished law school, I had worked about, between undergrad and law school, I worked about nine years straight, 100, 110-hour work weeks. I was tired. I barely even knew my family. I had two small children at the time. So, somebody said, "Listen, the perfect place for you, go to work for the state government. You won't work that hard. You'll have nights and weekends free." And I wanted to learn something about securities law, because I just always was fascinated with that.

I knew some former regulators and they said, "We'll get you right in. Stay for two years and then make a decision." So I did. I became a regulator. I took my bar, passed my bar on the first try, and I went to work as a regulator for two years.

Michael: In what area? Like, in securities regulation?

David: In securities regulation, yep. I did a six-month stint, a little bit in licensing, a little bit in securities, like, regulation, like Reg D and pro formas, and prospectuses. And then I spent the last year in enforcement.

Michael: Wow. And was that in a state securities department or were you federally with SEC or FINRA?

David: So, I worked for the Oregon Securities Division. At them time, I was...at least for a short time, I was the state's liaison to what was the NASD office up in Seattle.

Michael: Okay, so FINRA's predecessor.

David: Michael, I went into work the...it was on, like, literally the first day and the oddest thing happened, you know, you look back on these things and you wonder if that wouldn't have happened, but I sat down and somebody put this file in front of me and they said, "You're the rookie. You get the lowball assignments. And your assignment is to write a set of transition rules for this new group of advisors called independents."

So, and, you know, at the time, I didn't know what all those words meant, so I asked a lot of questions. And I said, "Transition, you mean like buying and selling?" And they said, "Yes." And I said, "So, we don't have anything in our statutes about independents." And they said, "No. They don't need anything special. They're just like wirehouse reps." I thought, "Huh." So, I never forgot that. But from a regulator's point of view, they're all the same. You know, the securities license, you know, 7 63, 65. And we regulate them. We license them. So, they all paid the same fee. I could see, from a regulator's point, they were all the same thing.

So, I sat down and I had to learn how to do transition rules. And I took that with me when I left the state a couple years later. I went out into the world and hung up my shingle as a lawyer. I had an instant RIA law practice, and I literally wrote a letter to every RIA in the Oregon and Southwest Washington area, and said, "Listen, if you need help, I'm a lawyer. I'm not very expensive. I know the rules and the regulations. And a former regulator. Call me if I could be of help," and I put my business card in there. This was back in the days of a dot matrix printer, so it took me about two weeks just to print the letters off. I had a 50% response rate to my letter.

Michael: And you were contacting them about things related to transition planning, in particular, or just anything? Lawyer for hire. Got a legal problem or question about your RIA, call me.

David: That's it, Michael. Perfect. I mean, I'm a relatively new, young lawyer, but I was hungry and I knew the rules, and I was pretty good at what I did. So, I had a huge response to my letter. And my plan was I was going to help them set up their entities. I was going to help them build businesses. When the time came, of course, I would help them sell those businesses.

What I didn't realize was that, even back then, given the relatively high average age in the industry, and without any other choices, I got a lot of calls from people who said, "You know, David. I've been thinking. This has been on my mind now for a couple years. I'm 63. I've got $75 million in assets under management, 50 some great clients. If I were to sell it, do you suppose anybody would pay me any money for it?"

Michael: And, I mean, at the time, this would have been, like, and independent RIA advisor with $12 million under management? I mean, were they mostly very small at that point?

David: Fifty to 75 million would have been real typical, at least the ones that I worked with.

Michael: Okay. So, that's a good size.

David: Yeah, so you look at that, and I said, "Well, I do know that we have rules in place that allow you to do this. Not many people do it, but I think it's possible."

Michael: Because I guess, at the time, I mean, literally, the idea of can you sell this investment advisor registration and the entity and the client contracts with it, like, that was actually kind of a novel legal question?

David: It was a novel legal question. But I had the advantage. I had, as a mentor, I had this really nice guy, senior attorney with a JD CPA LLM, and he always taught me to think the other way. And he said, "If there's not a clear rule that says you can't do it, your job, as an attorney, is to help them figure out how to do it." So, I started realizing that, you know, that was the secret sauce. I can help you do this. I don't know how, but I will figure it out. We're going to do it. And I was selling these things. I mean, nobody who called me went unpurchased. We found buyers left and right. That was easy.

The hard part was the deal structure and the valuation. So, nobody back then really knew how to do that. You know, we started out with nothing down, tenure earnout arrangements. But after a while, you go, "Okay, an awful lot of buyers, every time I let them know that we've got this opportunity, maybe that's not the right price. Maybe those aren't the right terms." So, little by little, that kind of wound its way into the genesis for FP Transitions.

Michael: So this idea of, "Okay, there are clearly some sellers who want to sell. There are some...there's no lack of buyers, even then, for people who want to buy. So, let's be a matchmaker and we'll help them figure out deal terms, valuation, because that's a vital function that some middle man needs to play." And that was the business. That was the deal.

David: Yeah. And then we created the first iteration of what would somebody become FP Transitions. We started with five owners. That was crazy, when you think back on it, but that's what we did. And I must have...

Michael: Where did they all come from? Were these all just people you knew that had some expertise to bring to the table?

