Welcome, everyone! Welcome to the 72nd episode of the Financial Advisor Success Podcast!
My guest on today’s podcast is David DeVoe. Dave is the founder of DeVoe and Company, a practice management consulting firm for RIAs with a focus on business valuations, succession planning, and facilitating mergers and acquisitions of advisory firms.
What’s unique about Dave, though, is the deep history that he has in consulting on and tracking trends in advisory firm mergers and acquisitions, and the valuation of advisory firms, both previously at Charles Schwab where he led Schwab Advisor Services’ Mergers and Acquisitions program, and now as an independent consultant who runs one of the industry’s leading “Deal Book” tracking studies on financial advisor M&A activity.
In this episode, we talk in depth about current trends in the valuation of advisory firms, the flaws in the traditional “2X revenue” valuation estimate for a firm (and why it can actually vary as low as just 1 times revenue or as high as nearly 3X), why focusing on profits and a multiple of free cash flow leads to better valuations than looking at revenue alone, the Growth, Profitability, and Risk factors that impact the valuation multiple for an advisory firm, and how in the end an advisory firm is still, like any business, priced based on the present value of future cash flows, and thus why Dave’s firm takes a discounted cash flow model approach to providing accurate advisory firm valuations.
We also talk about the mechanics of advisory firm deals from the buyer’s perspective, why deals were historically transacted primarily with seller financing, how the rise of third-party bank financing is changing the actual terms and even the valuation of a firm, and why arguably the most important factor in determining the affordability of a purchase is not actually the price of the firm, or the interest rate charged on the note, but the number of years over which the payments are financed that determines whether the buyer has some skin in the game, or if the profits of the firm can actually fully finance the purchase with no ongoing out of pocket cash.
And be certain to listen to the end, where Dave shares his perspective on the buyer and seller trends in the industry, why he sees it as both a “buyer’s market” and a “seller’s market” right now, and why he thinks the greatest risk to valuations is the danger that too many firms try to sell at once… not because there isn’t enough capital to fund all the purchases, but simply because there are still too few buyers for them all to be able to collectively handle the operational challenges of implementing so many mergers and acquisitions at once!
So whether you are interested in learning how to best value your own firm, what you should consider when deciding to purchase into or acquire another firm, or are simply interested in the general market dynamics in a continually evolving market for mergers and acquisitions of advisory firms, I hope you enjoy this episode of the Financial Advisor Success podcast!
What You’ll Learn In This Podcast Episode
- What puts Devoe & Co. in a position to help advisors with any strategic decisions that they need to make. [4:47]
- The typical profile of the firms they work with. [6:38]
- Common strategic issues coming up for advisory firms today. [8:14]
- Where to start with creating a succession plan. [20:31]
- The size inflection point where firms tend to become too expensive for the next gen. [23:41]
- The surprising percentage of people who are offered equity that will actually reject it. [25:59]
- What typically causes someone to decline equity. [25:59]
- Why looking at free cash flow tends to lead to better valuations than looking at multiples of revenue alone. [38:35]
- Three main factors that drive valuation. [38:35]
- Why interest rate is arguably the most important factor in determining the affordability of a purchase. [1:20:06]
- Why it’s so important for people not to procrastinate when it comes to succession planning. [1:15:28]
- Current trends in advisory firm valuations and M&A. [1:35:45]
- Predictions for M&A activity in the future. [1:42:29]
Resources Featured In This Episode:
- David DeVoe – DeVoe & Co.
- DeVoe Capital Services
- Live Oak Bank
- Oak Street Funding
- DeVoe Q1 2018 RIA Deal Book
- Live Oak Bank
- Oak Street Funding
Full Transcript: The Financial Mechanics Of Buying Into An Advisory Firm And RIA Valuation Trends with David DeVoe
Michael: Welcome, everyone. Welcome to the 72nd episode of the “Financial Advisor Success” podcast.
My guest on today’s podcast is David DeVoe. Dave is the founder of DeVoe & Company, a practice management consulting firm for RIAs with a focus on business valuation, succession planning, and facilitating mergers and acquisitions of advisory firms.
What’s unique about Dave, though, is the deep history that he has in consulting on and tracking the trends of advisory firm mergers and acquisitions and the value of firms themselves, both previously at Charles Schwab where he led Schwab Advisor Services mergers and acquisitions program, and now as an independent consultant who runs one of the industry’s leading deal book tracking studies on financial advisor M&A activity.
In this episode, we talk in depth about current trends in the valuation of advisory firms. The flaws in the traditional two times revenue valuation estimate for a firm and why it can actually vary as low as one times revenue or as high as nearly 3X. Why focusing on profits and a multiple of free cash flow actually leads to better valuations than looking at multiples of revenue alone, the growth profitability and risk factors that impact the valuation multiple for an advisory firm, and how in the end and advisory firm is still like any business, ultimately priced based on the present value of future cash flows, and thus why Dave’s firm takes a discounted cash flow model approach to providing accurate advisory firm valuations.
