Executive Summary
Over the past decade, an increasing number of financial planner baby boomers have reached the point that they would like to retire out of their practices; as a result, the 2000s saw a dramatic increase in the focus on succession planning, including how to prepare a financial planning firm for sale and steps to make the business more saleable and valuable.
Yet the reality is that once a financial planning firm is saleable and able to function effectively without the daily involvement of the founding principal, it's simply an investment holding like any other one; except it has an incredible cash dividend yield on top of significant appreciation potential.
Consequently, as the process of transitioning firms to saleability continues, a new challenge is beginning to emerge: planners who are successful in making their planning firm saleable and valuable are suddenly finding that once that point is reached, they no longer necessarily want to sell (all of) their business after all, which would force them to reinvest the proceeds into lower-return investments that could diminish their own retirement!
The inspiration for today's blog post are some recent conversations I've been having with three different financial planners, all of whom run (with some other partners) very successful financial planning firms (two generate between $4 million and $6 million of revenue, and the last has almost $8 million in annual revenue).
All three firms have spent the past several years transitioning their financial planning practices to be more saleable entities, by enacting critical changes that remove the dependency of the firm on the founding principals. The most significant changes include the successful transition of primary relationship management responsibility of the firm's clients away from the founding principals, the transition of business development responsibilities to be shared amongst several of the firm's (non-founding-principal) planners, and the inclusion of key members of the firm's "next generation" as a part of the management team steadily taking over the day-to-day operations of the firm. According to all the research of the past decade, these changes should make each of the three firms much more appealing to a prospective buyer - and allow the departing principals to receive a higher business valuation - because the firms have truly reached a point where they can be economically viable without the ongoing involvement of the founding principals.
At a roughly typical multiple of 2X revenue, these practices could each be sold for many millions of dollars, and still be well positioned to generate a strong profit distribution for the next generation of owners, with significant appreciation potential to boot. Viewed as a "stock" investment, assuming a healthy financial planning firm net profit margin of 25%, these business investments would provide the buyer an average dividend distribution of 12.5% (given the 2X revenue valuation), with both the dividend payments and principal value rising with future growth of the business.
The problem is, the business-as-an-investment would also provide the seller with an average dividend distribution of 12.5%, plus growth on the dividends and principal, by simply keeping the business. And therein lies the problem. For so many financial planning firm owners, their desire to sell the practice is as much a lifestyle decision about not being personally consumed by the demands of the business, as it is a literal desire to "cash out" of the business and reinvest the proceeds elsewhere. Which means a problem arises once the business is truly transitioned to be saleable: the lifestyle issue has been resolved, and now the business owner is just selling a highly profitable portfolio investment.
After all, look at it from the seller's perspective? You have a "stock" that generates a cash dividend of 12.5% on average, plus appreciation of the dividends and the principal. If you sell the business, you'll have to reinvest it elsewhere - for instance, the S&P 500 with a dividend under 2% and meager appreciation potential based on valuation, or fixed income that can't even generate a 2% yield unless you want to expose the portfolio to very significant duration and interest rate risk. If you were in that position, would you want to reinvest your business proceeds into alternatives paying 80% less income on top of a reduced appreciation potential... right as you transition into a retirement that is dependent upon that income?! And of course, the better the job you've done in truly building a stable, profitable business that can survive the original owners, the more appealing the firm's shares are to the owner, whether it is the buyer, or the seller.
Of course, the reality is that the business may be in trouble if at least a few of the key people in the next generation of the firm don't have an ownership stake. From the personal mental shift that happens when someone becomes an equity owner, to the outright financial incentive for building the company, it is a model in companies small and large (including the largest companies in the world) that key players need some equity stake. But perhaps that doesn't have to be everything, or even close to it. After all, the key management in multi-billion-dollar publicly traded firms are still doing their best to run an effective and successful firm that rewards its owners and creates shareholder value even though they don't necessarily own 100%, or 75%, or 51%, or often even 1% of the total value of the company (think executives at Fortune 500 companies). So while it is almost certainly true that the next generation still needs a personally meaningful stake in the business to be properly incentivized, in a firm with $5 million of revenue and a business value of $10 million, that might only mean transitioning 5% or 10% of the firm, not 50% or 100%.
