The Remarkable Liquidity Of Financial Advisory Firms When Planning Your Own Advisor Retirement: Kitces & Carl 188

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• Mitigating Risk From (Litigious) Clients When Your Advisor Team Grows Beyond You: Kitces & Carl 187

Kitces & Carl Transcript

Michael: Well, greetings, Carl.

Carl: Hi, Michael. How are you? You're good? You're very good.

Michael: I'm good. I'm very good.

Carl: That's nice.

Michael: I'm very good. We're getting this spring season. Things are starting to move. I'm looking forward to spring conference season in May when all the conferences start coming and I get to see lots of our listeners out there at various conferences.

Carl: Speaking of conferences, that was fun doing Kitces and Carl Live.

Michael: Yes, yes. For those who didn't get to see it, we did a live version of Kitces and Carl for FPA National Capital Area. There was an actual blue couch...

Carl: That's right. That's right.

Michael: ...that we both sat on.

Carl: How great was that?

Michael: And got to talk through together. It was pretty darn cool.

Carl: Yeah, that was fun. That was fun. So you got something like retirement on your mind or something.

The Elements That Truly Impact Firm Differentiation [01:11]

Michael: Yes. So, love doing these questions that come in from folks that listen to the podcast. So I guess a reminder for everyone, if you would love us to do your financial planning business practice management question, send it in to [email protected] and put "Kitces & Carl podcast topic" or something similar in the subject line so we make sure the team routes it to the right place and I get to see what your topic request was. And we are happy to take these and answer these.

So the question we had from an advisor wrote in, we'll call her Cheryl today. So Cheryl said, "I'm thinking about my retirement as an advisor 10 years out. I hired my own financial planner to do my..."

Carl: Smart.

Michael: This is her. This is Cheryl. "I hired my own financial planner to do a financial plan for us and to make it easier for me to have this conversation with my husband." Cheryl's like, I needed a neutral third party in the room. And so they projected out their savings. They projected out moderate growth of the practice. And they projected out what firms are going for. And the conclusion was, we're going to have some pretty good money to retire in 10 years. This is going well. But in order to do that, I have to get the value of my firm 10 years from now.

And so the very good question that Cheryl asked was simply, if I know I'm looking at this 10 years out, what should I be thinking about during the 10 years? What should I be starting now to be ready to do the sale roughly 10 years from now and hopefully get a get a good valuation? Are there financial things that I should be doing? Are there client things I should be doing? Are there firm and technology things I should be doing? Are there consultants I should be hiring to help me do these things? What do I do if I want to make sure I'm on track for my firm to have a good exit 10 years from now?

Carl: I have a question before you go deeper. Because I'm sure there's lots to talk about here. I'm actually quite curious from your perspective, what are the levers...assuming that you're going to sell the business, what are the one or two levers? If you were like, okay, I want to reduce the time frame for a second, I got three years to get my business ready for sale. And don't take very long on this because I want to make sure we answer Cheryl's question. But what are the two or three levers that the people that are buying firms these days...I kind of want it to go unnamed. The people that are buying firms these days, what are the two or three metrics that they're looking at that boost the firm value? Is it organic growth?

Michael: Look, the simple number one on this is profits, free cash flow, just how much...Buyers spend money, borrow money, put dollars in, in order to get returns on their investment. And so how much in cash, in profits are coming out of the business? That is the first big number one driver for all of this. And notably in that end, although the industry loves to use it as a rule of thumb, it's not revenue, it's profits, it's cash flow. Now, advisory firms tend to have fairly consistent profit margins, plus or minus a little. So we can approximate the valuation of a firm as a multiple of its revenue because a multiple of its revenue implies a certain multiple of profits at an average profit margin. But buyers don't buy the average firm, they buy your firm. And internal successors buy it very heavily relying on the cash flow that's coming out, and even outside acquirers are doing the math on the profitability and return on investment by looking at the dollars.

So profits, the cash flow that's coming out is number one. The slightly fancier version of that is kind of how good is the quality of the cash flow? There's a difference between cash flow from one-time commissions versus cash flow from recurring revenue fees. There's a difference between cash flow from clients that have very high retention and cash flow from clients that have kind of iffy retention where the long-term numbers don't look as good. There's a difference between cash flow from clients who are mostly in their 80s versus clients who are mostly in their 50s because the time horizon that they're going to be around.