David: In all humility, I will have to give credit to two other guys. I was actually the last guy on the team. So, I contributed the legal and the regulatory expertise. We had a CPA on the team. We had a marketing sales guy on the team. We had a website builder on the team. We had all the tools. I'm not sure we had a real good long-term strategy. We had to figure that out. But we had a lot of energy and we had, you know, like I said, "We're going to build this website and let it run itself." So, you know, as new, young, small business we probably made every mistake in the book. But here we are 20 years later, so if you adapt and adjust it just proves that you can figure your way through it, I guess.

Why Books And Small Practices Struggle When Their Advisors Retire [29:51]

Michael: So you now have about, almost 20 years under your belt of watching these dynamics. I mean, this has certainly been the rise of kind of the professionally managed advisory firm, and building, selling businesses for value. So, I feel like you've probably been closer to the heartbeat of advisor M&A trends over the past 20 years as pretty much anyone in the business. So, I'm curious, from your perspective, like, what's changed, what's stayed the same over the past 20 years?

David: We thought, as I said earlier, that there was going to be this tsunami of sellers. That was wrong. What we've learned over the course of time is that about 1 in 10 advisors sells their practice and moves on. So, that is not the first choice on the way out the door. So that's one thing we learned. Second, sustainability, durability. Those are important words and they're powerful words, but let's be clear. Independent advisors have an Achilles' heel. And that heel is they don't build something that will outlast them.

Most of the industry are built up of, I call them books, small practices. And they revolved around a force of one. You might have some staff members on board, but if we lose our central advisor, the clients will quickly dissipate and go someplace else. Everything revolves around one individual. And when they retire, die, or become disabled, it's over. So these models are extremely perishable on the one hand, but they're extremely valuable on the other. They make a great income. And it's more than that.

You know, most of these fee-based models, they have a good, strong, sustainable top line growth rate. They have predictable, recurring income. And everybody says, "Yeah, yeah, yeah. I get that." But what they don't understand is that predictable, fee-based income also tends to create predictable overhead structures. And what that means is, you can begin to create a very good, strong profit line, and it's predictable. And the reason that that matters is we're trying to get next generation advisors to buy into these models and invest their money and their careers to build on top of the first-generation practice model. You need growth. You need profitability. You need good compensation.

And these fee-only registered rep or RIA models, and now, lately, even the independent insurance that are headed that direction, they create these things inside the structure. They are built and can be easily...well, I won't say easily, but you put enough effort into it and you start soon enough, you can build a multi-owner, multigenerational business out of just about any practice out there if you know to ask the questions and to start learning the lessons soon enough.

Definitions Of Books, Practices, Businesses, And Firms [33:06]

Michael: So what are the lessons? What is it that, in your mind, that defines that difference or that transition from books to businesses?

David: We break the industry down into four distinct sectors: those who own books, those who own practices, those who own businesses, and those who own firms. And we don't use the terms interchangeably. So when I say book or I say practice, I mean something very specifically. Anyone in the audience listening, if you want to learn more, we cover these definitions in both of our books.

And I think if you understand what they are and how they apply to you, it changes everything. And the basic rule is this. What you built and how you built it will determine how you value it, how you transfer it, how you build a durable model out of it. So, let's start with the basics, those who own a book. So, a book is, obviously, it's smaller, but that's not the point. Structurally, most books are sole proprietors or sole practitioners. A book tends not to get above about $250,000 in revenue. They don't have much of any infrastructure. A book owner, which I think describes about 70% of the independent financial service providers, is the essence of independence.

Michael: Be your own boss. Do your own thing. Work with who you want. Do what you want for them within regulatory constraints. No employees. No burdens. Just you're your own boss. Do your thing.

David: Perfectly said, Michael. I mean, you get to make as much money as you want. You can work as hard as you want or not. So there's nothing wrong with that, it's just because there's no...it all revolves around one person. It's very perishable. A practice, next level up. And so we'll not put dollar signs with it, because that's not a good way to describe it. But structural elements are a good way to describe the differences.

So a practice will almost always be centered around an entity, an S Corp or an LLC will be the common means. A practice will typically have one shareholder of that S Corporation. A practice can be worth millions and millions of dollars. And usually there's a staff. They've signed a lease. They built an infrastructure. They have computers and a phone system, and a copier. They've been doing this for 15, 20 years and they're pretty good at it. But everything still revolves around what we call a strongly held model.

Michael: Advisor owner of the practice. I might lease an office space, and a couple of staff, and some infrastructure, but they're my clients. I work with them. I see them. Maybe you can occasionally call them about a service issue or help with some behind the scenes work or sit in on the meeting, but, you know, it's my practice and they're my clients.

David: Yeah, exactly. But what's interesting is, you know, we do a lot of valuation work on practices and we'll turn the first valuation draft around, and it'll come out to $3.5 million dollars. And you say, "Now, wait a minute. How does a one owner S Corporation possibly serve that many clients and generate that kind of value? You know, you'd have to somewhere in the $1.5 million to $2 million worth of gross revenue. That's a lot of money. How do you do it?"

So, what typically happens is that practice owners surround themselves with book builders. And when they turn the valuation inputs in to us for our opinion, they include in it all of the production of the book builders. So, one of the things we learned that helps us work with book builders and practice owners who want to grow into business owners is we've become very good at spotting what we call fracture lines.

And the fracture lines mean that that book builder, not that they would, but they could pick up and walk across the street at some point in their career. And 75% to 85% of those clients, maybe all of them, will follow. So, they don't own any shares in the S Corp, but they do own something. They are building a book.

