Advisors who want to optimize the value of their firm may be in luck.

In the third of a four-part whitepaper series on advisor firm valuation, the Alliance for RIAs (aRIA) outlines how advisors can create a path to grow the value of their business, dependent on liquidity of cash flow and risks within a firm’s business and revenue model. 

The white paper, released on Monday uncovers the behind-the-scenes knowledge that both buyers and sellers can use to their advantage in examining any potential transaction.

“This paper is for advisors looking to increase the sale value of their firm now, in the future, or simply curious about the behind the scenes assessment and analysis related to all of these deals we read about in the press” says John Furey, principal at Advisor Growth Strategies, LLC and managing member of aRIA.

Drawing from the combined experience and observations of the six aRIA members, all RIAs who collectively manage over $20 billion of client assets, the paper asserts that in order to determine the value of an advisor’s business, three things are in order – assessing the role of cash flow in an independent advisory business, removing the illusion that firms are worth more than they really are by identifying key drivers of value, and finally applying the corresponding risk premiums and discounts to an advisor’s business.

It’s All About Cash Flows

Because independent advisory firms do not manufacture and sell a physical product, they have very limited book value.

This means that a key value driver in determining what an advisory firm is worth is essentially its goodwill – which, in the case of an independent advisor, is determined by their firm’s ability to generate cash flow.

Cash flow, according to the paper, should be examined alongside growth in terms of net new revenue, and risks that may reduce future cash flow – such as key employee departures and client demographics.

“We feel we have a best-in-class growth rate (16% without changes in asset values), but growth is not enough to drive business value,” says Brent Brodeski, president of Savant Capital Management. “We have done quite a bit of work to limit the future risk to cash flow by diversifying our business lines, implementing a team-based approach to the client experience and pushing down relationship management responsibilities from owners to the team.”

By increasing cash flow as a percentage of total revenue, increasing growth rate and reducing risk to future cash flow, advisors will be able to maximize the value of their business, according to the paper.

Closing the Multiple Gap

Many advisors fail to properly gauge their firm’s true value, because they have not identified the key drivers of value.

This phenomenon, also called the “multiple gap”, causes many advisory firms to believe they are worth more than they really are.

Among the key drivers of value that the paper highlights are: size, revenue growth, revenue source, client demographics, relationship of revenue to owner versus the firm, compensation and expense management, employee demographics, and the legal framework involved in the transfer from seller to buyer. 

By understanding these key drivers, an advisor lowers his or her risk rate associated to future cash flows, and ultimately increases firm sale value

Risk Premiums & Discounts

Too often when advisors are preparing to sell their firm, they ask the question – “What multiples are buyers paying for a firm like mine?”

While taking historical records can be revealing, sometimes they create a false reality (think Luminous Capital’s whopping sale of its $5.5 billion in assets under management RIA to First Republic Bank for a reported $125 million in cash up front in 2012).

Deals like Luminous Capital “create a sense of overconfidence for advisors”, and may lead advisors towards the “multiple gap”, according to the paper.

Similarly, appraisals from an investment bank or a transaction advisor are based off a benchmark, which leads to too much focus on the multiple rather than the driving forces behind the multiple.

To avoid a misconstrued valuation of their firm, advisors should evaluate the health of a firm’s cash flows and the key drivers of value that the paper highlights.

By analyzing future cash flow targets and the risks inherent in reaching them, an advisor and buyer can better reach fair mutual ground of the sale value of a firm.

The white paper can be accessed at Part 4 will appear in the second quarter, titled “Part IV: Navigating your path forward and achieving your ideal model.”