Carl: So how important is the growth rate of the firm?

Michael: It depends a little bit on the size of the firm. Number one that tends to crop up is cash flow. Number two kind of closely tied to it is how transitionable are your clients in the first place? Right? Are they so unequivocally bound to you that it's going to be hard to get anyone else to take over?

Carl: Yeah, just the existence of process and advisor team, etc.

Michael: Process, teams, although, it's not necessarily...At the end of the day, I've seen a lot of advisors that kind of come and say, well, I want to make sure the clients are more transferable so I'm going to hire a junior advisor and transfer the clients to them, and then I can sell the firm to the junior advisors transferable. Well, if you could transfer your clients somewhere else, you could just transfer them to the buyer too. You don't have to create an…

Carl: I guess what I mean is...

Michael: ...to transfer off of them or anything. For larger firms, the buyer will very much be looking at, how sticky are the clients, how sticky are the advisors to stick with the deal along with the clients? If it's your clients more individually at the end of the day, as the buyer, can I bring in a younger advisor and get them up to speed on your firm and your client base? Are you going to be good to transition them? Are your clients inextricably linked to you in a way that's going to be hard to sever and break? Is there enough system and process that if someone else comes in, they'll at least be able to get up to speed? Do you have a CRM? Are there notes and documents? Because if there's not, I don't know how I train a new advisor to come in when there's no notes. They have to just talk to you and extract all client history from your memory, which is a lot harder than when things are more documented.

So number one tends to be cash flow. Number two tends to be just sort of transition risk. Sometimes that's even tied to cash flow and quality of earnings. Then growth comes up after that. It's there...I find it depends a lot on the size of the firm. Cheryl is a solo practice with a team around her. Buyers are probably not coming in to buy her growth rate because in a solo practice, your growth, in particular, is so built around the founding advisor. Unless you have a book, a podcast, a blog with great inbound SEO and site authority, something that would actually be a sustaining growth system without you, most solo practices are not bought on the growth metrics because buyers are just assuming that growth is going away with you.

Now, your clients, I hope, will stay, which is why I care about transition risk and the profitability of serving the client base. But growth tends to be only a factor that really heavily comes up...at least assuming the advisor is selling and leaving. Growth tends not to come up unless you're a bigger firm where the whole idea is like, no, we build a team, we have a marketing system, we have a centralized marketing person. The advisors are all trained into these various business development strategies. The advisors are all going to go with the firm to the new buyer. And so now the buyer feels like I'm buying a firm and a system and a business with a growth machine. And there's absolutely a premium on the valuation advisory firms that have genuinely strong organic growth.

But in a context of a solo, I'm probably not expecting a lot of sustaining growth from your firm without you because you're the firm. I care about the cash flow and profitability, and I may have to make some adjustments like you just take all...your P&L is gross revenue minus team expenses equals my income. A buyer says gross revenue minus team expenses minus the salary of an advisor to replace you equals profits. So if you're a solo, a lot of buyers will come in and say, I know how much you get out of the business, but that's not how I'm valuing your profits. So I'll give you a multiple of profits, but I'm going to give you a multiple of adjusted profits with some adjustments that we need to make because, hey, we won't have these expenses that you're putting through the business, but they're really yours and not business expenses. But I got to put in a salary for your replacement advisor and you don't have yourself on the P&L as a salary because it didn't really matter when it's just you, you're paying yourself anyways. But buyers absolutely care about that. So cash flow, ability to transition the clients become the big two and kind of growth and market demand start to come after that.

The (10-Year) Road To Prepare For Internal Succession [11:14]

Carl: Okay, that's helpful. So let's return to Cheryl. What are you thinking about with Cheryl? This question, what do I need to do to get ready? 10 years. Such a perfect planner question.

Michael: Oh, I know, leave it to a planner like, I was doing my planning, I went to a financial planner, I got my plan and now we're looking at…

Carl: 10 years.

Michael: Yes, Cheryl, I love it.

Carl: That's right.

Michael: Beautiful.

Carl: That's right.