Michael: They own the book. They own the client relationship. Right, they're the ones that see the clients. They own the client relationship.

David: So, a long time ago, we started differentiating between those who wanted to build a book and those who wanted to build a business. Huge difference. And, you know, the practice owners, I think, do themselves a disservice, and it makes it very difficult to plan, when they convince themselves that good cashflow and a satisfying life means I've taken care of my clients. No, you've taken care of your family. But you still have that Achilles' heel.

If something happens to our practice owner, that model is gone. There is no succession plan in place. There could be, but they haven't begun to work at it and they built a practice and a group of books. And a practice and a group of books, added together, do not equal a business no matter how big the dollar signs get. It's structure. And there is no structure that's durable or sustainable in a typical practice model.

Why FP Transitions Emphasizes Building Multi-Generational Firms [39:01]

Michael: Well, and it strikes me. I mean, even when you look at it in the aggregate, like, a practice owner that brings a bunch of advisors "on board", "Hey, you can run your books and business under my platform," like, I've watched so many advisors do this for a long time. And, you know, I say to them, sort of half-joking, half-seriously, "You're reinventing the broker-dealer model. You're reinventing what your parent company does.

Your parent company is a platform that has a whole bunch of advisors on the platform, each of whom own their own independent books, but use the platform. And the platform takes a slice of the revenue as an override, and that's what you're usually doing for the books that are downstream." And, you know, you can make some decent cashflow off of it, but, you know, look at what your ultimate fate is. Broker-dealers struggle to get sold for one times revenue.

Many of the big ones lately, in public news, have gone for less. They couldn't even get one year's trailing revenue. And they're struggling with, you know, mid-single digit profit margins, even at sometimes hundreds of millions of dollars of scale on up. All because, at the end of the day, like, it's a very commoditized business that's difficult to create much enterprise value, because you don't own the client relationship.

All those independent book owners are the ones that control the client relationships and, at the end of the day, kind of control the lion's share of the actual value creation in the process.

David: But, you know, it took a long time, and a lot of valuation data, to learn these things and begin to be able to spot them, and then to begin to create solutions for them. So, but we have. So, we think that practices are about 25% of the industry. So, think about what we've just said so far. Let's summarize this. Books and practices are one owner models that are not built to be sustainable. Basically, they die at the end of an advisor's career. And we just described 95% of the independent space. Now, that's scary.

But that's also, you know, Michael, earlier on you were asking me, you know, "Tell us about FP Transitions itself and what it does." That's one of the things that we have simply made as our mission, that we want to change that. So, either more of these folks need to sell to a bigger business that is durable and sustainable, or we need to convert more and more of these practice models into businesses so that they can serve the children and grandchildren of their current clients, and have a multigenerational model. That's what we're doing.

Michael: So, if the book is the individual advisor with basically no infrastructure that just does their thing for their book of clients and that's that, and a practice is, all right, it's still kind of built around me. I've got some staff and some infrastructure, and maybe an office space with some lease and a couple of people that are supporting, so I can get a little bigger because I'm not just constrained to my hours of the day. At least I've got some people's support. But you still cap out.

So, I'm curious then how you define the next level, which, I guess, in the sequence, is from the practice to the business, and how you define the distinction between a practice that has a bunch of advisors, which you're called books, tucked up under the practice versus a multi-advisor business.

David: Yeah, thank you for that segue. So, I think the biggest single issue that we'll spot that creates a difference between a practice and a business is compensation. So, and again, this is what comes out of the valuation process. You know, to the client, they like the dollar sign and the big number in bold print on page five of our valuation. To us, it's the PNLs, the balance sheets, 10 pages of input data, an interview to learn more about them.

And what we have learned is this. What really creates a business are just a handful of things. Let's start with compensation, though. First of all, practices tend to be eat what you kill revenue splits, revenue sharing models. A business will move to a very formal W-2 based salary structure. There may be some variable comp on top of that, a bonus, or even a little bit of eat what you kill, but it's not the predominant method of compensation.

That's a big deal, because as I said earlier, especially these fee-based models, they tend to have good, strong, sustainable growth rates. They have predictable revenue. They have predictable overhead structures and relatively low overhead structures compared to the world of law or accounting. But the bottom line, and it literally is the bottom line, when you have a correct compensation structure, you will have profits, profitability.

And what we've learned is this. Businesses are built with a bottom line in mind. In other words, they literally are about the earnings. So, when you look at a book or a practice, those typically are valued top line of the PNL looking down. Businesses and firms are bottom-line, looking up. It's a different approach. It's a different valuation methodology. Everything is unique because of the profitability. But it's even more than that.

Businesses, they have a strong organizational structure where the goal is enterprise strength. Of course, revenue strength matters, but there has to be a balance between the two. Businesses will have an entity. Our definition of a business is that it has to have at least two owners and at least two generations of ownership. That's not hard, and that's not describing a company of 25 or 30 people. That's a father and a son, a mother and a daughter.

Michael: I was going to say, that could be a father and a son and one or two staff members with an entity.

David: So, but the key is, we need W-2 comp, not 1099. We need to start getting away from eat what you kill, and get into scalable, profitable growth. The goal for most of our business owners is they're going to bring at least 30%, 3-0 percent of gross revenue to the bottom line and disperse it from there as a profit distribution to those who take the risk of ownership. Now we're talking next generation. Thirty percent, people look at that and go, "Well, how is that possible?" We do it all the time. And all the credit goes to the independent advisors out there.

