When it comes to our homes, businesses, or anything we’ve worked hard for, we want to make sure we’re getting the most we can when it’s time to sell. Value isn’t gauged on the blood, sweat, and tears we’ve put into building our legacy but based on very specific requirements. So what does go into determining the price of your practice?
Our 7 steps to determine the price range of your book of business:
1. Analyze the Income (P&L) Statement
Analyzing your business’ income statement is not just looking at your tax returns. Remember, income tax returns are made to show the least amount of tax payable, not the most profitability! Therefore you want to show the most profitability to increase the price of your book. Often you’ll have to adjust for unusual cash flows in and out, family on the payroll, personal expenses paid by the business, etc.
2. Determine Discretionary Cash Flow
You need to determine what your cash flow is. Many advisors/agents don’t differentiate between the compensation they receive for performing their duties or their ownership of the business. This means you're going to have to allocate a portion of the total advisor/agent income to direct costs of operating the practice. What would you pay for an advisor or agent role? The balance of income equals your profit or cash flow.
3. Calculate the Discount Rate
Okay, now we’re getting into some deep math - bear with us. The expected discretionary cash flow has to be converted to its present lump sum value to account for the fact that it won’t be received over time and that there is some risk that it won’t materialize as calculated.
We need to account for both Market Risk and Business Risk. Business risk is derived from an assessment of productivity, profitability, and a number of qualitative factors that make one practice worth more than another of equal size. So, in a nutshell:
Market Risk + Business Risk = Discount Rate
4. Estimate Growth Rate
You don’t want to just apply the Discount Rate to the Discretionary Cash Flow because you won’t be accounting for future growth of the business through development or market gains.
Because we all know that high rates of returns aren’t usually sustainable over a long time, you want to be conservative in your growth assumption to take into account market volatility and fluctuating revenues.
5. Calculate that Capitalization Rate
Capitalization Rate is the rate at which we capitalize discretionary cash flow to bring it to its present value:
Cap Rate = (Discount Rate - Growth Rate)
6. Range of Values
This one isn’t too hard. Calculating the range of values is handled by dividing your discretionary cash flow by the capitalization rate.
7. Calculate Those Ratios
Investors want to know ratios like price-to-earnings (P/E), multiple revenues, and percentage of AUM.
Of course, there is bound to be subjectivity when it comes to creating a fair market price for your business. The range of valuations account for some of the subjectivity that goes into determining the discount rate but it also provides room for negotiations. The final price will depend on both the buyer and seller’s motivation to complete the deal and ultimately did everyone believes they received fair value.