Michael: So the biggest question to me when I hear situations like Cheryl's is, what is your vision about what's actually supposed to happen at the end? And lots of nuances and details that we'll get into in a moment. But the fundamental crossroads question is, is your vision at the end that the firm continues more or less as you built it or you don't actually care if your firm survives, you just want to be certain that your clients and team are taken care of?

Carl: Or a third, which I'm not suggesting in any way. In fact, it makes me sick to say out loud. Or a third, you just want to maximize what you get out of the business, the value of the business.

Michael: Yes, I kind of put that in a subset of category two. But yes, there's probably...

Carl: It's probably a lens through all of it, of course. Of course you want to maximize things. But there's a third category where I actually don't care about anything but, and not...

Michael: I just need a certain amount of money to make my retirement goals work so we're…

Carl: Not listeners of this show. They care about clients, etc. But there are people out there, believe it or not.

Michael: So the reason why that split matters, in the simplest sense, if I want to see some version of the firm continue on as I built it, I have to go down an internal succession plan. And if I don't care that my firm continues, we just need to see the client served, the team continues, the cash flow continues because buyers buy future cash flows. Then I can be and probably am looking at an external sale. And it matters because if I'm going to go down the road of successor...Cheryl's basically got to start now-ish. It takes time to get someone in, get them up to speed, get them trained, make sure they really align to the culture in the firm. Start maybe even selling a small piece in a first tranche, they've got a little bit more buying power for the last piece. There are folks that do this later stage and might hop in with one or two or three years to go to do that.

But if you're taking someone in that new, the reality is they're probably going to buy the firm and make it whatever they want it to be. They're not they're not really going to continue the firm as much as the way you built it. Ultimately, the future owner gets to go whatever direction they're going to want. That's the deal. But if you spend 10 years with someone training and developing them in the firm's way of doing business and the firm's way of serving clients, that will tend to be the thing that they continue to do because that's all they've known. If you're going to bring someone in on the finish line, they're probably not going to come in to learn to do it the way you did at that point. They're coming in to figure out how to take on the clients to do whatever they want to do with it in the future, which is why I put that more in a bucket number two scenario, which is your firm's probably not continuing at that point. They'll hopefully serve your clients well. Maybe there's some team that continues on.

But if the legacy of your firm as your firm matters, you're looking at an internal successor route, which means you need to start sooner than later either finding your internal successor or at least finding someone you can merge with who is extremely aligned on all of your style and philosophy and culture and approach, who is enough years younger than you that if you merge with them, then you can bring them up as your successor and part ways and you run off into the sunset and they continue with your combined firm. You don't always have to hire someone brand, brand new to the business to do that track. But if you want the firm to continue in a shared philosophy and approach, you have to spend time finding that person and actually getting aligned with them, which is a much slower and longer process.

How To Prepare For An External Buyer As A Financial Advisory Firm Owner [16:18]

Carl: Hmm. That's internal successor. What's the path if you're thinking about an external buyer? I don't want to go down this path. I can feel myself getting slightly sick to my stomach, but we're going to do it.

Michael: You call an investment banker, and you say that you're ready to sell your firm and they'll probably get you a check in about three months if it's really urgent, but more likely it's six to 12 months to run a normal process.

Carl: So Cheryl waits nine-and-a-half years and then worries about it?

Michael: Yeah.

Carl: And do all the things we talked about earlier like focus on those levers.

Michael: Yeah. You spend the time making sure that you've got some reasonable systems, healthy documentation of clients. Notably, if you're a smaller firm selling to a larger firm, I do find there's some misconceptions here. Big firm buyers don't care how cool...or at least many of them don't care how cool your super dialed in installation of Redtail or Wealthbox is and how you build out all these awesome workflows because they run Salesforce and they're putting you in Salesforce. They're not buying the implementation of technology you put for your individual system. They care about your CRM because they definitely want to understand that things are well documented, that a new advisor can get up to speed, that they can go through the notes and make sure that they understand what's going on with clients and how to serve them well because you're not going to be here in the long-term future because they're acquiring the practice and taking it over.

But an internal successor or a merger might actually want to take on your systems. A much larger buyer is not here for your systems. They're here for client relationships that they can transfer to an advisor in their firm and good, clear documentation and a clean book of business that doesn't have a lot of risks. So, getting back to the episode we had last, is your investment philosophy and approach reasonably aligned to them? Are you using at least some tech that's similar to theirs because it'll be easier to migrate? Because you're going to theirs, but if you've already got some overlapping systems, oh, you use Black Diamond and they use Black Diamond. Well, that'll be a little bit easier for them to ingest. But if you're on Black Diamond and they're on Orion, they're going to figure it out.