When you have a fee-based model with repetitive, predictable income and it grows in the 7% to 10% a year top line range, and you create scale through the right compensation system, because of the relatively low overhead in this industry, at least compared to other professional service industries, a practice, a big practice that is evolving into a business can bring 30%, sometimes even 40% to the bottom line.

And Michael, here's the point. Why does profit matter? It matters if you're an investor. In other words, if you're a next generation advisor who says, "It's time to make a choice. I've got my own book. Do I want to go across the street and build my own practice, maybe a business? Or would I be smarter buying into the existing owner's business and using the money that flows through it to help fuel my ambitions?"

Let's build a second generation on top of a founding level's platform. Is that smarter? And we help them answer that question. But I'll answer it real succinctly for you. If you're 30 something years old and you have an opportunity to make an investment with a 30% ROI, and you have a good paycheck, and it comes with a mentor, you look at that package and you go, "Gosh, I wish I would have had that opportunity when I was in my 30s." This generation does, and they're smart. They're looking at that and they're saying, "Yes," when they're asked.

Why Revenue-Based Compensation Destroys Equity Value [47:43]

Michael: I'm struck by your comments about compensation because I feel like there are a lot of advisory firms out there that would call themselves businesses and have multiple owners and pretty much all the other things that you described there. But I feel like it's still an industry standard, even in large, independent RIA businesses, that advisors are compensated based on their revenue that they're responsible for, even if it's not directly an eat what you kill kind of thing, because maybe the firm generates the revenue or the senior partners generate the revenue, bring in the clients and hand them down.

But that, you know, the advisor who manages $100 million and a million dollars of revenue for clients get paid a much bigger number than the advisor that only generates $300,000 or $400,000 or $500,000 of revenue, or is only responsible for a couple hundred thousand dollars of revenue. So, I don't know. Can you talk about that more? I mean, I'm imagining a lot of firm owners that are probably saying something to themselves like, "David, no offense, but you're nuts. If I take my advisors and I turn them...and I pay them a salary, they're going to leave." And they're going to leave and take the clients. They're supposed to be the value of the firm. It's like, "If I do what you say, I'm going to blow up my business."

David: Michael, that would not be the first time I've heard that. So let me respond. So, in our industry right now, whether you're building a book or a practice or a business or a firm, most owners have one primary tool with which to reward a producer: compensation. So, if it's the only tool in the toolbox, you have to solve all the problems with comp. So, yes. In that case, comp does have to be high. And that's why people have gravitated towards the revenue split.

So in other words, how do I get somebody to act and think and produce like an owner? Ah, I know. I'll pay them like an owner. But here's the problem. And I'm an English major, but I love to say, "Do the math." So, let's say you've got an RIA with...well, that's probably...you know, a hybrid model. That's a better model. That'll apply to more of our listeners. You've got a hybrid model. Typically, overhead not including owners comp, about 35% to 40%. So, the way you're going to reach really strong, sustainable growth, you're going to give your producers a 50% payout. And we hear this all the time.

Michael: And just think of how many reps I can get on at that payout, and then my revenue will be huge.

David: Yeah. So, okay. But think about this. Just do the math with us. So, this person produces half a million dollars a year. They take $250,000 of it. You get $250,000. Well, that's nice. That's a lot of good cashflow. Except, out of your half, you have to pay all the overhead. So, basically, you get what's left. Now, if I look at those two sides of the equation, I would rather have what the book owner has.

Michael: Yeah, why would I... I've already got the $250,000 with no responsibility, aside from serving the clients. Why would I want your $50,000 that has all of the expenses and the management crap?

David: Yep, and we say the same thing. I mean, they don't worry about payroll. They don't sign a lease. They come and work when they want to. They want to take a month off, they take a month off. Owner side or the founder side, they've got all the responsibilities, some of the liability. They've got all the overhead structures, and then they get what's left over. And let's take it one step further.

The book builder also does have value. Right? Because if they're the only ones talking to these clients, they're building a book, right underneath your roof. Now, that's what we call fracture lines. So they get most of the money. They get none of the expenses. They get all of the equity. So, the founder who's saying, "Well..."

Michael: I got to pause you and interrupt. So, you say they get all the equity, except...so this is kind of like: They get all the equity, except they don't actually have any of the equity, except they really do?

David: Well, the equity in the book. Yeah, because that book is perishable and that book will walk across the street.

Michael: Because I feel like it's this thing like, I own the firm. The clients sign the paper with my firm. The servicing advisor may have a book and, you know, gets a 50% payout on it, but the clients are signed with me and I own 100% of the equity. Ha, ha, ha, ha. I'm going to run all the way to the bank. That's a painful distinction to actually say to someone, "Well, no. You really don't actually have the equity in all those client books."

David: No, but let's make that the point, equity. So, our argument is let's put equity into play. How do you motivate somebody to work hard, to produce a lot, to think like an owner? So, in our models, and one of the things that is one of the difference makers between a business and a practice, is that the owners and the producers are typically one and the same. Our producers are rewarded both with compensation and with equity.

