While buying into an advisory firm can be an incredible opportunity in the long run, there are also some very important caveats and potential problems to consider, in terms of both the financial terms of the succession deal, and also the more nuanced challenges of participating as one of several partners in a multi-owner firm.
In some cases, the problem is as “simple” as the fact that the business is not actually very profitable, especially once accounting for a reasonable salary to the existing owners of the practice (given that if/when they retire, a comparable salary must be paid for their replacement to do the same job duties!). Similarly, sometimes the problem is just that the valuation of the business is unrealistic, especially when it is valued based on a multiple of revenues but does not have very healthy profit margins to support that multiple.
On the other hand, some of the most challenging problems that crop up when buying into an advisory firm are more nuanced; for instance, if the timing of profit distributions won't line up to when the required loan payments are due, or when there are significant disagreements between the (new and existing) owners about how much to withdraw from the practice versus reinvest for the future. Often, it’s feasible to work through these conflicts – or even bring in an outside expert – but unfortunately, sometimes the only resolution is to raise the issues in advance, negotiate where possible, and if the challenges can't be resolved, to walk away from the deal.
How Profitable Is The Firm, Really?
Large and established businesses – both advisory firms and in other industries – tend to have relatively “clean” books that clearly and appropriately account for the income and expenses of the business. In the case of small-to-mid-sized advisory firms, though, this isn’t always the case. As a result, sometimes just getting a handle on “how profitable is the business” can be harder than it might seem at first.
In some cases, the problem is that the firm owner (or partners if there are several) have become accustomed to trying to route “personal” (i.e., “questionable” as business) expenses through the company for tax breaks. While as an individual owner that’s their own gamble between themselves and the IRS, when more owners get involved the situation quickly gets messy, as running personal expenses through the business can materially distort the relative shares of income to the partners. This might include situations where family members are on the payroll, where the founder leases a car through the business, or even where the founder buys/owns the building the advisory firm uses as an office and leases it back to the firm at non-market rates. This can make the business appear to be less profitable than it actually is, and suppress distributions to new owners that might otherwise be higher.
Alternatively, though, in many cases advisory firms have never actually gone through the process of separating the “salary” of the owners from the profit distributions of the owners, especially when there is only one owner, or there are multiple owners who are all equal owners of the business. After all, if the business generates $500,000 of profits, and is a pass-through entity, the owners take the same income (and generally the same tax consequences) regardless of whether they take zero salaries and $250,000 of profits, or $150,000 salaries and $100,000 each in profits. When a new owner arrives, though – especially one with a smaller ownership interest – it suddenly becomes crucial for existing owners to be paid an appropriate salary, and only then divvy up the remainder as profits to the (current and new) owners.
Given this dynamic, be wary that the anticipated cash flows when buying in as a partner of an existing advisory business are accurately represented. In particular, be certain to clarify whether all owners are currently taking a base salary for their job in the business, after which profits are allocated to partners based on their ownership. Otherwise, there is a danger that what looks like a highly profitable business could actually be one with very mediocre cash flows after existing partners shift from pure profit distributions to salaries – which would be an unfortunate problem to discover after the fact!
Another caveat to be aware of regarding profitability of the firm is that accounting income is not the same as profit distributions, due to expenses like depreciation that are deductible for tax purposes (and reduce accounting and taxable income) but are not impact cash flows. As a result, sometimes the anticipated cash flows of a firm can be higher than the profit-and-loss statement suggests, especially if there are a large number of non-cash deductions.
Terms Unreasonable Relative To Profits
In some cases, the problem with a potential deal is simply that the terms really aren’t tenable. The profits of the firm just won’t come close to sustaining the purchase price. Gaps of this nature can be especially common in situations where the owners are pricing the firm based solely on a multiple of revenue, and fail to recognize that because they have higher-than-normal expenses and below-average profit margins, the revenue-based valuation isn’t justified (remember, the common 2X revenue valuation is usually predicated on an assumption of 25%-30%+ profit margins!). The gap can be especially severe in situations where the owners think their firm is profitable but don’t account for their own salaries, and fail to realize that once they receive a reasonable salary for the work they do in the business, the firm isn’t generating much profit at all for partners to share.
Ultimately, the best way to resolve the situation may be to get the owners to get a third-party valuation, as if the problem is really a lack of profits and cash flows, a quality third-party valuation will recognize this (as ultimately all advisory firms are valued based on future cash flows, not 'just' revenues) and reflect the issue back to the owners.
If the gap can’t be resolved, this is often still a reason that many successor advisors have to just walk away from the deal. While the opportunities for equity ownership in advisory firms can be incredible in the long run, do not assume the valuation being offered is really a fair and appropriate price just because the owners say so, especially if they cannot recognize the lack of profitability in their own firm.
Timing Of Profit Distributions Relative To Loan Payments
Another important caveat to bear in mind when negotiating a buy-in deal as a junior partner is that the timing of the profit distributions should be reasonably aligned to the timing of the loan payments. This is especially important in situations where the transaction is financed by a third party (e.g., a bank) that has its own expectations for the timing of payments.
For instance, cash flow problems can emerge quickly if the business only makes quarterly distributions to owners, but the bank (or even owner seller-financing) requires monthly loan payments. This is common for many firms that bill clients quarterly, and therefore (only) make partner distributions quarterly.