We also talk about the mechanics of advisory firm deals from the buyer’s perspective. Why deals were historically transacted primarily with seller financing, how the rise of third-party bank financing is changing the actual terms and even the valuations of firms, and why arguably the most important factor in determining the affordability of a purchase is not actually the price of the firm itself or the interest rate charged on the note, but the number of years over which the payments are financed that determines whether the buyer has some skin in the game or if the profits of the firm can actually fully finance the purchase with no ongoing out-of-pocket cash.
And be certain to listen to the end, where Dave shares his perspective on the buyer and seller trends in the industry, why he sees it as both a buyer’s market and a seller’s market right now, and why he thinks the greatest risk to valuations is the danger that too many advisory firms try to sell at once, not because there is enough capital to fund all the purchases at current prices, but simply because there are still too few buyers for them all to be able to collectively handle the operational challenges of just implementing so many mergers and acquisitions at once.
And so with that introduction, I hope you enjoy this episode of the “Financial Advisor Success” podcast with Dave DeVoe.
Welcome, Dave DeVoe, to the “Financial Advisor Success” podcast.
David: Michael, it’s good to be here.
Michael: I’ve been looking forward to this episode for a while because you live in this to me is a very interesting space of mergers and acquisitions and advisory firms buying other advisory firms. And it’s kind of becoming the hot trend in the industry these days, particularly in the RIA space, but, I mean, like, it’s a huge challenge for most of us to think about this as advisors because the entire process of what it takes to go through a transaction of selling your firm, most of us will only ever do once, at the end when we’ve built the thing that we’re ready to sell, making probably the largest financial decision of our lives, having absolutely no experience in doing it, unless, like, we happen to have clients who bought and sold businesses and maybe had some experience or familiarity with it.
And so I’m looking forward today just talking through, like, this world of advisory firm mergers and acquisitions and valuations and investment banking. Just, like, how all this works. So hopefully, like, everyone listening understands just a little more of what goes on in this world where we just talk about M&A mergers and acquisitions as a thing that I just don’t kind of experience until you’re in the thick of it.
David: Yeah, yeah. No, it’s great running this business. I think it’s a lot of fun. It’s got a mix of both the analytical and quantitative, but it also has a big emotional component. I mean, people are quite literally making some of the most important business decisions of their career. So to be part of that, it’s really rewarding, you know, to make these things work out well. So it’s been a lot of fun.
What Allows DeVoe & Company To Give Advisors Strategic Advice [4:47]
Michael: So as we get started, like, why don’t you as a starting point you just tell us a little bit about DeVoe & Company. Like, your business, what do you guys do?
David: Yeah, yeah. So we really do three things. We do consulting, we do investment banking, and we do valuation work, all exclusively for the RIA space. So I’ll define those a little further.
So consulting, momentarily I can talk about the team, but we have a really unique team. And literally, half the team has sat in the chair of our clients. They’ve run either as COO, president or CEO billion dollar-plus RIAs. And that experience…plus the other half is a couple of ex-McKinsey folks. That experience really puts us in a position to help advisors with any strategic decision that they need to make. You know, human capital, succession planning, incentive compensation, strategic planning, growth, fee increases, fee decreases. Quite literally any strategic discussion or decision that an advisor needs to make, we can help them with. You know, we don’t get into hyper-technology decisions, we don’t get into, you know, hyper-detailed operation decisions, but the strategic elements we’re really good at. So that’s the consulting side of the equation. Which is different from investment banking, you know, helping firms buy, sell or merge a core component of the business.
And then the third component, valuation, it’s kind of a pet project for me. You know, I sat in a chair at Schwab for eight and a half years and saw valuations done in a way that I think I thought about differently. So when we launched the company, we took a very nerdy approach, scientific approach to valuation. And we have a lot of passion about making sure that we’re crafting the right numbers. So that’s an entire business line for us. It’s not a loss-leader, that’s a line of business for us.
Typical Profile Of A Firm That DeVoe & Company Works With [6:38]
Michael: Okay. So I’d love to dig into each of these a little bit further. So let me start with the consulting end. So I guess as a starting point, like, when you’re doing these consulting conversations of, you know, fee increases, decreases, human capital, these things, like, what’s a typical profile of a firm that you’re working with in the first place? Just so we have a little context of, like, we’re thinking about this consulting, like, who’s the firm on the other side of the table? Is it like a $100 million RIA, a $1 billion RIA, small or larger? Like, who are you consulting with?
David: Yeah, yeah. So you’re spot on, it’s RIAs. It’s the vast majority of our business. You know, sometimes we’ll have hybrids, etc., but it’s truly, you know, the wealth managers that you and I work with every day. And the size ranges. Our smallest client has had $40 million. I guess you could say even a de novo startup, our largest client has had probably $60 billion or more, one is coming to mind. You know, the sweet spot is probably a couple hundred million to a couple billion.