But, to me, the strange effect, the strange phenomenon of all of this is you don't have to go back that far in the industry, 10 years, seven years, where the only answer, unless you were a huge firm, was you better get started on your internal successor or there ain't going to be no one to buy this thing when you're ready to go. And you're just going to kind of be stuck with the change of the desk. It's not a bad runoff business as it were. It's very profitable if you just keep going as your client base slowly winds down. If you want a check, you better find your check writer and spend a number of years training and developing them.

And just the weird reality now is that's really not true anymore. The stat is still out there that there's 30 to 50 buyers for every seller. Not all are perfectly matched, highly qualified. But there's so many firms that want to buy with a seemingly unending supply of capital that, just the fascinating phenomenon, advisory firms are astonishingly liquid. This is supposed to be ridiculously illiquid, relationship-based. It takes 10 years to find someone to be your successor and you got to hope that they actually stick all 10 years to have a chance at getting a check at the end that now is, I call an investment banker and someone's probably got a check for me in six to 12 months. And we could do it faster if we had to.

Carl: I'm curious about your view of the implications of that. Is it changing the way we're running our businesses? Is it changing the way people are thinking about...? Because I've had this conversation with a couple different people who are a bit torn up about it because they're like, "Gosh, if I do this internal thing kind of locally, maybe even my employees, I get X. But if I just spend two years getting the business sort of cleaned up, I might get two, three, four times X." That's got practical implications.

Michael: So there's a few things I'd highlight to that. The gap between the internal X and the external Y is not as big as most people think it is. There is a little bit of a gap, just well-funded buyers can write the check and are not cash flow constrained and internal successors are cash flow constrained. And so you're going to end out with a ceiling on what an internal buyer can buy just based on their personal balance sheet, which is probably not that large relative to the size of your practice, which means they cannot buy the practice for more than the business's own cash flow can support. So tell me how many years the bank will amortize and I'll tell you roughly what your earnings multiple is going to be capped at.

Because otherwise the math just doesn't math. You can slightly ameliorate that if you sell internally in tranches. Maybe there's a tiny bit more of an X versus Y gap on the first tranche. But then by the time they're ready to buy the rest, they've got the profits from the first piece and maybe a little bit from the second to invest in the third big chunk, which means you don't need to take a haircut on the last chunk because they can cash flow it from the portion that they've already got. You only might've taken a small haircut on just the first tranche. So if you can do it a little bit more gradually...which isn't always bad, firms on average grow. So if you have to do it gradually and hang out a little bit longer, you just also get more for your shares because you sell them as the firm keeps growing on average.

So the X and Y gap is not as big as a lot of people think. The caveat is if you're planning this in advance, you don't do the giant sale internally in one lump sum. You do it in tranches and build buying power of your next generation. And then there's not nearly as much of a valuation haircut. And although not all, most of the eye-popping headline numbers that you see in the media, we see the headline number. We don't see the terms. The term's like, "My friend up the street got this amazing multiple." And what you don't hear is, "Oh, and he has to stay for three more years and grow it at 30% a year. If he doesn't grow to 30% a year, he's getting nowhere close to the number that you saw on the news. Oh, and by the way, historically he's grown at 7% a year." So the odds he grows 30% a year are basically non-existent. So that number is never actually happening. The number he's actually going to get is materially different than that and might not have been as far off as what you thought you were going to get from your internal buyer anyways.

The Future Of Firm Sales? [23:45]

Carl: Okay. That's actually really helpful. Let me ask you another question just, and let's not spend a ton of time on this, but I just...There's an underlying assumption here that this all continues.

Michael: Yes.

Carl: Right? That, A, the value of these firms continue, these current price multiples continue, that this all continues. Is there any piece of that where you're like, hmm? Maybe that gives you pause.

Michael: Is there some risk? Yes. Obviously always. Right? No one, including me, has perfect crystal ball foresight for the future. I'm pretty good at predicting some future things, but obviously there's limitations. Slightly more practically, it's really hard to envision any possible path where this doesn't continue for the very simple reality, the deals math. What we have now...