But again, the key point I'm finding in conversation with some planners going through this transition is that ironically, the key problem is that the very act of making the business saleable and enhancing its value - by removing the founding principals from key business functions - effectively turns the business into an incredibly profitable lifestyle practice. So much so, that when the original owners actually reach that point, it suddenly becomes unclear to them why they would actually want to sell it at all (or at least, sell any more than a relatively modest piece to incentivize a few key next generation owners).
So what do you think? Are you a business owner that's experienced this in preparing your business for sale, or simply as the business grows? Have you ever tried to buy into a firm and encountered this mentality? If you were buying a firm and could acquire a stake significant enough to be meaningful to you, and the founding/other owners were "out of the way" to let you run the business as you wished, would owning $1M of the business value still be a sufficient incentive to buy into and grow the business, even if that was only 10% of the entire entity?
Hi Michael,
I think you are taking the annual revenue and assuming it all goes to the founding principals and none of it goes to the next generation of young principals. Hence, the large dividend yield.
Sincerely,
Joe.
Joe,
I am simply assuming that net profits are distributed evenly to all shareholders, after all employees (including staff and owners) have been paid a fair wage for their services.
Yes, in practice many firms distort profits and owner’s salaries and commingle the two, but I believe the numbers here are a fair representation of net profits from successful firms, based on the years of benchmarking studies from Moss Adams/FA Insight. If anything, the numbers are low; I’ve seen many $500M+ firm running 30%-35% profit margins, after paying fair wages to all those who provide services to the firm, and in those scenarios the profitability of retaining the stock is even higher.
Respectfully,
– Michael
Michael,
What about the concentration risk to which any putative seller of a business might be exposed?
The long time owners of a widget manufacturing business face the same dilemma. The decision to sell and reinvest the proceeds in a diversified portfolio, perhaps including a slug of treasuries or munis, is made because their financial future can be in the hands of the hundreds of businesses and millions of employees in the S&P 500 and not just the handful of employees in one company and one industry.
Steve,
Indeed, there certainly is some concentration risk here, but on the flip side the business owner can also diversify out of the business simply by reinvesting the significant profit distributions over time.
And even if the business doesn’t grow AT ALL, and falls off a cliff into bankruptcy in a decade, the owner STILL generates more net worth by taking the profits and reinvesting them than by selling the business and reinvesting it into bonds!
I absolutely agree with the underlying premise of the article. I think Michael ought to take it one step further by determining the necessary equity share with the next generation and then see what the yield is to legacy equity owners.
While public corporations do indeed incent manageemnt with low equity participation, the scale of the public equity valuation still makes it relevant to an individual. These RIA firms are exponentially smaller.
I would certainly be interested in his analysis.
Good work Michael!
If the valuations were based on free cash flow (EBITDA) instead of revenue, there could be even more opportunity for value creation. I would think that the efforts of these founders would open opportunities for more profitable growth (and higher risk-adjusted cash flows, given the reduction in key person risk). Great post…and great examples of practices being transformed into businesses!
Brian,
Indeed, better free cash flow makes the valuation even better. The problem is, that also makes it even less desirable to sell it!
If you owned an investment that didn’t used to generate much free cash flow but now generates a ton (as the business got transitioned to be more saleable), why would you want to sell it now that it’s so profitable? Wouldn’t that be a great time to finally be owning the business as an investment?
– Michael
One additional dilemma that is possibly unique to our industry is what to do with the proceeds of sale. Like it or not our business valuations are a function of the market. In the case of the advisor selling out, he/she is likely to take those proceeds and invest them in a similar manner to the one espoused at their firms. So while selling the business is a lifestyle life balance thing, advisors may have trouble seeing the real risk reduction inherent in divesting of a business based on market performance only to invest the proceeds in the market…
James,
Ironically, I’ve actually seen the opposite arise as a problem in a few situations – in essence, the equity of the firm has such a great cash-and-cash return that when the owner looks at selling it, the proceeds they’d get, and the returns for reinvesting into the available alternatives, it’s not so appealing anymore. Firms with a 25% profit margin and a 2X revenue multiplier are essentially paying a 12.5% cash dividend; not so appealing to reinvest into today’s stock and bond markets.
Granted, the risk is not the same, but for better or worse most owners heavily discount the risks of the business they already successfully built…
– Michael
Michael
Finding this article from nearly 4 years ago and amazed at how relevant and real this information remains. With the current market remaining in the 2x range, its difficult to find an agreeable deal the fairly compensates the seller and the buyer. Ultimately, the seller has to want to sell (or be forced to sell) for reasons other than maximizing total income.