So in other words, they become shareholders in that S Corp or that LLC. And what people don't understand, and they really do need to just do the math and compare the models, and look 10 years out, when you have W-2 comp plus some variable plus equity...and think about what equity means in a fast-growing, profitable S Corp or LLC. It means that owner now has at least three ways to build wealth.

One, compensation. They've always had that. They still have it. But now, instead of that being the only tool, that's almost the worst tool. Ordinary income tax rates, and it's like riding a bike, you stop pedaling, it falls over. We're going to add to that the benefits of equity, which are twofold. One, profit distributions. Now, you have a separate, second stream of income that comes in that augments your compensation. And remember, compensation is for really what you do. It's wages for your work.

Profits, that's the benefit of being a shareholder and building something bigger than you. But there's one more thing that people always overlook, and that's the value of your ownership. So, think about that. If you're a 20% owner in an S Corp worth $3 million, you've got $600,000 worth of value in your stock. It's protected internally with a shareholders' agreement.

But you know what? Let's say you're 40 years old. You've got a 20 to 25-year runway still left. This thing is growing. Let's just say, you know, average of 7% a year top line. So what happens over the next 20 years? Well, your $600,000 worth of stock could double in size twice over. That isn't just going to happen to you. You've got to work at it, but you could easily end up with $2 million worth of ownership and maybe buy more stock.

And we always quiz our owners, because it's fun, but we say, "Listen, wages, ordinary income. Profit distributions, slightly less an ordinary income. Do you realize what the tax rate is on the growth of equity in these models?" And of course, the answer is nothing. As long as you just start building it and holding it, it's all deferred. You add all of that together, Michael, and put that on a spreadsheet, and lay it, look that out into the future 10, 15, 20 years, generation 2, generation 3, by building on top of an existing model, by layering in multiple layers of tax strategies...and this isn't rocket science.

I mean, lawyers have been doing this since the Mayflower came over. You don't end up with a multiple of two. You're in the five, six, sometimes seven times range. It's far more lucrative to build and stay, and build on top of an existing model than it is to hang out your shingle and go at it from scratch.

Michael: So, for those advisors who are business owners, or nominally business owners, but are kind of stuck with this, you know, they're giving their advisors 20%, 30%, 50% payouts on the revenue they brought in or the revenue they service or some combination of both, depends a little on, I find usually, on which channel it is and a big distinction between did you get the client or are you servicing the client that someone gave to you.

But, I mean, what's the transition plan? Because I'm still imagining, like, okay, I get it now. My stock will be even more valuable if I stop paying them the rev shares, but how do I actually transition that? Because I'm assuming if I go out and say, "Hey, great news. I'm converting your comp from revenue-based to salary, but you'll also have the privilege of writing me a giant check to buy into this business. So, you know, I'll take away your income but you can also pay me for the privilege," I feel like it still isn't going to go over very well. So, how do you work through this?

I mean, I get it, at least, if you were building from scratch and saying, "Hey, I'm going to avoid this trap. We're going to build from the start with the expectation that the advisors are going to come on board, get salary and bonus, and opportunities to buy in and become partners. But, you know, it's easier to...unfortunately, it's a lot easier to build that way than it is to unhinge an existing structure where the advisors already have revenue-based compensation.

David: Yep, and you would be exactly right. So, we call the founder G1, generation one, the second generation, G2, and the third, G3. Effectively, G3 are the 20-year olds coming out of Texas Tech with a newly minted CFP. That part's easy. G1, they can turn on a dime. The tough segment to change is G2. So, we have some rules around generation two. One, as people step into the equity circle, never do that with anything that feels like a pay cut.

So, even though we may well take the wrenches and start turning the nuts and bolts on the compensation system, the goal can't be a pay cut. That'll never work. So, you have to turn gently and slowly. And the place you start, a plan. You don't start with the hiring. You don't start with firing. You don't start with changing everything. You have to make a plan and you have to lay it out. You have to gather the facts, and you have to teach, and you have to explain, and you have to adapt the plan to the people and what they're building and how they've built it, and how much time they've got.

So, you adapt the plan very carefully. It doesn't have to be an overnight process. But let me tell you something we've learned. Equity, the question, "Do you want to be an owner? Will you invest in this business with me and put your heart, and your soul, and your career into it alongside me?" That's easy, relatively speaking. It's harder on G1 than it is G2 and G3. Ninety percent of our next generation advisors, when asked that question, say yes.

But, the tough part about it, in this industry, is compensation. And the reason compensation is so hard is that we encourage book building instead of business building. We pay non-owners like owners. And then we expect them to give that up and go and become a minority owner. That's really, really difficult to do. It's not impossible. We do it every day. But it is challenging. And the sooner you get started, and the faster you come to grips with, "Hey, I've always been told that revenue sharing is the only way, it's the right way."

The sooner you start challenging that assumption, and then doing the math, and looking out into the future, and wondering why all the best producers you've hired have gone across the street and are now your competitors, I think it starts right there with the comp question.

Michael: It strikes me, because I've just watched so many advisors go through this. If you're a business owner now, you've probably been at this awhile, 10 or 20 years. And if you've been in for 10 or 20 years, the odds are virtually zero that you actually started out...you might have started out as an independent advisor. You certainly didn't start out as an independent business owner. I mean, you started as an independent producer, right?