Carl: But let me ask a question because so far the number's only gone up. Right? We're in a huge bull market. The deals math because part of it's built on 8.5% equity returns, right? If we have a prolonged normal...oh, heaven forbid we have a three-year bear market, you could see some world in which...This pricing is all based on recent history, which recent history is the last decade, the last 15 years have been really good.

Michael: Well, yeah. Yes and no. Yes with some crazy volatility and stress along the way. But yeah, cumulatively from the market bottom after the financial crisis, we've come a heck of a long way.

Carl: Yeah. Is there some assumption that that is built into...? Of course that's built into the...

Michael: Yes, it's partially built into...So I guess here's this situation. There's a difference between do the multiples continue and does the buying power continue? Does the buying power continue at some reasonable multiple? Do the multiples continue is a pretty broad debate in the industry, but again, I find a lot of it is very confused by headline multiples that have BS terms that no one's actually hitting. So the deal sounds great at a cocktail party, but it's not the actual cash that's going to change hands. The actual cash that changes hands is certainly higher than it was in the past, but PE firms that allocate a lot of money are not dumb people. They're actually pretty good at what they do. And they structure terms and deals in a way that makes sure that they are not getting blown up on the stuff that they're doing. So there are clawbacks, and givebacks, and contingencies, and earnouts, and all sorts of things that will protect them that if the growth doesn't really show up at the level it would take to make the deal math, they're going to end up, after the fact, having spent less on the deal.

What you get to pretty quickly though is, look, if I just go to the bank and someone will still give me a ten-year loan, I'm going to be able to mathematically buy a business for somewhere between seven and 10 times its cash flow because I can just literally take the profits and pay the note. I'm going to buy you for 10 times earnings. 10 gets a little sticky. I'll buy you for eight times earnings. I'll finance it over 10 years. So even after taxes and some slippage in interest plus principal, I'm probably slightly underwater for the first year or two. My cash flow is breaking even by year three, I'm doing well in years four through ten, and then my income goes vertical in year 11 when the note pays off. So I need some down payments or some cash flow in the early years to make that work. But I can do that by buying in tranches. I can do that because I've got a little bit of savings built up, depending on the size of the firm that I'm trying to buy into.

So to me just there's a lot of reason why, again, I'm slightly spitballing numbers here, but six to nine times profits probably doesn't go anywhere for a long time. Getting 10-plus requires a little bit more buying power or growth momentum or something else. And getting 13-plus is usually a lot of other circumstances and things going on that is not accessible to most of us anyways. And if I just get back to… if I'm running 30% margins and I can get eight times profits, eight times 30% is 2.4 times revenue. And if my margins are a little bit better and I can get my multiple a little bit higher, I start approaching three. And that's where a number of deals are getting done is somewhere in a two-and-a-half to three times revenue with, again, the giant asterisk, your profits and, therefore, multiples may vary.

So, to me, there's, again, at least for practices like Cheryl's that are not going for like Peter Mallouk creative planning 20 times profits to a sovereign wealth funds, like us mere normals, can valuations wobble a little bit? Perhaps, but not drastically from anything we can see. And look, there were people who were saying three years ago, whatever, two years ago, "Oh my gosh, we're finally out of zero interest rate policy. Fed's raising rates and has for two years. Bond market went through all the crazy turmoil." Pounding the table like, "Watch all the valuations crack because the cost of money is up and interest rates are rising." It didn't crack.

To be fair, they stopped...they're not really continuing to rise. We're kind of in a channel now for the past few years, and some terms in the fine print got adjusted to have a little bit more give back or a little bit more flexibility, but we already didn't see valuations materially shift with all the interest rate increases of the past few years. The secondary part to this, beyond do the multiples hold, and okay, can they wobble a little? Sure. But for normal firms getting done at normal deals in the first place, I'm not sure they're that frothy. So I don't know that they need a lot of give back.

But the second part is just, does the buying power continue? And I don't see any reason why the buying power doesn't continue. Even as large as a lot of the so-called mega firms have gotten, mega firms are now finally getting to the point where they might have, I don't know, one-fiftieth revenue of a wire house. Because all the rest of us are like one-thousandth the size. So the the point being, even the firms that we say are like mega huge, how far can the growth continue? The answer is, they're still tiny by industry standards. They're still not large. There's a lot, a lot, a lot of room left for firms to get bigger. And what the industry just has collectively figured out over the past 10 years is when you run the process appropriately, recurring revenue clients are remarkably transferable.

