Updated Wednesday, July 23, 2014 as of 9:37 PM ET
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What Advisors Get Wrong About Firm Profits
Wednesday, March 26, 2014
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From a valuation perspective, which of these two advisory firms do you think could command the higher number in the sale of the business?

  • Advisory Firm A: $50 million in AUM, annual gross revenue of $500,000 (with a 1% fee), annual profit of $100,000 (20% profit margin)
  • Advisory Firm B: $100 million in AUM, annual gross revenue of $700,000 (with a 70-basis-point fee), annual profit of $70,000 (10% profit margin)

At first glance, one might be tempted to value Advisory Firm B higher. After all, it is twice the size of Firm A in terms of AUM and it generates 40% more revenue.

But, with a 20% profit margin, Advisory Firm A is actually more profitable it has more money left over after compensation and overhead expenses are paid. All else being equal, Firm A would likely command a higher enterprise value.

Profitability is among the most important measures of success of a business and its ultimate value. The three main drivers of enterprise value, or the value of a financial advisory business, are:

  • Current profitability: The amount of money left over after all compensation (including the salaries that advisors pay themselves) and overhead expenses are paid.
  • Sources of growth: The amount of increase in profits that is reasonable to expect in future years. This is highly dependent on capital markets assumptions, ability to acquire new client households and the growth potential of the current book of clients.
  • Profit sustainability: An objective assessment of the riskiness of future profits essentially, a "discount rate" that can be used to measure future profits in today's dollars. It encompasses aspects such as vulnerable client relationships, the level of client turnover, the level of fee-based business, clients' affinity to the firm rather than to a key-individual, and the level of "institutionalization" of the firm.

When it comes to assessing profitability in the case of Firm A, Firm B or your firm it's not that AUM or revenue don't matter. But think about it this way: If you were transitioning the ownership of your business, the new owner would be entitled to a percentage of future profits the business will generate not of past gross revenue.

In simple terms, a business can't have value without having profits.

40-40-20 RULE

Curious about calculating your own firm's profitability? Consider the "40-40-20 rule."

Start with your gross revenue for last calendar year − that's all of the dollars that your business generated over the course of a year. Then separate your expenses into two categories: advisor compensation and overhead expenses.

In order to benchmark your profitability, consider this rule of thumb: you should be spending approximately 40% of gross revenue on advisor compensation; and another 40% on overhead expenses which includes the cost of doing business with your broker dealer and/or custodian, if applicable. The remaining 20% should be your profit.

If you are an owner of your advisory firm, you have two sources of income, stemming from the two roles you play in the business:

  1. As owner, you are compensated by your share of the firm's profits (so a 100% share if you're the sole owner).
  2. As a financial advisor/employee of the firm, you are compensated by a salary. (Think about how much you as an owner would have to pay a financial advisor to do your job.)

BOOST YOUR PROFITS

But what should you do if your profit margin is too low, and your expenses don't adhere to the 40-40-20 rule? There are a few key ways to improve that profitability and your enterprise value.

Measure profitability regularly. Without a good understanding of your firm's profitability, it can be hard to improve margins (and, in turn, enterprise value). If you are the owner of your business, consider paying yourself a fixed salary to separate your income as an owner from your compensation as a financial advisor. An awareness of your firm's profitability and a sharp focus on improving it tends to lead to improvement.

Look at your fee levels. Ensure they are in line with the level of service you offer. Consider building a tiered service (and fee) model and sticking to it. Resist the temptation to offer a discounted fee schedule to clients with a larger asset base or offer a disproportionate amount of service (time and effort) to lower-revenue clients. Instead, charge fees that fairly represent the level of service required for high revenue and low revenue clients.

Manage your costs. If your compensation and other expenses are far out of line with the 40-40-20 rule of thumb, consider realignment.

Although assets under management and revenue typically get a lot of attention when describing advisory firms, calculating enterprise value typically starts with profitability. Calculate the profitability of your firm and see how it compares to the "40-40-20" rule of thumb. Make adjustments as needed, measure profitability regularly and use it as a guide when making strategic business decisions.

Johann Schneider is program director for capital market insights, Private Client Services - Russell Investments. To see this post in its original form, with more information and full disclosures, visit Russell's Helping Advisors blog.


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(1) Comment
Wouldn't the picture be more accurate if you lumped the owner's compensation and profits together? Owners have considerable discretion in how they pay themselves.
Posted by HELEN H | Friday, March 28 2014 at 1:35PM ET
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