This article is the first in a three-part series on practice valuations and will explain the basis of valuing a practice. The second article will unpack the different calculation methods and the third will help you understand what you should do to increase the value of your practice.
Across every sector of the economy, businesses are bought and sold every day. Some of these businesses are small and others are multi-nationals. It may be that the entire company is acquired, or merely a portion or a division. Sometimes it is a private deal, while in others is on a public platform like the stock market. The point is that a lot of businesses are acquired every single day.
In every instance of business acquisitions, the buyer does a valuation to determine whether the price is fair. And in every instance, the valuation is based on a version of discounted future cashflows, although many models use either future revenue or future profits. You may argue that some businesses are valued on a net assets basis, but you would only buy those assets if you believed the you would generate future cashflows from them.
In most cases, the projected growth of future cashflows are determined by looking at historic net cashflows. These are then adjusted up or down for significant changes in the competitor, customer or regulatory environments. But that is still the relatively easy part.
The difficulty comes in determining that discount rate that you will use. This is often reflected as a multiple of current cashflows, but it is essentially the same thing with a different mechanism. The main thing to assess here is the certainty of future cashflows, where you will increase the discount rate if the cashflows are uncertain (ie you will pay less). This would be influenced by a range of factors such as the age and quality of clients.
The final thing to consider is that you would be willing to pay a premium for something that is a very good fit for your strategic objectives. A great example of this is when Whitey Basson bought OK Bazaars in 1997 for R1 despite it having R200 million of debt and was making losses. From the outside, it seems crazy to pay anything for a loss-making business with debt, but Whitey did it to stop Raymond Ackerman from buying OK and entering the mass market – and the rest is history.
Let’s now apply these principles to valuations of financial planning practices. The first thing to determine is what you are going to buy. This can vary from buying the entire business on one extreme to buying the clients on the other, or something in between. If you are buying the entire business, you will buy the company, FSP, staff, infrastructure and the clients, which means you will probably base your valuation on the future profits. By comparison, if you are only buying the clients, it makes more sense to base the valuation on the future revenue because you will plug this into your cost base.
To determine the future cashflows, you will look at the existing recurring revenue – in other words ongoing trail fees, as and when commission, recurring planning fees and anything similar. Upfront commission / fees are usually ignored but could be factored into the calculation in specific circumstances – although they would be heavily discounted.
The next thing to determine is the discount rate or multiple that you will use. This is based on the stickiness of clients, which is determined by the way in which they have been engaged and the nature of the products that they hold. Clearly you would pay more for clients who meet with the adviser four times a year than you would for clients who choose to skip their annual reviews. Similarly, you will pay more for clients with compulsory assets like living annuities than you would for clients holding discretionary assets.
The final aspect to consider is the strategic fit. Consider an example where you have an investment practice and you’re looking to grow into short term insurance, but you need to be under supervision. You find someone who wants to sell a short term practice with a similar client profile to yours and they would like to exit after 2 years. In that scenario, you would very happily pay more because the strategic fit is so good.
In the following articles we’ll go into more detail around the actual calculations and tell you how to can increase the value of your practice.
