As I thought about it, I realized that three factors determine most of the value in a financial advisory firm. Taking my cue from finance giants Fama and French, I developed my own "three-factor model." Examining these factors and how they affect a firm's value can give you a reasonable way to decide whether this kind of offer could be a good deal.
LET'S MAKE A DEAL
Here's how the offer might go: A buyer says, "I want to buy 50% of your firm now. You'll diversify some of your concentrated wealth (your ownership in the firm) and be able to put the cash from the sale to work." The buyer also promises to provide help and services such as better compliance, internal accounting, marketing training and, if necessary, access to capital at a competitive rate for growth. The buyer assures you that this will accelerate your growth, cut your costs or slow their growth and generally make you better off. "The deal will be fully liquidated in about seven to 10 years, because you'll be part of a billion-dollar-plus conglomerate sold to a bank or other strategic partner," the buyer promises you.
What makes this work? The buyer has to buy your firm "low" and sell it "high." Ultimately, the more valuable the buyer helps make your firm, the better off everyone will become. The issue for you is how much a buyer will increase the future value of the firm over what you could have done on your own.
To cut to the chase, let's use my three-factor model to determine whether you should go for a deal like this. The factors are growth rate, profitability and size. Size is related to earnings volatility and indirectly determines the price/earnings ratio and discount factor used in these calculations. The analysis also uses the price paid for the initial equity sale.
Let's look at a simplified example. Say your firm has $1 million in annual gross revenue and is expected to grow at 10% annually for the next seven years. After that, growth is assumed to be zero, because you will have left the firm and no one works as hard as you to bring in business. Your net profit margin is 10% after paying a competitive salary to everyone, including yourself.
The buyer can only offer you a p/e ratio of five for the first 50% of your business. If net profit is 10% of $1 million, or $100,000, that means $500,000 for a 50% interest in your firm.
For the purposes of this example, I'm not putting any other terms or conditions on the sale for either buyer or seller. (In a real deal, there would be plenty.) I'm also ignoring taxes, which could be a considerable factor in the decision, and all the staffing and management issues inherent in any change of ownership. A couple of other assumptions: I'm using a discount factor of 6% for future-sale present-value calculations and a discount factor of 15% for baseline discounted- cash-flow calculations.
ANSWER, PLEASE!
To decide whether this is a good offer, you must examine the three key factors that affect value. Begin by making two baseline calculations using the previous assumptions:
One. You do not do the deal, but wait seven years to sell the entire firm. The total present value is $1,225,608. (If you want to see the math, just email me and I'll send you the spreadsheet.)
Two. You do the deal, sell half the firm for $500,000 today, wait to sell the other half in seven years, and assume growth and profits will remain the same. The present value of the future sale plus the $500,000 is $1,112,804. That's $112,804 less than if you hadn't done the deal. Ouch.
But what if your growth rate and profitability both doubled to 20% as a result of the deal? Your business is worth more--the present value of the future sale plus the original $500,000 is now $2,753,573. That's $1.6 million more than if you hadn't done the deal and growth stayed the same. You've made more money using the buyer's expertise. Of course, the buyer must bring skills and resources to the table in order for the deal to work.
You could also benefit from the deal further down the road, when the final sale is made. If a future buyer believes the entire conglomerate is more valuable, there may be a "p/e lift." This is the size factor coming into play.
On the other hand, what if you invest in the business yourself? Say you bring in business consultants, hire a personal coach to fire up growth and profits and add top-notch employees. Assume this do-it-yourself strategy increases your growth and profitability to 15%. The present value of the firm's cash flow and ultimate sale value would be $2,509,453, only about $250,000 less than if you had accepted the buyer's offer.
So, a partial buyer must bring exceptional changes in growth, profits and scale for you to have a better future. Put another way, if you do it yourself, you might still make out better--even if you accomplish less--because you didn't sell a chunk of the firm as cheaply in the beginning.
THE FULL MONTE
Now that you know what has to change to make the deal worthwhile, let's not forget the fickle finger of fate--otherwise know as uncertainty. To understand more thoroughly the chances that this deal will work, we'll use a Monte Carlo simulation that varies growth and profits to perform a sensitivity analysis. (See "When to Sell," above right.)
This brief column doesn't allow me to delve into any of the math, but suffice it to say I've done a lot of these analyses. If you get the assumptions right, the model can assess the probability of an outcome fairly accurately. We'll use the previous baseline assumptions for the comparison.
What conclusions can we draw from this simple example?
- If you're presented with a deal, you should know how to think about the offer. A "compare and contrast" model is useful to sort out the numbers.
- You must consider three factors that affect value: growth rate, profitability and size (total annual revenues). Part of your analysis must be to develop a clear understanding of how the deal will affect these three factors.
- If your firm is already quite profitable and has a higher-than-industry- average projected growth rate, future numbers may have to go to extreme levels to make the deal work. If that isn't plausible, a substantial p/e lift from the combination of firms must occur at final liquidation for the deal to be attractive. The problem is the final p/e can't be guaranteed up-front.
- If your current operations don't seem to be moving you ahead quickly enough, joining forces with others who have the skills and expertise you lack might be just the thing to propel you to a new level of business.
With any potential business deal, the devil is comfortably ensconced in the details. I purposefully avoided them in this example to focus on the three factors that have a sledgehammer impact on value. Just remember, if you are considering taking on a new partner, look long and hard at how the deal will transform these three factors before you say, "I do!"
Glenn G. Kautt, CFP, EA, is an active financial planning practitioner and president of The Monitor Group, a wealth management firm in McLean, Va. He can be reached at kautt@themonitorgroup.com.
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