That's really what's bid up the valuations as it were, it's firms are doing these deals and they're putting a good advisor in and they're doing all the outreach to service the clients, and they're trying to continue the service, and clients are staying. And if it turns out it's profitable and transferable, guess what, people write you a check. And I don't see anything in particular that says margins are going to collapse. If anything, people are obsessed with the idea that AI is going to make margins go through the roof. I don't think that's going to happen because the AI will make us more efficient than we'll just do other things for our clients and replace the cost.

But most people are in the camp that AI makes margins go up. They're certainly not dropping. So the profitability continues. We seem to be able to continue to transfer the relationships. We figure out how to do it. The buyers have done it successfully, repeatably over and over and over again. And the math works for deals to continue to get done with firms that are big, but actually not that big by broad industry standards. So it's hard for me to see a future where the buying power, the buying demand isn't still there. And the valuations can only come back so much because if the profitability stays or gets better from here, better margins will push the valuations up.

Carl: I'm hesitant to even say this because it will cause you to want to spend an hour talking about it. We'll have to do it another episode. But people are making arguments that margins could compress, the same argument people have been making forever, specifically because of AI outside of the firm. Right? You're saying AI inside the firm might increase margins. There's certainly lots of people talking about, "Oh no, are we in trouble?" And let's not spend any time on that because we've…

Michael: It's out there. We went through it with the robos. Our fees margins were supposed to collapse.

Carl: But there's risks here that are real.

Michael: Absolutely. Notably there are...those risks are not distinct to internal versus external, right? And sort of the question I put before Cheryl. Look, if competition is actually going to get so bad that growth rates are going to go flat and then negative as AI firms start peeling us off, and then they force us to cut our fees and compress our margins just to try to compete, that's going to be a tough sale for your internal successor as well.

Carl: Sure. No, no, no.

Michael: The aggregate valuations of firms could shift, but does the opportunity to have an external sale from someone that has enough capital to do a transaction go away? It's hard to see any scenario where that goes away.

Carl: Yeah. Well, we should...

Michael: And so if you really care about...your firm has to continue your way, as much as anyone you train will do it exactly the way as you because they're fully formed adults and they can make their own decisions in the future. But if it's important for you that the firm continues in some legacy of you and what you created with people that were trained by you to continue to do it in the way that you've trained them, then to me folks like Cheryl have to start either an internal successor process of hiring someone, begin developing them, or at least finding your at least X years younger than you merger partner who wants to come in and make a bigger thing that you'll have together, and then they buy out your share and you leave. If that's important to you. And if not, then we seem to live in this world where these completely intangible, purely based on trust relationship businesses that we build with clients over 30 years are just weirdly, bizarrely, remarkably liquid.

Carl: Yeah. Yeah. That's super helpful. I just feel like I want to be on the record that I am probably wrong about this, and I've been wrong for 15 years about it, but I just want to caveat this entire discussion with things change.

Michael: Yes.

Carl: Right? And when we start...when I hear it's hard to imagine, I have slight PTSD from other times of other things changing. But I think that doesn't change the question we're answering.

Michael: Yeah. It can change the whole state of the business, how profitable it is, whether this thing is worth anything to anyone in 10 years.

Carl: But regarding planning for Cheryl...

Michael: I don't think it changes your crossroads about what you're going after. And it doesn't change the things that matter, which is the profitability of the business, the strength of the relationships to retain, the transferability of you ready and able to do the things that it takes to get a new advisor on board and have enough information documentation and a clean book of clients that another firm can take over and handle. That stuff doesn't change.

Carl: Yeah, I think that's helpful to those are the things we actually have some control over. And in any good planning process, that's what we're going to focus on. But we can think about the externalities all we want, we think about potential risks, important thought exercise. And then we take that hat off and we return back to here's what I can control. And that's super helpful. I'm glad Cheryl asked.

Michael: Absolutely.

Carl: Cheers, Michael.

Michael: Thank you, Carl.

Carl: Yeah.