M&A Solutions by Category:
LANDSCAPE
101 GUIDE
COMPONENTS
ROI
MULTIPLES
ADVOCATE
MARKETPLACE
SOURCING
Investment in Advisory Acquisitions
Are advisor acquisitions still worth it today?
It depends.
Acquisitions offer the opportunity to significantly enlarge an advisor's asset base in substantial increments. This can outpace the rate of annual organic growth, typically achieving in a shorter timeframe what might otherwise take years.
It's important to note that the realm of advisor mergers and acquisitions for most of the advisorverse is not predominately comprised of the multi-billion RIA acquisitions. In reality, 80% of advisors earn under a million a year in revenue, with most buyers also falling below this mark. Statistically, the overwhelming majority of transactions each year are under $5 million purchase price with most being between $500,000 and $1,500,000.
Are financial practices a desirable business to acquire today? The answer is a resounding yes under the right conditions. Are financial practices as desirable today as yesterday from an ROI perspective? That answer would be a resounding no under all conditions.
Before determining an acceptable return, advisors must first address the investment aspect. What are the sacrifices, risks, and investments needed to acquire a practice? For many advisors, the investment is significantly more substantial than initially anticipated, particularly for those financing the acquisition, which has become the norm. From value, to price, to financing costs, everything is more costly these days than just a few years ago. Let's highlight the aspects of the total costs invested in acquisitions.
Investment Costs Considerations
Purchase Price
Initial Purchase Price: This is the most apparent investment. Advisor buyers currently face the highest multiples and interest rates in over two decades. The cost difference between paying a 2.5x versus a 3.5x multiple is equivalent to a 5% increase in the interest rate of the acquisition loan.
Running on too tight margins
The biggest concern here is when advisors buy practices which do not cash flow without the advisors current practice's profits making up the difference. This puts an advisor is a tight cash flow position where a combination of just a few factors hitting at the same time in the first few years could be impactful.
For Small Business Administration (SBA) loans, the minimum Debt Service Coverage (DSC) ratio is 1.15. If you secure a loan with a 1.15 DSC, you're operating on a tight cash flow from day one. While you may still be ahead if revenues dip by 20% in the later years of the loan, the initial years are when you face the most vulnerability. If revenue declines by 20% in the first year, you could find yourself underwater.
A tight cash flow situation can significantly increase the stress and risk associated with acquiring a practice, especially when faced with unexpected challenges like rising interest rates or market downturns.
These events exasperates the stressful and precarious position. In short, don't cut it so tight you can't make the cash flow work and have to dip into something else like savings to make ends meet. The longer term CAGR play only works when you have ample cash flow to rise out near-term storms like if the market goes down by 15% and your costs go up by 10% at the same time in the next few years.
M&A Brokers
M&A broker/marketplace charge buyers a typical commission of 6% to 10% on the purchase price and provide the matching, mediation, and agreements (or charge you extra for).
Broker Fes + Premium
The biggest M&A brokers and marketplaces brag to sellers (on their websites) they get them 15% to 20%+ premium price. Then of course you're paying high multiple plus 15% to 20% plus a 6% to 10% broker fee on top of that.
New General Rule: Here is an eye-popping rule of thumb we tested: Acquisitions where an advisor uses an M&A broker or marketplace and pays a 6% broker fee and a 15% premium price on a 3x valued practice is the same as the buyer paying 20% of the seller's revenue in an EXTRA premium price. And that's if the deal was paid in cash and not financed.
Financing Cost
This will be most advisor's largest portion of investment cost.
Right now for 100% bank financing of a $1 million valuation practice on a 10 year term could add from 39% to 83% interest cost to the valuation price depending on if a conventional or SBA loan and if buying direct, buying with a broker, and if there is a seller premium.
Investment Costs Considerations
Investment Costs Can Drastically Vary on the Same Acquisition
CONVENTIONAL LOAN
Valuation: $1 million
39% PREMIUM IF LOAN: With 100% conventional 7% rate add 39%
47% PREMIUM IF LOAN+BROKER: If Broker fee is at 6% + 100% conventional 7% rate loan add 47%
77% PREMIUM IF LOAN+BROKER+SELLER PREMIUM: If there is a ~20% premium price some brokers share they get for their sellers + Broker fee is at 6% on top of premium price + 100% conventional 7% rate loan add 77%
SBA LOAN
Valuation: $1 million
58% PREMIUM IF LOAN: With 100% SBA 10% rate add 58%
69% PREMIUM IF LOAN+BROKER: If Broker fee is at 6% + 100% SBA 7% rate loan add 69%
101% PREMIUM IF LOAN+BROKER+SELLER PREMIUM: If there is a ~20% premium price some brokers share they get for their sellers + Broker fee is at 6% on top of premium price + 100% SBA 10% rate loan add 101%
While Financing Enables Investment it Amplifies Buyer's Personal Risk
Advisors who finance practice acquisitions through bank loans are required to provide personal guarantees and collateral. This means that the lender can pursue the advisor's personal assets if the business defaults on the loan.