Maybe you were at a broker-dealer. Maybe you were at an insurance agency. But you started as an independent producer. And only later did you go and shift towards a business model with recurring revenue, and then find the benefits in recurring revenue and stable recurring revenue with stable overhead, let's you create a profit and start getting bigger, and started to build a business. And I think the biggest challenge that I still see for so many experienced advisors today is, when they then have to start going to the next stage of building a business, without even realizing it, they revert to their roots. And their roots were independent.

I started out as an independent producer who managed to succeed, so I am going to grow my business and the next generation of advisors by giving them the independent producer opportunities that I wish I had. And often, I think, try to genuinely give good offerings and good opportunities, but don't even realize that they defined it as, "I'm going to give them the independent producer opportunity I wish I had." You know, my firm took too much out of me. I'm going to give them a better payout. And my firm didn't support me with the right stuff, so I'm going to give them the right support.

And they do all of those things, but all they really try to do is reinvent a better independent producer model, and then eventually they hit the same wall that every independent producer company is hitting today, which is lousy profit margins and valuations that aren't even one times revenue because, eventually, the model starts to break down. And we just seem to keep doing it to ourselves, because when we start asking that question, "How do you build a business?" we still keep reverting back to, "I'm going to build the business the way it worked with the business I first joined." Not recognizing that was a bed model in the first place.

David: Michael, you asked earlier about trends we're seeing. And a lot of the trends, I think, that is real clear, is that independent advisors have something that's very valuable. As I said earlier, I mean, this little practice of theirs is the single biggest asset that they own. And once they have a valuation done, they tend to start looking at it differently. But there are two kinds of value, right? I mean, one is, okay, what I built is worth. $1.4 million.

But the other kind of value, I go to work and I get every day. My clients appreciate me. I like going there. I enjoy the work that I do. And I certainly enjoy the income and the lifestyle my work affords me. Why would I want to give that up? So, that's a real common client for us. So, people say, "Well, I'm going to do this until the day I die. I don't need any help."

Well, but here's what happens. You turn 57 or 58 and you start taking most of Fridays off. And then you stop working on the weekends and you don't do the reading, and you don't do the marketing. And little by little, you know, the three-day weekends all turn into four or five day weekends, and the business starts to slow, because you basically have one person doing all the pedaling.

So, early 60s, growth rate starts to go down. And then the income starts to go down. That's a real difficult process to reverse. But if we get ahead of it, and build a stronger foundation and platform while these owners are still in their early to mid-50s, give us a 10-year runway and we can bring in generation two and generation three.

And we can show the group how to work collegially, collaboratively to build something that's good for all of them and to allow generation one to begin to slowly throttle back and retire on the job, but to be a mentor, to pass along the opportunities that maybe they didn't have, to take care of the clients' children and grandchildren, to build a profitable, valuable business, and to have a choice to transfer it inside or outside, or to merge it with somebody.

In other words, let's build something that's investment worthy, something that's valuable, and give yourself option. You know, you don't have to do any one thing, but it sure is nice to have choices. But that takes planning.

The Overall Health Of The Advisory M&A Marketplace Right Now [1:05:56]

Michael: So, I'm curious, as well, in terms of trends and what you're seeing, since I think you get a unique look at kind of the health of the advisory firm marketplace since you literally run the largest marketplace for advisory firms. So, I'm curious for your perspective around just the supply and demand dynamics and, I guess, in essence, the valuation trends that those imply. Because I feel like there's a lot of discussion out there right now centering around two related themes.

Number one is that age wave of sellers hasn't showed up yet, but it's going to at some point soon here, and that the onslaught of sellers will cause valuations to crash. And then the number two that I often hear is, you know, with DOL fiduciary rolling through, it's going to drive a bunch of advisors out of business and valuations are going to crash. So, I feel like I'm hearing lots of concern, at least from my world of who I talk to, about whether valuations are in real trouble soon or whether the supply-demand dynamics are shifting, or have shifted, or about to shift.

So, I'm really curious for your perspective on that, as someone that just actually sees this data on a daily, weekly, monthly, yearly basis. What you're seeing in terms of supply and demand and valuation trends.

David: Yeah, that's a challenging question. If we list a recurring revenue practice in Scottsdale, Arizona with $750,000 a year of mostly fee-based income, we'll pick up 50 to 75 interested buyers for it in a week.

Michael: Fifty to one or more.

David: So, that makes it sound easy, but it's not, because, I mean, you know, that's like putting your house up for sale and on Saturday morning, 50 people are lined up down the sidewalk. Well, on the one hand, you're going to be real busy. But on the other hand, you know that you'll find success. But it's different in this industry. For most of our sellers, this is like selling a...almost like selling a child. I mean, it's their baby. They built this thing and they care about all of the clients. It's not just a number.

So, the seller wants to find somebody, someone who will do things the way they did them, perhaps better. But you have to take care of the clients, and you actually have to care about them. What a seller is doing is they're kind of looking for almost a needle in a haystack. They're looking for the perfect buyer. Who would I trust to manage my money and give me advice if I were on the opposite side of that table? So, you don't need 50 offers. You need one or two or three great offers from near perfect matches.

How Great Matches Still Necessitate A Deal With Shared Risk And Reward In Order To Maximize Value [1:09:00]

And that's the genesis of our system. It wasn't to run values up because of demand. It was to get great matches. Now, let's go down that path just a little further. If you get a great match, then you create this thing called shared risk, shared reward, a balanced transaction. So you need a seller who's going to make sure they stay around after the transaction and shepherd all of their clients and relationships carefully into the offices and the waiting arms of the buyer. And that has to be done professionally, politely, and diplomatically.

