Busting the valuation myth

31 August 2020

Money & Life team

Money & Life contributors draw on their diverse range of experience to present you with insights and guidance that will help you manage your financial wellbeing, achieve your lifestyle goals and plan for your financial future.

Valuing a business during times of uncertainty can be challenging, but demand remains for quality practices that have ‘volatility proofed’ their business models. 

Valuing your business is an important and necessary part of getting finance, attracting investors and stakeholders, as well as selling. But valuing a business in times of uncertainty and volatility, can be challenging and fraught with risks.

As the Founder and Director of Forte Asset Solutions, Stephen Prendeville has helped numerous buyers and sellers of financial planning practices. He agrees that business valuations can be significantly affected during periods of volatility, like COVID-19, if practice owners don’t properly prepare.

“We regularly assess the value of businesses, and I’ve found myself asking questions of businesses that I wasn’t asking last year,” Stephen says.

“During this pandemic, we’re asking more questions about the client, including: what number of clients have been impacted by the coronavirus; how many SMEs are accessing JobKeeper; how many clients have accessed their super early, and if so, how much FUM has been withdrawn. Each of these considerations have financial implications for a business – either now or in the future.”

Stephen then builds upon these initial questions by asking a second tier of questions for the practice owner to ascertain the business’ response to the pandemic.

These questions include: what has been the level of communication to clients; how have staff performed by working remotely; what changes have been made to the practice’s infrastructure; what future fixed costs does the business expect; and what has the FUM performance been for the first and second quarters of 2020?

Stephen concedes that while many of these questions weren’t asked in 2019, each of them today provides much greater insight to the value of a business during these unprecedented times.

But for Graham Burnard – a consultant at Elixir Consulting – the value of a business during this period of volatility depends on the nature of the business.

“We’ve seen some businesses over the last six months increase their revenue and continue to take on new clients. Their business valuation has gone up because they are growing, profit has continued to increase, and they are in good shape,” says Graham.

“However, there are other businesses that have variability in their income, as they are still on asset-based fees and are possibly more of an investment-focused value proposition, rather than a holistic advice proposition. These are the types of businesses that have probably suffered the most and have experienced a drop in earnings, which means, a drop in valuation. So, it really depends on the nature of the business.”

A time to sell

When it comes to selling a business, the managing director of CoreData, Jason Andriessen CFP®, agrees that buyers don’t like uncertainty. But for the past several years, the one constant that financial planners have dealt with is change and uncertainty.

“For the most part, COVID-19 has just been another thing for planners to deal with, just as they have done with the FASEA standards. There will be ‘no normal’ for them to return to. This is the new world, so planners need to adjust and re-engineer their businesses in order to operate within it,” Jason says.

So, given this ‘new world’ reality and the continuing uncertainty surrounding the COVID-19 pandemic, is now a good time to sell a financial planning business? Surprisingly, for quality practices that have ‘volatility proofed’ their business models, the experts agree it is.

“Currently, we’re seeing the greatest imbalance of supply and demand for financial planning businesses that I’ve seen in 17 years,” says Stephen. “The demand for practices is excessive, but  the supply level has remained steady.”

Stephen attributes this high demand to the rising costs of doing business, which means the need for scale has never been greater.

“Historically, in a recessionary environment, financial services has actually boomed because that’s when the need for advice is at its greatest. It’s a period that sees growth for the industry and demand for practices,” he says.

However, on the supply side of the equation, Stephen says the market has been operating as if valuations have collapsed, which he emphasises, they haven’t.

“In actual fact, valuations are still reflective of 2019 when there was a depreciation in the market. We went from 3x recurring revenue to 2.5x, but EBIT valuations have remained constant around 6x,” he says.

The reason for this, says Stephen, is because the vast majority of valuations are focused on profitability. For example, on a purchase price based on 6x adjusted EBIT, there is a 15 per cent minimum return on investment.

“Compared to other industries, financial services is in the middle of the greatest disruption we’ve ever seen. With the exit of the banks from financial advice, a vacuum has been created for mass advice, which is creating opportunities for the industry. We are already seeing significant interest from domestic and international investors looking at this sector.”

In fact, Stephen says the financial advice sector has experienced an inversion, where up until recently, 70 per cent of the advice industry was dominated by the banks. However, that figure has now reversed, with 70 per cent of the industry being independent or non-aligned.

And what of planner numbers? Does Stephen expect an exodus of planners under the new FASEA standards to affect business valuations or the supply of businesses for sale?