Lien Placement:
Lien Placement: A lien is placed on the entire business, not just the acquired assets. This means that the lender has a lien on all business assets, including those acquired before the loan and those after the loan.
Personal Property:
Personal Property: Typically only on SBA loans $500,000 or more when borrower has 25% equity in personal property.
Cash Flow Challenges:
Cash Flow Challenges: With higher multiples and interest rates, the available cash flow post-purchase is often lower than in previous years, making it more challenging to service the loan.
Default Consequences:
Default Consequences: Defaulting on a loan can have severe consequences, including legal action, damage to creditworthiness, and potential loss of personal assets.
Acquisitions Can Cost 50% to 68% More Today Than a Few Years Ago
Just a few years back when multiples where 2x to 2.6x and the interest rate was somewhere in the 6% range the concept of a practice paying for itself just from CAGR was a no brainer. A few years ago you could acquire a $1M practice for 2.5x for $2.5M at 6.5% rate. The total interest paid is $900K. This $1M revenue practice example costed $3.4 million with interest cost factored.
Today the same $1M recurring revenue practice is sold for 3.5x at current rates:
8% rate (conventional loan neighborhood): $1.6M interest
10.5% rate (SBA loan neighborhood): $2.2M
With the now $3.5M purchase price plus $1.6M to $2.2M in interest the investment skyrockets to $5.1M to 5.7M for the same practice that went for $3.4M investment a few years ago.
Yesterday (few years ago) the $3.4 million investment to buy $1M revenue now costs about $5.1 to $5.7 million. This means for the typical advisor acquisition investment costs of advisory books and practices have risen from at least 50% to 68% for the same practice.
$5,100,000 - $3,400,000 = $1,700,000
Percentage difference: ($1,700,000 / $3,400,000) * 100% = 50%
$5,700,000 - $3,400,000 = $2,300,000
($2,300,000 / $3,400,000) * 100% = 67.65%
Advisors should adopt a financially savvy approach to acquisitions, similar to the advice they would offer their clients. This includes setting clear ROI goals, avoiding overextension in deals (in terms of money, time, resources, energy), and recognizing when to step back from a deal that no longer aligns with their objectives. Emotional investment in a deal, driven by significant time and effort, can cloud judgment, but advisors must remain ready to walk away when necessary.
Today CAGR is even more of a critical factor to justify many of the pricing in the market today. If you aren't absolutely confident in strong CAGR over the next five you most of the deal prices today just don't make sense.
What About the Intangible Investments
When considering the acquisition of a financial practice, it's essential to go beyond the tangible financial costs. The intangible investments required can significantly impact the overall return on investment (ROI).
Sacrifices & Risk
Time Commitment: Acquiring a practice is a significant time commitment, requiring attention to detail, client onboarding, and integration of operations.
Emotional Toll: The transition can be emotionally taxing, especially in the initial stages of retaining clients and staff.
Lifestyle Changes: The acquisition can alter your daily routine, work-life balance, and overall lifestyle.
Financial Risk: Financing the acquisition can expose you to financial risks, such as debt repayment and potential losses.
Hidden Costs
Financing Costs: Interest rates, loan fees, and other financing-related expenses can add to the overall cost of acquisition.
Opportunity Cost: The opportunity cost of investing in a practice can be significant, as it may limit your ability to pursue other investment opportunities.
Integration Challenges: Merging two practices can be complex and time-consuming, requiring careful planning and execution.
Individual Considerations
Personal Priorities: Each advisor has unique priorities and values, which will influence their perception of the sacrifices and risks involved.
Emotional Resilience: The ability to handle stress and navigate challenges is essential for a successful acquisition.
Skillset and Mindset: The advisor's skills and mindset will play a significant role in their ability to manage the acquisition process and achieve their goals.