You also need a buyer who's going to work incredibly hard at this thing to make sure that they keep...the goal isn't 70% or 80% or 90%. The seller cares about every one of these clients and they want to see all of them being taken care of. So you need a buyer that's motivated, too. How do you do that? You start with a great match, and then you balance the deal terms. How much down? What are the tax structures? What are the penalties if we don't succeed?

All of this flows into the valuation perspective. When we list a practice for sale, the typical choice of a buyer would be someone who owns a business. If we list a book for sale, they will typically sell to someone who owns a practice. In other words, bigger buys smaller.

Michael: But usually, kind of one step up the line. Practices buy books. Businesses buy practices.

David: Correct. But think about all the impacts this has on the valuation angle, because if I own a business and I've got four partners, and I bring 30% to 35% to the bottom line, I'm going to buy a practice. A practice owner typically doesn't manage for profitability. That's not the defining goal. The manage for growth. They manage to take care of the clients. They manage for take home pay. Whether it comes out as W-2 or 1099 or profits is irrelevant.

So, as a business owner, do I penalize the practice owner for not bringing more profits down? Honestly, most of our business owners could care less. They're buying relationships and cashflow. They're going to take those relationships and cashflow, and even the key staff members, and they're going to drop them inside the business' infrastructure and systems and office confines. It's the business' cashflow and profitability that matter, not the seller's.

Michael: And so is that why, at the end of the day, we still see so many firms that are valued based on...sorry, I should say books and practices, to use your terminology. Is that why we still see so many books and practices that are typically quoted as a multiple of revenue? Because at the end of the day, the buyer isn't actually buying profits. The buyer is buying revenue and putting the revenue onto their cost structure to generate the profits.

David: Yeah. I love that question, but I'd answer it a little bit differently. I think book builders probably should just go ahead and use a multiple of revenue. It's simple. It's not going to be that wrong. And I can't expect a book builder, if they're selling something worth $125,000, they're not going to spend $10,000 on a formal discounted cashflow or an appraisal. Why would they? But now, shift up to a practice level, or certainly a business level.

Practices should never use a multiple of revenue. I mean, other than just for a smell test. A practice, I mean, if you use a multiple of revenue, here's what I'll guarantee you. You're going to be wrong by somewhere between about $50,000 and $100,000. Maybe high, maybe low. But if you can get a valuation, a market-based valuation for about $1,250, why would you not do that?

So I think it's just a matter of A, knowing enough to ask the question, and B, putting the work in. You know, it's quality in, quality out kind of thing, to do the formal valuation. You need a formal valuation if you've got more than about $400,000 or $500,000 worth of recurring revenue. And you need it every single time. Period.

Why Selling Your Book Through Your Broker-Dealer Or Custodian May Not Get You The Best Deal [1:13:27]

Michael: And so I'm also curious then. So, I know you run a marketplace for advisors. You, frankly, have been successful enough, I think, that you've spawned some competitors out there, so RIA Match and 3X Equity, and a couple of others that are trying to do something similar. And then there's also a world of you broker-dealers and custodians that have made their own marketplaces as well.

And so, granted, I know you, obviously, have a little bit of natural bias towards your platform since you built it, but I'm curious for your perspective across the different platform options that are out there, or even just, like, is there a reason to go to one versus the other? Like, I know a lot of advisors on any particular broker-dealer, custodian platform seen to naturally say, "Well, I'm going to go to my custodian or broker-dealer's platform solution first because I'm assuming," right or wrong, you tell me, "that my most likely buyers are ones that are going to want to be on my platform already because it's easier to transition the clients and hold on to them. So I may as well just go there."

David: Well, so here's our philosophy. Advisors in our space are independent. They have choices. So, if you're looking for...if you agree with our philosophy and your number one goal is not highest price, but best match, which tends to get you best price and terms. If you're looking for best match, do you look in a small crowd or a big one? Our philosophy is cast the net wide, and then be very discriminating in terms of who you keep in that final group of two or three.

If you look only intra BD or intra custodian, which, frankly, that's probably where you're going to end up anyway, but the idea is let's look for somebody who's bigger, stronger, faster, and who is a great match for my clients. Where they happen to use as a custodian or where they have, who they choose to use as a BD, I think it's relevant. I think it's important, but I don't think it's job number one. I think best match is job number one. And I think you have to look around all the corners to find best match. Now, if you don't agree with that, then go ahead and just look locally. You might find somebody who's good enough.

How Predatory Buyers Force You To Take Your Practice Off The Market And Leave Most Of Your Hard-Won Clients Hanging [1:16:04]

Michael: And I mean, it always strikes me as well, because I've seen one or two horror stories coming out of this, and frankly, I imagine you've seen even more, that there is a fundamental kind of misalignment of interest for broker-dealer and custodial platforms. As the seller, you want to get reasonable value and a best match. As a broker-dealer or a custodian, I really only want you to do a deal on the platform, because if you do a deal somewhere else, you might get a great deal and a great match for your clients, but I'm going to lose the assets.