“Not at all,” he says. “About 5,000 planners left the industry in 2019 but from Forte’s perspective, we did not see a lift in business sales. This is largely because those who left or were forced to leave were mostly salaried bank planners or non-profitable businesses. These practices did not come to the open market.

“And it has been reported that an additional 2,000 planners have so far left this year, but again, I believe most of these departures are the same cohort as those who left in 2019. So, we have not seen an increase in supply of businesses for sale. In fact, it’s the opposite.”

Instead, Stephen confirms there remains significant demand for businesses but a continuing undersupply of practices for sale. “Therefore, if you have a quality practice and you’re thinking of selling it, now is a great time to be doing just that,” he says.

Jason agrees: “There are genuine buyers in the market. They are long-term focused, career-minded planners, who have met all the FASEA requirements, and have used technology to adapt to the COVID-19 environment. These planners are ready to grow their businesses.”

Despite the challenges of adapting to this new COVID world, Jason remains bullish about the opportunities available for planners. In fact, over the next 25 years, CoreData estimates the size of the advice market will increase to $3.6 trillion.

“This will provide a significant opportunity for planners to plug the advice gap that is emerging,” he says.

It’s a view shared by Graham, who adds that for quality practices, business value will continue to increase, while practices that have not re-engineered their businesses to be “volatility proof”, can expect to take a hit in earnings and be priced at a lesser value.

“Good businesses are in demand and are attractive to buyers. So, if you’ve done the hard yards and created a contemporary value proposition that is well priced, you’ll have a business that is very saleable,” says Graham.

Re-engineering a business

Part of the reason for the current undersupply of businesses for sale is not only the myth of low valuations during times of volatility, but also as a consequence of the handing down of the Hayne Report in February 2019, which has resulted in many practices re-engineering their businesses to ensure they are compliant with the Hayne recommendations.

Many businesses that were considering selling in 2019 have actually deferred their sales and began re-modelling their businesses to optimise their valuation.

This included moving to annual renewals and a fixed fee structure, which from a valuer’s perspective, is more secure than percentage-based fees. These re-engineered practices also outsourced their asset management, introduced managed accounts for improved efficiency, refined their client value propositions, implemented client relationship management systems, digitalised client files and processes, and used technology to streamline business processes.

“We saw this happen during and post FOFA where again, the common belief was there would be an exodus of planners. But the reality was better businesses emerged after adaptive structural change occurred,” says Stephen.

Graham advises practices that have not yet “volatility proofed” their businesses, to step-back, re-evaluate and re-engineer their practices in order to realise a higher valuation.

“There’s a lot that owners can do to make their business more saleable and attractive to buyers,” says Graham. “Moving clients to fixed fees rather than asset-based fees is a great first step. I’ve had clients who have been doing this through the past six months, and often with a fee increase at the same time. And provided they do it well and correctly position their value proposition, they have been able to successfully move clients across to a more equitable fee structure.

“Just as you would renovate your house before a sale, do the same with your business. However, the reality is there are some businesses that buyers won’t touch if these types of improvements haven’t been made, because without them, there is added risk.”

As part of preparing a business for sale, Jason also recommends that sellers take the time to closely examine their practice, identify any issues and properly address them.

“Make a plan and give yourself some time to work the plan. It will be the best investment in your business you ever made,” he says. “If you’ve been operating for several years, there will be historical or legacy issues within the business that will need to be addressed. If these issues aren’t addressed, they will be a huge drag on the valuation.”

Jason recommends business owners develop a client strategy, including defining the ideal client they want to service.

“Everything flows on from that, including governance and processes,” he says. “By understanding your ideal clients and their needs, you can then design your services and messaging for those clients. If you have a client strategy and a client value proposition that is anchored on those clients, your business will be in much better shape when selling.

“And don’t forget efficiency. We know that the cost of doing business and running a business will only continue to increase. So, the efficiencies of your practice and the protection of your profit margins are very important. Therefore, make sure you are investing in processes and technology to reduce your costs to service your clients.”

Business valuation methods

Traditionally, financial planning businesses can be valued in several different ways. But when it comes to valuing businesses under the current pandemic conditions, Stephen believes ‘EBIT’ and ‘recurring revenue’ remain the two best ways.

EBIT is the methodology traditionally applied to internal succession or partner negotiations, while  recurring revenue is most often applied to trade sales.

According to Stephen, the predominant methodology being used today is adjusted EBIT, which has a focus on profitability.

