Author: Maria Considine King

Chances are, your firm is paying you pretty well. But do you differentiate between paying yourself a salary for being the financial advisor and paying yourself a profit bonus for being the entrepreneur? If you’re like many advisors, the answer is no.

In a recent survey we conducted on our back-office website, 48 percent of 409 respondents indicated that they do not pay themselves a regular salary. Indeed, many advisors simply take home whatever is left over from each commission run after expenses are paid. But there’s a flaw in this model. When you don’t distinguish between your work in the business and your work on the business, you may have a difficult time determining how profitable—or unprofitable—the business is.  

On one hand, your business doesn’t necessarily need to be profitable to be successful, although you should make a conscious decision to be unprofitable rather than remaining unaware of your situation. On the other hand, as your practice evolves into a business and your business into an enterprise, the sophistication surrounding your profit margin will likely increase, especially if you want to grow. Realizing profits that fuel rewards and expansion is critical.

40/40/20
Paying yourself a regular salary can help you tease out the profits of your firm. Not only will this allow you to see the fundamental financials of your firm more clearly, but it will also help to stabilize cash flow so you can build reserves against the vagaries of future revenue streams. But what should you pay yourself? The 40/40/20 model suggested by Mark Tibergien (formerly of Moss Adams) is a good place to start.

Direct expenses. Compensating the person (or persons) who brings in and does the critical strategic work of the firm, particularly rain making, is considered a direct expense of the business. Direct expenses also include referral fees that you may pay to strategic alliances as part of the Commonwealth Alliance Program. You should pay yourself a salary each pay period/commission run for doing the financial advisory job in your business.

As a starting point, consider targeting this direct expense at 40 percent of gross revenue. For example, a solo advisor with gross revenue of $1,000,000 annually will want to target salary and referral fees of $400,000. Over the course of 24 commission runs, this translates to a salary of up to $16,667 each pay period.

Also consider that paying yourself a salary shows that you value your own work as a financial advisor as highly as you value the work of your staff or the work of contractors, vendors, and suppliers who help you run your business.

Indirect expenses. Gross profit is what is left over after you pay direct expenses. From gross profit, you will pay the indirect expenses of your firm (e.g., staff salaries, rent, marketing costs). These expenses should generally account for another 40 percent of gross revenue. Once they are paid, you are left with net profit.

Net profit. This includes, in part, your reward for working on the business and for absorbing the risk of being an entrepreneur. Target 20 percent of gross revenue as your net operating profit.

Profit can be used to satisfy four key needs of a growing business:

• Capital investment to help grow the infrastructure of the firm
• Bonuses to reward people for going above and beyond in their roles
• Operating capital to help you through periods of cash flow shortfalls
• ROI to reward you for taking on the risks inherent in running a business

When you separate your profit reward from your regular salary payment, you can clearly see whether your business model is a revenue engine with good prospects for evolving into something larger. You can also see whether your profit is intentional or accidental. If you know why profit is at a particular level—and where it is coming from—that’s intentional profit. It’s also replicable. If you cannot identify the why and what behind the profit, the profit should be considered accidental. Further, you should not assume that it will continue in the future.

AN EXERCISE IN PRICING
When you begin using these benchmarks regularly—40 percent direct expenses, 40 percent indirect expenses, and 20 percent net profit—you can better manage your firm’s financial obligations. There are a variety of financial ratios that you can derive from a disciplined financial management approach, including using this information to ensure that the pricing of your services is reasonable.

Mispriced services can be characteristic of an unprofitable business. The 40/40/20 framework makes it easy to calculate hourly pricing for consulting and project work. Rather than picking an hourly rate out of the air, calculate the cost of client work conducted by your entire organization—that is, consider your efforts, your staff’s efforts, and the incremental elements needed to run a business.

Returning to our above example, a $1,000,000 one-advisor firm would allocate 80 percent of revenue ($800,000) to cover the expenses of running the business. In a typical year, an advisor has approximately 2,000 hours available to work with clients (50 40-hour work weeks). We focus on the hours this particular advisor has available because there is no revenue generation infrastructure without him. Consequently, each hour would translate to $400 of infrastructure cost—the value of the advisor’s time, the staff’s time, and the necessary costs of running the business. The advisor may further buffer that number to realize some profit, bringing the fee to $450–$500 per hour.

GETTING A HANDLE ON THE METRICS
These examples illustrate how differentiating between your work as an advisor and your role as an entrepreneur can help you gain control over the basic financial metrics of your firm. Start by identifying the direct expenses associated with generating revenue and move on to ensuring that you have priced your services appropriately. This information will set the stage for a deeper understanding of your firm’s operations, opportunities for improvement, prospects for growth, and attractiveness to future potential buyers.

Maria Considine King is the director of practice management. She is available at mking@commonwealth.com.