Investment Costs Considerations
Buying Direct + Loan
Valuation: $1 million
Price: $1 million
100% conventional 7-8% rate loan add 39% to 45%
100% SBA 10-11% rate loan add 58% to 68%
Broker + Loan
Buying With Broker Without Seller Premium
$350,000 Recurring Revenue Book
Valuation: $1 million
$1,000,000 Purchase Price
$60,000 Based on 6% Broker Fee
$1,060,000 Gross Purchase Cost
Gross Practice Premium Paid: add 6%
Conventional Loan:
100% conventional 7-8% rate loan add 41% to 48%
Total of 47% to 54% premium costs with Broker + Conventional loan
SBA Loan
100% SBA 10-11% rate loan add 62% to 69%
Total of 68% to 75% premium costs with a Broker + SBA loan
Broker + Premium + Loan
Buying With Broker Plus Seller Premium
$350,000 Recurring Revenue Book
Valuation: $1 million
~20% premium price they share they get for their represented sellers
$1,200,000 Purchase Price
$72,000 Based on 6% Broker Fee
$1,272,000 Gross Purchase Cost
Gross Practice Premium Paid: add 27%
Conventional Loan:
100% conventional 7-8% rate loan add 50% to 58%
Total of 77% to 85% premium costs with a Broker + Seller Premium + Conventional loan
SBA Loan:
100% SBA 10-11% rate loan add 74% to 83%
Total of 101% to 110% premium costs with Broker + Seller Premium + SBA loan
Return on Investment
CAGR is ROI's Best Friend
What's one of the most beautiful things about buying advisory practices? That practice revenue growth is tied to the growth of the markets. The same fundamental truth you give your clients in longterm financial planning, that the markets rise over time.
As of August 2023, the S&P 500 is reported to have a 10-year CAGR of approximately 10.2%. The 10-year CAGR of the S&P 500 for the period ending 2020 was approximately 11.8%. There are only a handful of ten year periods ending in any year where the S&P didn't return 10% or more annually.
If you purchase $1,000,000 in revenue on day one and achieved a 10% Compound Annual Growth Rate (CAGR) for 10 years, the revenue at the 10-year mark would be approximately $2,593,742.
If it grew at a 5% CAGR for 10 years, its revenue would be approximately $1,628,894 at the end of the 10th year. At a 2.5% CAGR for 10 years, its revenue would be approximately $1,280,084 at the end of the 10th year.
So after 10 years the practice doing $1 million in revenue bought a practice for $3 million might have a 5% CAGR over those ten years which has the current revenues at $1,628,894. The loan is paid off and now depending on the interest rate you had you now have from around $430,000 to $475,000 in annual loan payments you get to allocate to anything else. If the value multiple stayed constant at a 3x the book you bought for $3M is then worth right at $5 million and you have $400K+ which is going to your bottom line instead of servicing debt.
Of course this is added to the practice you already have which depending on the size compared to the book or practice purchased may increase the multiple you receive, especially if they are a younger average client age base than the book you purchased to lower the overall average age.
But the flip side of this coin is client attrition, whether it be natural (through death) or losing the client to another advisor. If you're running at a 5% attrition rate and a 5% growth rate your dog peddling, a lot of effort and exhaustion and you're still in the same place. Attrition is very case-by-case basis depending on factors like the average client age and service model.
While CAGR looks to the future, Banks are focused on the past
Banks fundamentally differ from borrowers and investors in their approach to evaluating deals. While advisors are focusing on return on investment (ROI), banks rely on historical financial data rather than considering the net present value of future cash flows. Even if a bank conducts thorough underwriting and cash flow analysis, believing you will generate enough cash flow to meet your payments, they often disregard compound annual growth rate (CAGR) as a critical factor in their decision-making process, focusing solely on historical performance.
When a bank underwrites an acquisition they are not evaluating directly if this is a good investment, they are evaluating if you have the cash flow to afford it, risk, and require a business valuation to support price.
The bank doesn't need for the practice you're buying to cash flow on its own, they need for your business combined with the business you're purchasing to cash flow. If an advisor wants to acquire a practice that makes no profit but has some other value, the deal could easily cash flow because of combining with your current business. It's a deal that can get done, because it "cash flows", even though it doesn't.
Equity value after 10 years?
What will the equity value be after 10 years?
What will values look like in ten years? Will they rise or fall? While financial advisors will remain essential, will as many advisors be needed in the future? Will some AI powered "e-trade" change a significant aspect of our industry within the next decade that may have an overall or direct negative impact on how advisor practices are valued? Who knows. We do know there is a growing army of entrepreneurial firms which are about to unleash a wave of innovation in fintech over the next decade.
Online trading changed the game years ago. I don't know what, but the game will be changed again in how clients interact and use advisors. The model ten years from now may look as different as the models today look from a decade ago.
