Point of view: Hypervaluing your business

Increasing levels of industry sophistication and improving technology mean existing financial planning proprietors wishing to sell their business will no longer be able to rely on large institutions wanting to establish a presence in the industry to buy their business.

Many institutions have mistakenly viewed the purchase of financial planning businesses as enhancements to their distribution channels, only to discover that many of these entities are principal dependent in nature, devoid of loyalty to their ultimate shareholder.

So what does this mean to financial planners who are looking to exit their business within the next few years?

Simply that large financial organisations are unlikely to be waving unlimited cheque books around.

Many of the purchases in recent years have highlighted the conflict of objectives between the various parties. The institutions have the objectives of gathering assets, and increasing funds under advice, whereas the financial planner is more interested in providing a range of financial services to attract a suitable fee.

In other words, if you’re looking to sell your planning business over the next few years, you will need to ensure it is a stand-alone business that will attract ‘real’ business purchasers.

This real business purchaser should not be confused with the buyer of last resort (BOLR). While BOLR appears attractive in theory, it sets an artificial floor price for most financial planning businesses, confusing proprietors into believing that their entity is worth more than it actually is. BOLR must be regarded as a ‘worst case scenario’ backstop when all other attempts to exit the business have failed.

For many planners contemplating their exit strategy, there is still time to enhance the valuation by transitioning their financial planning operation to a financial planning business.

Financial planning businesses are valued according to one of two methods: the most common is to apply a multiple to the recurring income of the business, while the other is to apply a multiple to earnings before interest and tax.

The multiple of recurring income places a value on the recurring income stream with no regard for the cost of producing it. This method is only valid if a business is going to buy the client base and merge it into their cost structure.

In the planning industry, practices often sell on a multiple of recurrent income. This is because the purchaser is actually buying the rights to the income generated by the client base.

Recurrent income is the amount of income received by the business in the previous 12 months where that income is of a recurring nature. This includes managed funds commission, life insurance servicing commission and recurring fees for service. Recurrent income excludes fees or commissions received for once-only events, such as plan preparation fees, and implementation fees and commissions.

Once these recurrent incomes have been identified the main methods of valuation are capitalisation of maintainable earnings, or discounted cash flow. Both of these are most suited to businesses that are going concerns. That is, a business that a prospective buyer is looking to continue to operate and accrue the future benefits from, rather than liquidate.

The capitalisation method relies on historical financial performance as the basis of predicting what is likely to be the future performance. In this approach, much is made of the certainty of known results and the assumption that it is reflective of what is likely to be repeated.

The discounted cash flow method relies on budgets and cash flow projections for the business into the future. It is normal that at least three and preferably five-year projections are available if this method is to be adopted. The integrity of the approach is greatly influenced by the accuracy of the projections and the assumptions upon which they are based. In an industry that is experiencing rapid growth or changes in earnings profiles, the preferred method is the discounted cash flow basis simply because it represents a more reasonable prediction of what is likely to occur than to rely on historical performance in a changing environment.

All business owners should endeavour to understand the inputs into various valuation models, and be in a position to measure how effectively their business is operating. Viewing their business from a buyer’s perspective will assist in creating HyperValue when they are ready to collect their final cheque.

Clayton Coplestone is head of non-Japan Asia distribution at Credit Suisse Asset Management . He is the co-author of Hypervalue, the latest paper on financial planning from Credit Suisse. A complimentary copy of the HyperCompetition series of papers can be downloaded at www.csam.com/au.