Similarly, the problem can be present in a more nuanced form if the firm typically pays out distributions more regularly, but distributes less than its anticipated profits throughout the year and then makes a final larger distribution at the end of the year (commonly done to keep a contingency for the business, and also to handle variable end-of-year staff bonuses). For instance, the firm’s projected profits for the year might be $500,000 and you might be a 5% owner, but instead of getting a little over $2,000/month, the firm distributes $1,000/month and then a big $13,000 end-of-year distribution. While the total amount may add up in the end, the intra-year payment fluctuations can create a cash flow squeeze with ongoing loan payment obligations, and should be planned for and addressed in advance (to the extent possible).
Distribution Of Profits Versus Reinvestment
While all advisory firm owners generally want their business to succeed and be profitable, it’s also crucial to recognize that not all owners have the same goals and views about how to pursue those profits. In particular, disagreements can emerge between partners regarding how much to reinvest into the practice versus drawing out as profits in the first place.
For instance, while the firm might nominally run a healthy 25% profit margin, if the existing firm owners are trying to grow aggressively, they may be distributing far less than the pro-rata share of the profits, either because they are building a cushion to manage against future business risks, or because they’re spending the profits back down with subsequent reinvestment. As a result, a firm that otherwise appears “profitable” may actually distribute far less than anticipated, which may result in a bigger cash-flow-gap between profit distributions and loan payments than originally anticipated.
Alternatively, for some firms the friction point is actually the opposite – when some owners primarily wish to draw income out of the business as profits, while others want to reinvest for future growth. The problem arises commonly in the context of succession planning transactions in particular, where typically older founders are at a life stage where they care more about the business cash flows (e.g., to support a partial retirement lifestyle), while those who are younger and have a longer time horizon would actually prefer to take out less, pay more out of pocket for their purchase, and reinvest for greater long-term growth.
At a minimum, be certain to discuss with the existing owners whether there is a policy around determining how much in profits will be distributed versus retained, and if there is no existing policy or rule around it, suggest creating one. Otherwise, partners with different goals and views about reinvestment can be a significant point of friction down the road.
Buy/Sell Agreements And Handling Partner Disagreements
One final – but especially crucial – issue to consider when buying into an existing advisory firm is how the business will handle the potential death, disability, or retirement of an owner. On the one hand, you simply want to protect yourself, and understand what would happen to your shares and/or how you would be bought out in the event that you ultimately decide to leave. Conversely, though, the biggest issue is actually about the situation where you buy into a practice and one of the founders/majority owners dies or becomes disabled. What happens then?
If the business doesn’t already have a buy/sell agreement to address what happens if any owner exits the firm, insist on creating such an agreement as a part of the buy-in. Otherwise, you risk being left on the hook for managing a business – and possibly owing money to the founder’s surviving spouse or heirs – without having the liquidity to pay for it.
Hopefully, the business will already have some form of buy/sell agreement in place, especially if there are already multiple owners. But even in that situation, ask to see a copy of the buy/sell agreement, look at the valuation formula and the payment terms of the agreement, and make sure they’re still feasible in light of the current state of the business. Just as is common with many of our own clients who are small business owners, buy/sell agreements often become outdated, and buying in as a junior partner to a business with an outdated agreement can create a personal crisis if something unfortunate happens and the documents haven’t been updated.
Similarly, understanding the terms by which a partner can leave the business is crucial if there’s any risk that a partner could someday leave and take their own clients with them. If your purchase of the practice is based on a certain expectation of revenues and profits, and one of the partners decides to leave and take his/her half of the clients (and revenues and profits) along, where does that leave your purchase agreement? Does the business have an agreement that a departing partner must sell back the shares, and/or buy out the clients? Does the business have a non-compete agreement for all the partners to prevent them from just breaking away and opening up shop across the street, taking with them the revenue and profits you were counting on to handle the payments for your own purchase? (Funny how a non-compete seems much more important and appropriate when it might be you left on the hook, eh?!)
In addition, it’s also important to simply raise the issue of how the firm will make decisions going forward, especially in the event that there are partner disagreements. As noted earlier, the reality is that as a small minority partner, you may or may not have a major role in the decision-making process of the firm, but the reality is that a firm which struggles to make decisions or has contentious disagreements across the partners can ultimately lead to the dissolution of the firm, which is damaging for everyone. Fortunately, there are services available to help manage conflict resolution amongst partnerships, but ideally the firm should address how conflicts will be resolved in advance, rather than the risk of sorting it out real-time, especially when as a minority owner you may be relatively powerless (at least legally) as the problems unfold.
Walking Away From The Buy-In Deal
Sometimes, the potential problems and caveats of a purchase are just too great to bear, and it’s necessary to walk away from the deal. Whether it’s an ‘unreasonable’ valuation of the business given its real cash flows, disagreements about how to run the business, or simply that you’re not comfortable with a marriage-like long-term relationship with the potential partners, in some cases there’s just no viable resolution.
Notably, walking away from a deal doesn’t have to mean walking away from the firm altogether, although there’s no doubt that declining a partnership and staying at the firm to continue managing clients can be awkward. Perhaps declining the offer is a “wake-up” call the existing owners need to get their own ship in order – if that was the problem in the first place – and after a year or two of resolving the issues, a new partnership opportunity may emerge.
In other situations, though, the reality may be that the failure to reach a deal leads to a breakdown in the relationship altogether, and it’s simply no longer feasible to stay at the firm at all.
So what do you think? Have you ever had to walk away from an opportunity to buy into an advisory firm? What was the "deal-breaker" for you? Have you ever gone through with a buy-in and then regretted it later? What do you wish you'd known then that you only discovered too late? Please share your thoughts in the comments below!