Values have about reached a ceiling without creative contingencies being inserted; otherwise, in ten years, many may find themselves selling to large firms that prioritize different metrics than the mortals who have to get bank loans to finance the acquisitions. These firms may be less concerned about ROI, have reduced borrowing needs, are playing the flip the multiple game, and could potentially push smaller advisors out of the market and I would argue already are starting to.
There are compelling arguments for both scenarios and offsetting scenarios, but let’s assume the multiple remains unchanged for this discussion. If you sell for the same multiple at which you purchased, the difference will simply manifest as a multiple of a larger revenue figure in ten years.
Purchasing a depreciating asset which has free will and can grow old and die: So you bought a book and the average client age is 70 years old? Is your 70 year old average client base purchased today going to be more or a lesser value in 10 years? Ten years from now are these average 80 year old clients maintaining and adding assets or are they drawing down and generating less and less revenue each year?
Potential Returns on Investment
Inorganic Growth can Super Charge Organic Growth
When acquiring a practice, focusing on strengthening relationships with existing clients can often be more rewarding and less stressful than the constant pursuit of new prospects.
Here’s why:
Familiarity: You already have established rapport with these clients, which simplifies communication and service delivery.
Trust: Existing clients are more inclined to trust your recommendations and referrals.
Reduced Stress: Nurturing relationships with current clients tends to be less stressful and more enjoyable than cold prospecting.
Expand Wallet Share: Encourage clients to invest more by offering additional products or services that align with their objectives.
Leverage Referrals: Satisfied clients can serve as your most effective marketing asset. Don’t hesitate to ask for referrals and incentivize them to connect you with their network.
IRS Deductions
What's the financing interest benefit? The benefit is that the cost of financing is your biggest expense and this cost is tax deductible.
Deduction:
Interest paid on a business loan is generally deductible in the same year it's incurred. You'll need to provide documentation to the IRS to substantiate the deduction.
Amortization:
- Assets: Intangible assets like goodwill, covenants, and customer lists.
- Schedule: Typically 15 years.
- Method: Straight-line method is commonly used.
Essentially, generally speaking the principal of your investment is tax deductible over 15 years and the financing costs (interest) deducted each year for what was paid that year.
Time Value of Money & Opportunity
If you're an advisor who is at $500,000 revenue and you feel the 10% growth you've had will continue and over the next 7 year period you'll have a 10% CAGR.
Stay the course: With 10% CAGR $500K becomes $1M in 7 years and at a 3x would be about $3M value
But an advisor in your office wants to sell you their book which does $350K and doesn't have too many households so you can handle yourself. So what would it look like in 7 years if you had the same growth but purchased this book now?
Buy $350K book for $1 Million
Use conventional loan, pay on 7 year schedule, 100% bank financed, pay about $351,354 in interest
$350K book has a total outlay investment of about $1,351,354 after 7 Years.
But the $350K is part of your CAGR from year one and the $500K+$350K = $850K doubles in 7 years to $1,700,000.
So you can stay the course and with a 10% CAGR $500K becomes $1M in 7 years.
Or buy a $350K book you can handle yourself for $1M and pay off loan in 7 years
You have a practice you now own debt free doing $1.7M instead of $1M
You own a debt free practice valued at over $5M instead of $3M
Possible tax benefits of $351K in interest payment write-offs and amortization of the $1M purchase allocated for cap gains over a 15 year period, and broker fees and contingencies typically same year.
Combined Value & Operational Scale
Added value when combined with existing practice. Two separate one million revenue firms are worth more in the multiple world as one combined two million practice.
The operational scale at two million with one firm vs split between two is also enhanced.
Each advisor has their own unique scenario and situation but streamlining operational efficiencies and costs and increased combined value are two returns on investment which are highly individualized and whose return value can greatly vary from one acquisition example to the next.
Increased Payout
For advisors positioned at the lower end of their payout grids, acquisitions can yield a bonus return on investment that those in higher payout brackets miss out on, as they already enjoy the benefits. A significant increase in payout can greatly influence the returns from an acquisition.
For instance, if an advisor has a $500K book with a 70% payout and acquires another $500K book also at a 70% payout, the combined revenue of $1M could elevate the payout to 90%.
This scenario results in an additional 20% income, translating to an extra $200,000 directly benefiting the bottom line. This difference in cash flow should be considered in cash flow analysis, as it can affect loan approval, and potentially determining whether an advisor qualifies for an SBA loan versus a conventional loan.