Sloppy books, dirty data can undermine RIA sales or mergers

Before embarking on a succession plan through a merger or sale, registered investment advisory firm owners need to take a careful look at their company's data.

Leaner, comparable figures will aid owners who choose either type of deal, according to a webinar held earlier this month by consulting firm Succession Resource Group. Kristen Grau, the head of the firm's seller advocacy listing program, and Nicole Frey, its director of team solutions, explained how the quality of a firm's data affects its formal valuation. And getting a professional valuation represents an essential step prior to pursuing any sales, Grau said — and one that Frey said she highly recommends for owners ahead of a merger, as well.

Unfortunately, data preparation "is the step that most advisors underinvest in, because it doesn't feel like progress," Grau said. Reliable data, she said, can help prospective sellers by accomplishing four important goals:

• Ensuring that due diligence and valuations come from standard metrics
• Rooting out personal expenses and other costs that don't relate to operations
• Placing owner compensation at market levels
• Verifying that assets and liabilities stem from the actual business

Even though there is "no buyer yet, no offer, nothing exciting is really happening," the process of preparing the data will show owners "where true value surfaces and where deals actually get won or lost," Grau said. "It's important for you to organize your historical and current financials and gather specific and aggregate client data from sources a buyer can actually verify. Sloppy books don't just slow due diligence. They cost you money because uncertainty and a lack of organization gets priced as risk." 

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Choosing between a merger or a sale

Similarly, even if an owner opts to merge one firm with another rather than sell outright, they should still "spend some time cleaning up" their firm's data, Frey said. That won't necessarily entail completely eliminating every possible personal cost spent on the business or the accompanying tax deductions.    

"If you actually think through whether or not you want to transfer that over to a partnership, and now have your partner pay pro rata for those expenses, you might feel like, 'Well, maybe I should clean this up a little bit,'" Frey said. "'It is more something on the personal level. I might still want to pursue deductions, but not within our partnership.' And there are ways to do that. So you definitely want to clean up your P&L. You want to understand your balance sheet to see what assets do I have, how are they treated, are there any related liabilities, because all that flows into the actual deal structure later on." 

After completing that phase, then the owners can choose between a merger or a sale, depending on their goals, according to the SRG presentation. Frey and Grau outlined five common reasons to pursue a transaction, noting that a sale generally offers a faster path than a merger to clear monetization, lower risk and a solution to having no successor. For advisors wanting to reduce wealth concentration risk while continuing to work, a "sell and stay" deal could work well. A merger, however, prioritizes firms' combined growth and expansion and brings its own complexities.

"What if you are not quite ready to hand over the keys? What if you want to keep working and maybe even grow the business before you exit? What if you need more flexibility and would like to structure your transition over time?" Frey said. "In a merger, you are not just transferring clients or revenue. You are actually redefining ownership, rules, economics and how decisions will be made going forward. So the goal in a merger usually isn't just to exit. It is to build something stronger and more scalable, and to provide for an owner's exit with little to no disruption at some point in the future." 

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The data, the valuation and the right technical sale structure

However, as RIA consolidators and other buyers increasingly backed by private equity push transactions to record volumes, owners may find it easier and more financially rewarding to quickly sell their companies instead of figuring out a merger. Investing in "a certified valuation report" can help RIA owners understand the key drivers of that value and the risks to it "well before you're sitting across from a buyer who already knows these numbers better than you do," Grau said. 

Interestingly, owners could help themselves and their company's valuation by, in effect, making themselves expendable.

"Streamline your processes, reduce how much of the business runs through you personally, so that it keeps running smoothly without you, or, if you're a solo advisor, document your processes and utilize systems," Grau said. "The more transferable the information of your business and your clients are, the more perceived value there is. Every process that is tied directly to you or goes undocumented is a discount that the buyer will find."

Clean data, a realistic valuation and care in selecting the right buyer will help RIA owners succeed in a deal. Finding any buyer is relatively easy compared with the difficulty of finding one that's a great fit, Grau noted.

In the bidding and negotiation process, owners face decisions about whether to sell through "the most common structure in advisory practice sales" in a transaction for the assets of the business or the less typical format, an exchange of equity in the entity, she said. Neither structure is better for the seller in every case, she said, but "tension between seller preferences and buyer preferences" can throw off negotiations. So owners have a vested interest in preparing for that fork in the road instead of simply going the buyer's way.

"That single choice is going to drive your optionality, your tax outcome and your negotiating leverage all at once," Grau said, explaining that the more common deal structure transfers the business, the client relationships and certain other assets. "In an equity or stock sale, the buyer purchases your ownership interest in the entity directly, so contracts and liabilities generally are going to transfer along with it. This structure can be a great option for greater client retention, but it's less common because buyers usually don't want to inherit liabilities."    

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Writing the fine print of a merger deal

When taking every factor surrounding a merger of one or more businesses into account, those deals may prove even more complicated than a sale. For instance, one party may bring existing debts from previous acquisitions, a stronger operational infrastructure that also results in less cash flow or divergent expectations about the partners' roles and responsibilities in the newly merged firm, Frey pointed out.

That requires reaching agreement ahead of the deal, which entails "a high level of trust" on either side, informed by verifying each firms' strengths and weaknesses through the reliable data and, often, the signing of a non-disclosure agreement during the due diligence phase of the negotiations, she said. And a valuation could play an important role, too.    

"The valuation is not always a requirement, unless there is some sort of lending component involved in a merger, or your CPA has some tax concerns that can be remedied by having a formal valuation in place," Frey said. "The valuation is key in the due diligence process because it helps you understand some of the key performance indicators. It helps you assess any risks or opportunities associated with your merging parties' business or strengths and weaknesses. So I do highly recommend to obtain a valuation, and then you can go from there."