Valuing an Advisory Practice: Fundamentals to Consider

Christine Heuston
Christine Heuston

01.31.24 in Marketing & Practice Management

Estimated Reading Time: 8 Minutes (1559 words)

Keywords: growth, experience, consultative, team, scale and capacity, training, prospecting, strategy, digital marketing, brand design

If you’re in the market to buy an advisory practice, valuation is undoubtedly top of mind and usually the first point of discussion. Many well-established methods for valuing an advisory practice exist, but they all involve some degree of complexity and subjectivity. And, of course, a valuation is not necessarily what a buyer will pay or what a seller will accept.

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8 Determinants of Valuing an Advisory Practice

The value of a firm you're looking to buy hinges on a range of criteria related to financial strength, infrastructure, and more. Here are key determinants to consider:

Age, wealth level, and stability of the client base, as well as the depth of client-advisor relationships

Revenue trends, profitability margins, cost structures, and cash flow consistency

Future growth prospects, expansion capabilities, and scalability of the business model

The range and quality of services offered, including niche specializations

Brand recognition, market presence, and competitive positioning in the industry

Efficiency of operations, quality of staff, and the integration of technology in business processes

Compliance with regulatory requirements and any legal matters or risks associated with the practice

The current economic climate, market trends, and industry-specific challenges or opportunities

Examining the Client Base and Recurring Revenue

A strong client base in an advisory practice is a key player in ensuring stable, predictable income streams. This kind of steady income is more than just beneficial—it's a reliable buffer during economic uncertainty and market fluctuations. It helps the practice survive and potentially thrive, even when the financial seas get a bit choppy.

Evaluating client loyalty and retention involves several important metrics:

  • Retention rates. High retention rates are more than just numbers; they are testimonials of client satisfaction and loyalty and demonstrate a stable, dependable revenue stream.

  • Client relationship duration. The average duration of client relationships sheds light on the practice’s ability to build and maintain long-term client engagement.

Understanding Client Demographics for Future Growth

Beyond the numbers, getting a good grasp of client demographics is like having a roadmap for the practice’s growth potential. It involves looking at who makes up that client base and understanding their needs and potential. The demographic factors include age, wealth levels, and specific needs or interests.

  • Age distribution. The age spread of clients can hint at opportunities for future asset growth or potential risks of attrition, especially as clients near retirement.

  • Wealth levels and accumulation potential. Examining clients' wealth levels and their capacity for wealth accumulation helps project the practice’s future growth.

  • Niche markets. Specialization in certain niches or demographics opens avenues for unique growth opportunities and potentially higher profitability.

Advisory Valuation Methods

There are several ways to approach a valuation, each with its own strengths and shortcomings for different scenarios.

This approach compares the statistics of a practice with those of similar businesses recently sold. This is a good place to start when doing preliminary analysis or negotiations. Here are two common variations:

  • Multiples of revenue. This method applies a multiple to the selling advisor’s past production data (typically, from the past 12 consecutive months). The multiple is presented as an average, and it's adjusted based on the quality of the book. The multiples of revenue method is an easy way to determine a starting point for negotiations, but it doesn't account for any firm expenses.

  • Multiples of cash flow. This method allows buyers and sellers to account for expenses by applying a multiple to net operating income (NOI); earnings before income taxes (EBIT); or earnings before income taxes, depreciation, and amortization (EBITDA). These metrics are particularly important if the acquisition target is a complete business and not just a book of clients.

Keep in mind that these methods don’t forecast the future cash flow to the buyer, which is essentially what’s for sale. What if significant client attrition was imminent?

These methods are also commonly quoted as averages, but that's difficult to define. If you were looking to purchase or sell your home, you wouldn’t want to use the average home price in the U.S. You’d take other factors into account, which would contribute to either a premium or a discount from that average figure.

So, while these methods provide a great starting point, as negotiations progress, you’ll want to perform a more detailed financial analysis.

Additional Considerations for Valuation

Brand reputation and intellectual property

When you’re on the lookout for an advisory practice to acquire, the brand’s reputation in the market is a key asset to consider. A brand that’s well-respected and recognized in the industry is like a seal of trust and quality to clients—and that’s something you inherit with the purchase. It can mean a smoother transition and a stronger starting point for you.

Then there’s the intellectual property—the unique processes, methodologies, or exclusive financial products the practice owns. These aren’t just assets; they’re the recipes that help the practice stand out. As a buyer, you should weigh how these intellectual assets can bolster your competitive edge in the market. They represent not just value in terms of innovation and uniqueness but also potential for future growth and diversification under your leadership.

Technology infrastructure and systems

As a buyer, you don't want to overlook the technology infrastructure of the practice you're considering.

Think of a practice with top-notch technology solutions as a future-proof investment. These systems speak volumes about the practice's commitment to efficiency and scalability. As you evaluate, consider how these technological assets can integrate with your current setup and elevate your service offerings. A technologically advanced practice might come at a premium, but it's worth considering for the long-term benefits it can provide in a digitally evolving marketplace.