So, if I'm the BD or the custodian, I really want to push you to do a deal on our platform, regardless of whether it's actually the best match client-wise or financially for you. And, you know, I mean, I don't want to cast all broker-dealers or custodians in a nefarious way, but, I mean, I have seen more than one deal now where, frankly, looking from the seller side, I'm like, "You got a really lousy deal out of this." And they're saying, "Well, you know, my platform said it was a great deal and this is what everyone else is getting."

And to which I said to them, "Well, then apparently, they're giving a crappy deal to everyone else on your platform, too, if everyone's doing this." Because I'm looking at the deal terms and saying, "This is not what your practice would have gone for on the open market. You had a healthier business than this."

David: And Michael, earlier you asked me a good question. I didn't really get to the answer, you know, about valuations and how these things are trending and changing. Let's connect that question with what you just said about, you know, the effect of a broker-dealers closed platform. So, in my second book, "Buying, Selling, and Valuating Financial Practices," I was pretty hard on the practice management folks at the BDs. And some of my best friends are the practice management folks.

What the BDs tend to do is, job one, they don't want to lose the clients or the assets. You getting best match and you getting highest price as a seller, that's not their job. That's not their mission. That may be yours, but it's not theirs. So, what they tend to do is they want to put a buyer in front of you and see the deal gets done. If they were to start with, "Seller, you have great value. Don't accept a penny less than this," they're working against their own interests.

So, what they tend to do is they like multiples of revenue. They may dress up the multiples, you know, in a 12-page form, but it's still just a multiple of revenue. They don't look any further than their best buyers. In fact, one of the terms we coined in our second book was "predatory buyers". They give these buyers...they literally are, though. They give them a two-and-a-half-page revenue sharing form.

Again, we go right back to that compensation system. If this is what you know and this is what you've been taught, then this is your only solution set when it comes time to get the tools out of the toolbox. So, we see these guys all the time. Books and practices fill out this form. You can do it on your lunch hour. And they'll split the revenues 50/50 for four years. So, you look at that and you go, "Well, that's a two times multiple. I'm a genius." Well, not exactly. So, the buyer pays nothing down. The buyer can pay for just what they choose to keep.

Michael: And then, in a predatory sense, they literally just pick through the book. Like, I'm going to cherry pick your eight great clients and I'm just going to dump all the rest and not call them and not work with them because it's not very good revenue to me, and I don't have to pay you for it.

David: And what we found was, those forms get handed out like candy, and they make their way into the larger practices, and even some of the smaller businesses out there. And people fill out the form and they say, "Well, you know what? I don't want to sell my business using that form. But if I get hit by the bus, I needed something better than nothing so I filled that form out." And they didn't take the time to read that it said, "This form is triggered on death, disability, or retirement."

So, they effectively took their practice off the market. They're not going to get a two times multiple. Our experience is they'll get about 60 to 70 cents on the dollar, all at ordinary income taxes. And the bottom half of their client base will be left to go find somebody on their own. That's a lousy deal, Michael. And when the BDs say, "Well, that's better than nothing," I'm sorry. That's a pretty low hurdle, and we can and we should do better.

Michael: Well, you've got a platform to give them a better than nothing alternative. Like, the option wasn't, you know, that deal or nothing in the first place. The option was that deal or, granted, a little bit of work that you have to do as the business owner to go through a formal valuation process or to list in an open marketplace. But there are other alternatives.

David: There sure are. And that's why we wrote both of our books. We just said, "You know what? If you're a business owner and you agree this is your single, largest, most valuable asset, spend a couple weekends. Read about how to build something that's sustainable. And if that's not for you, then read about how to transition it professionally and responsibly to the best situated buyer, and do a good job doing that." But do one or do the other. Don't just let it die. That's the worst thing you could do.

Michael: Yeah, and we'll make sure we have a link to both of your books in the show notes as well. So, for those who are listening, this is Episode 8. So, got to kitces.com/8 and you can get a copy of the show notes, including links out for FP Transitions and both of David's books. Both of which I've read and really do highly recommend. So, David, as we get to the end of the podcast here, I'm curious.

You've seen lots of different financial advisors that are successful across, frankly, many different business stages where, as we've said, successful books look different than successful practices, which look different than successful businesses. And I think there's even some self-selection that happens about who chooses which of those lines based on their own inclinations. So, I'm curious, from your own perspective as someone that's built a business with 30 something employees, what does success mean to you?

David: That may be the toughest question you've asked all day. I remember when, about 1995, I opened up my first little law practice, and it was pretty much just me. And about 5:30 a.m. on Monday morning, I couldn't wait to get up and go into work. I was excited. Partly scared, but very, very excited. You know, I owned it. I was building it. And whatever it would become, whatever maybe it didn't become, that was on me.

I've never...I've always hoped that I would never lose that feeling. And I have to think that a lot of the folks we talk to who say, "You know, I can't sell. I could never sell. I'll die at my desk," they love what they do every day. And to me, that's success. You have to love what you do every day or you shouldn't be doing it. And I have a lot of passion for what I do, and you can probably hear that coming through the phone, but if you love what you do then you work at it, it will evolve, you will get better at it, you will bring people good solutions, and it's fun. It's not work at all.

Michael: And I guess, alternatively, if you hit the wall on the other end where it's not fun anymore, there are options for succession or selling.

David: Absolutely. I truly believe that.

Michael: On that note, I'm going to wrap us up. Thank you so much for joining us on the Financial Advisors Success podcast.

David: Michael, it's always a pleasure.