“There is always a relationship to profit – the higher the profit, the higher the multiple applied,” he says. “However, the reality is that while both valuation methodologies are used, EBIT is increasingly becoming more prevalent, and not only for internal succession but also as a determining factor for trade sales.”

He believes if a business wants to maintain value, it needs to operate at an EBIT level of about 40 per cent. “And there’s never been a greater time to leverage profitability because of the technology that’s now available, enabling businesses to significantly reduce their operational overheads.”

Graham agrees that adjusted EBIT is the preferred business valuation method currently being used, as it reflects the quality of the business in two ways. “Firstly, you’ve got the actual profit – what the EBIT is – and then you have the multiplier.”

This means that for buyers looking to make an acquisition, there are a number of key factors to consider. These include:

  • How robust is the revenue stream?;
  • What is the profit being generated?;
  • How repeatable is that profit?;
  • Are clients already signed up to annual fee agreements?;
  • What’s the likely attrition rate of clients if they are not signed up to annual fee agreements?; and
  • Is there any legacy/grandfathered revenue that still needs to drop out of the business?

“So, it all comes down to the quality of earnings,” Graham says. “That’s what planners are looking for, rather than just a multiple of revenue, which doesn’t explain what the quality of that revenue is.”

When pricing a business, Jason believes that planners need to look beyond COVID-19. Instead, he says the much bigger issue are the Royal Commission recommendations and the regulatory impact of these.

“From that perspective, if you’re pricing a practice and anchoring your expectations on FUM, then that’s not a sustainable anchor point. What you should be considering is the revenue you’re generating from your active client relationships. That has the greatest value, if you’re pricing on a valuation of a multiple of revenue,” Jason says.

“Otherwise, it’s a multiple of sustainable profitability, which is EBIT. But obviously, this does depend on the buyer and their strategic reasons for purchasing a business.”

The challenges of financing

When it comes to financing a business acquisition, Stephen warns buyers to do their due diligence and be mindful of the information required by financing companies for the purchase.

“Finance companies will make an assessment on the quality of the management of the buying group and their business plan. They want to see how the purchase will be done, what the transition plan is, and what the financials will look like. They will also look at debt – both the principal’s and business.”

Graham agrees: “When it comes to financing, lenders are looking at the financials, including commission statements to validate the income being listed. They want to see how robust the income is. And even the non-bank lenders are asking for the same type of information, but they are probably more flexible with what they can offer and not as demanding in some of the caveats they require post purchase.”

And what of ‘buyer of last resort’ (BOLR)? Is that all but gone from the industry?

“BOLR has tightened up quite significantly,” Graham says. “The most obvious one was AMP, which had to very publicly pull back its BOLR. And while you wouldn’t say BOLR doesn’t exist within the industry, it certainly is not offered to the extent or format as it was in previous years.”

However, despite the fact we’re currently in an incredibly low interest rate environment, which means that finance is the cheapest it has ever been, Graham cautions that obtaining finance to purchase a business can still be challenging.

“The big issue we are currently seeing with buying is the considerable difficulty in getting finance. A lot of the traditional banks and lenders have either pulled out or tightened up their lending criteria. They are also placing a lot of caveats on businesses,” he says.

“So, it’s one thing to work out a valuation when buying or selling, but the challenge is actually getting the finance to make that purchase.”

Demand will remain

As the world adjusts to living with the new norm of COVID-19, most financial planning businesses are poised to emerge from this crisis with more targeted business models, closer client relationships, stronger professional and ethical standards, and robust client value propositions, which will support current and future valuations.

And as Stephen says: “Remember, there is no oversupply of businesses, valuations have not collapsed and if anything, there is upward pressure. Good profitable businesses will always be in demand.”



Checklist for selling a business

So, you’re ready to sell. Here is a checklist to assist you prepare for the sale.

Do you have an understanding of your business value and current market conditions?
• Are there improvements you can make that will maximise price outcomes before coming to market.
• Check your Dealer Agreement for exit and client transition requirements.
• Address any compliance issues prior to coming to market.
• Ensure all financials are audited and complete.
• Ensure all client information is readily and electronically available.
• Segment all clients by age, location and revenue.
• Segment products – total FUM, platforms, super, investment, risk.
• Have an understanding of the likely timeframes of achieving settlement and the client transition.
• What costs are involved – valuation, practice improvement, accounting, vendor advocate/broker, legals and run-off insurance?

Source: Forte Asset Solutions