Regulatory environment and compliance

Finally, the regulatory environment and compliance status of a practice cannot be ignored by a potential buyer. A practice that consistently meets industry regulations minimizes your risk and is a credible choice in the market. It's about peace of mind, knowing that you're stepping into a practice that values and upholds legal and ethical standards.

Consider practices with robust compliance and risk management systems as a smart investment. They signal a commitment to maintaining high standards and reducing potential legal or financial pitfalls.

While you're assessing the financials and client relationships, these additional factors are equally critical. They round out the full picture of a practice's worth and offer a comprehensive view of its value.

Assessing Deal Breakers and “It” Factors

Although guaranteed business growth over time is a positive outlook, keep in mind that past performance isn't always indicative of future results. The value of existing accounts hinges on their potential to generate future business and quality referrals.

You should consider how broader economic shifts, such as stock market downturns, might affect revenues from an acquired business. These factors should be integrated into your valuation analysis to account for potential risks.

Key factors that can diminish valuation include:

  • Predominantly older clients with limited long-term growth potential

  • Absence of relationships with younger next-gen clients

  • High concentration in either assets or revenue streams

  • A substantial number of small accounts that may not mesh with the existing service model

Buyers also need to consider their own time horizon.

What does your succession timeline look like? If you plan to retire in five years, does an acquisition make sense? Or will you be out of the business by the time the book starts generating significant profit?

If you are planning for a longer time horizon, there may be opportunities to maximize the growth potential of the acquired business. For example, you could focus on cultivating meaningful relationships with next-gen clients or targeting a new niche market within the acquired business. Opportunities like these may warrant paying a premium.

Another “it” factor that could warrant paying a premium would be if a notable opportunity for a top-dollar investment presented itself.

A prime example? There's a practice that's ripe for introducing comprehensive financial planning, particularly to clients who haven't experienced these services. Transitioning a practice from commission-based to fee-based can be a strategic move and lay the groundwork for enhanced long-term revenue streams.

Don't overlook practices that cater to specific client niches or operate in regions where you currently don't have a presence. These are hidden gems that offer untapped potential for growth and expansion. Whether it's a unique demographic or a geographic stronghold, these attributes can open new avenues for business development, allowing you to diversify your portfolio and establish a stronger market presence.

Remember, investments like these can be the catalysts that propel your practice to new heights in an increasingly competitive landscape.

Aligning Care for Clients

Let’s talk about client transitions.

The goal is to create an exceptional transition experience that leaves clients feeling secure and confident in where they are placing their trust. You'll want to maintain the quality of service that they are accustomed to, preserving the business's foundational stability.

Establishing transition timelines and communication strategies

Setting clear timelines for the transition is the next step. This timeline should outline when and how responsibilities will be transferred and how long the current leader will remain involved, if at all.

Communication is also crucial.

Stakeholders, including staff and clients, need to be informed about the changes in a way that assures continuity and stability. This communication should be ongoing, transparent, and reassuring to maintain trust during the transition.

Addressing potential challenges and risks

Business transitions are not without challenges and risks. These might include resistance to change from staff, concerns from clients about new leadership, or unforeseen market conditions affecting the transition. To mitigate these risks, have contingency plans in place.

Thinking About Your ROI

We understand that one of your main goals is achieving maximum long-term value for your business.

When thinking about the potential future profit of the acquisition, it’s important to be realistic about the range of returns you’re prepared to accept and how long it will take to recover if there is a decline in revenue, assets, or clients.

A practical way to think about your return is to measure if an acquisition is worth your time—which is your most valuable asset—and to weigh the risk involved.

  • Start by assessing the return you generate on your practice today.

  • Think about how you’ll continue to provide services to existing clients during the integration period, so they don’t perceive a drop-off in attention.

  • Then, factor in the potential loss of newly acquired clients, as some may not be a good fit for your firm.

A riskier, more time-consuming integration demands a higher return. And it should be one that presumably exceeds the return you currently realize on your own book of business.

Part of getting to the right number is focusing on the opportunity cost of your time and capital. No one wants to invest hundreds of hours in making a deal and establishing new client relationships only to generate a minuscule return. To avoid this, think about what you’re willing to pay based on your estimates for a worthwhile return on your investment.

Let’s Connect

Ready for your next step? Engaging with experienced professionals can provide you with the tailored expertise and insight needed to successfully manage these processes.

At Commonwealth, we have a deep understanding of market trends, valuation methodologies, succession planning, and regulatory compliance, ensuring that your decisions are well-informed and strategically sound.

Contact us to learn how we support the continued growth and evolution of independent advisory firms like yours.

Editor's note: This post was originally published in January 2020, but we've updated it to bring you more relevant and timely information.

This material is for educational purposes only and is not intended to provide specific advice.

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