PRACTICE MANAGEMENT

Understanding the Value of Your Business

By FP Transitions

Business valuation is the starting point for owners who want to effectively manage their equity and build a business of enduring and transferable value. Growth-minded leaders, sellers, and prospective buyers need to accurately assess the value of financial services practices, understand what drives that value, and learn how it can be increased and improved—all in an unbiased manner. Whether the goal is an immediate or eventual M&A transaction or a long- term internal succession plan, valuations play a foundational role in the successful transitions of businesses of all sizes across the financial services industry.

Purpose

A professional assessment of value should be supported by a comprehensive analysis tailored to your specific purpose. The first step is to establish a clear understanding of the valuation purpose (intended use). This will inform many of the steps that follow. The second step is establishing the “level of value,” or the control and marketability characteristics of the business interest in question. This, along with the purpose, will establish if the market value of the client relationships (e.g., the “book of business”), the cash flow/rights to cash flow, or a combination of the two must be considered.

The need for a professional third-party’s opinion of the value can be driven by various factors. The most common motivations are:

  1. General Knowledge – For strategic planning, performance monitoring, and continuity planning
  2. Reasonability Assessments – To determine whether an ask or offer price is reasonable
  3. Bank Loans – To assess the value of the collateral to secure a loan
  4. Tax-Related Matters – For estate planning and charitable contributions
  5. Disputed Matters – For divorce, breach of contract, or partnership dissolutions

While this list is not exhaustive, it covers the common reasons an advisor seeks a business valuation. Each purpose listed above has unique factors that need to be considered to estimate a value for that specific circumstance. In other words, there is not a single value solution that can be uniformly applied to all purposes.

Approach

Once the purpose has been identified, the type of sale needs to be determined. The type of sale can be broken into two categories: asset sales or equity sales.

Asset sales are the most common type of transaction that occurs in our industry, when 100% of the business is sold. These transactions usually occur on a debt-free basis. Asset values for financial service businesses don’t always include the value of tangible assets as they are often minimal or not transferred. Instead, most of the asset value in a financial services business resides in intangible assets, namely personal and professional goodwill. Our transaction data tells us asset sales rarely happen as cash transactions. In other words, the consideration exchanged between buyer and seller involves elements other than cash, such as a promissory note or non-compete agreement. This is important, because the value of the business will be dependent upon the assumed deal terms of the contemplated transaction, which should be clearly stated in the valuation analysis.

Equity sales differ from asset sales in that these transactions are purchasing an interest in the business and must account for the totality of a business’s invested capital. This invested capital includes equity investments and debt incurred to support the growth and operations of the business. An owner of fractional interest is buying rights to future cash flows and capital appreciation, which are both affected by debt. While not all equity sales are cash transactions, our data tells us equity is more likely to be transacted on a cash basis and it is typical for equity values to be quoted on a cash or cash equivalent basis.

One of the most highly debated topics is which valuation approach is best to value a practice. The correct answer is “it depends.” As we’ve established, the purpose, not the approach, is the first step in a valuation analysis. Attempting to select a valuation approach without first establishing the “why” is like a doctor making a diagnosis without having a conversation with the patient to understand their symptoms. There is no “one-size fits all” valuation approach for all practices, all purposes, and all levels of value.

The market approach is well suited for valuing a book of business or practice when the operations of the practice are expected to be dissolved and absorbed into the acquiring firm (strategic value). If adequate transaction data is available, and the practices within that dataset are comparable to the practice/ownership interest being appraised, a market approach can and should be used. Also, this approach is often used as a reasonability test to ensure an income approach is grounded to market transactions.

The proper application of the market approach requires a professional appraiser to analyze the characteristics of the transactions then make appropriate adjustments to value to reflect the unique risks and opportunities present in the subject practice.

The income approach, specifically the discounted cash flow method, is based on the concept that the value of a practice is a function of the future economic benefits that will flow to the investor. The value of the forecasted economic benefit stream is discounted to a present value. Similar to the adjustments in the market approach, the discount rate should be adjusted to reflect the unique characteristic present in the subject as well.

The income approach is well suited for valuing a going concern where the net operating profits of the practice should be considered and the future earnings are expected to change.

Conclusion

Determining accurate value is the starting point for any path for your business, whether it’s being used for inorganic growth financing operations or growth, or building a powerful team for internal succession. It allows you to plot a way forward to realize your vision for the business. Realizing the complexity and sophistication of your business and assessing its value on a variety of factors based on purpose rather than just applying a simple rule of thumb across the board is an important evolution indicative of the impact of the financial services profession.

If you’re interested in learning more about this topic, experts from FP Transitions will be presenting a session on valuations at the NAPFA Spring 2024 National Conference in Fort Worth.

FP Transitions is a full-service consulting firm specializing in providing valuations, succession planning, M&A, and business insights to independent financial services firms.

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