When I started this company, I thought, “Okay, you know, clearly a business consultant, I’m all about helping clients think about segmentation and being very focused.” And I thought about that and I decided, “You know what? I’m going to go into the marketplace with very transparent fees, and, you know, firms will pay if that makes sense to them. I’m not going to jack it up for the big ones, I’m not going to create, you know, really tight or sort of throwaway work for really small ones.” So what we find is, you know, we put out into the marketplace what we’re doing and both large and small will hire us.
Current Trends In The Advisory Industry [8:14]
Michael: So what kinds of…I mean, you mentioned a few areas like fee increases, decreases, human capital, but just as someone that’s doing it, like, what are the hot strategic issues that you’re seeing come up for advisory firms these days?
David: Yeah, yeah, there’s a number of them. So, you know, succession planning has been a big component since we launched for six years. You know, clearly, some of the trends are pointing in that direction. So a lot of succession planning from day one. The last probably three years, we’ve done a lot of strategic work. Clients are coming to us saying, “Hey, you know, we’ve built this platform, we have a solid machine here.” It could be, you know, $400 million or $800 million, sometimes it’s $1 billion or more. And they say, “Okay, we’ve gotten to this point, but now we have all these different options.” You know, I call them shiny objects, and they’re almost overwhelmed by, you know, they can grow the business faster, they can enter this new market, they can create this ancillary business or go after this new segment of clients. They could acquire, they can merge, they can sell. You know, and they almost get overwhelmed.
So we’ve done enough of this business that we’ve created a methodical approach to really starting with the goals, really creating a criteria out of that, then identify an option set, and methodically collaborating with them to determine which elements need to be removed and which ones they should really focus on and ultimately arrive at a focus. So that strategic work has really gained a lot of momentum over the last couple of years.
Recently, we’ve done a lot of work on the human capital side, incentive compensation, in particular, which I’m just fascinated by. I love incentive comp. And more recently, a lot of governance work, especially once a firm hits about $1 billion they start having more shareholders. It’s not just one person or two partners making the decisions. It’s methodically thinking through how decisions are being made with, you know, 5, 10, even 25 different shareholders. So it ebbs and flows a little bit, but those are some of the overall trends and some of the hotter pieces that were working on.
Michael: So I’m kind of fascinated with the governance piece in particular as kind of an issue I’m seeing cropping up more as firms just get larger and get multi-partner. Like, a lot of firms get founded by either one person or maybe two people, occasionally three, kind of they band together, “We’re the advisors. We go out getting the clients.” And you get clients, you hire some staff, you get more clients, you hire a few more staff, you hire maybe some associate planners, you start handing off the clients and you’ve got room to get more clients. And you can grow the firm for quite a while that way.
But eventually, you want to introduce some additional partners. The ownership spreads out a little bit. And then all of a sudden these, like, very challenging real-world questions start coming up like, “So does everyone who’s a partner sit at the table when we make business decisions?” Like, in theory, a lot of people say, “Well, I want to buy in to be a partner so that I can be part of the decision-making process.” But if you do that with a lot of advisors and have a lot of partners, eventually you’re just making 15-person executive committee decisions. That means nothing is getting done at that point because there’s too many people in the room. So how do you see firms dealing with this? Like, what kinds of I guess governance structures do firms start putting in place as they get large?
David: Yeah, yeah. You know, it’s interesting. Each firm is a little different, but we start to see certain themes. One of those themes is, “Gee, you know what? DeVoe & Co. come in here and help us put an equity plan in place. We want every employee to be behaving like a shareholder. A matter of fact, we want, you know, people watching the paper clips. We want everyone to be behaving in that way.” And, you know, we’re good soldiers. We work with our clients. Oftentimes we’ll share our perspective, pros, cons, and implications of different ways to proceed. And in this circumstance, we’re often sort of saying, “Okay, we’re happy to craft something like that, but let’s think about that. And is that really the best path forward, and is that going to achieve your goals?”
So for instance, oftentimes, you know, an administrative assistant or, you know, a junior operations person, giving them a couple shares of stock, which frankly they don’t even understand. It’s this illiquid, theoretical construct that they have, you know, that could be worth thousands of thousands of dollars, but they don’t get it. And frankly, they’d be happier with a couple hundred dollar bonus instead of that. So instead sometimes we’re helping our clients think through, “Okay, you know, let’s talk about it, what do you seek to achieve here? And, you know, are people actually going to change their behavior patterns simply because they’re a shareholder or are there better ways to change their behavior patterns?”
Oftentimes we’ll start getting into…it’s somewhat philosophical, but it’s important in many cases. You know, are we talking here about shareholders or are we talking about partners? And how do we define that? Is this a process where we’re rewarding based on success to date or we’re giving shares out because of either fear, we fear that they’re going to leave, or aspiration, we expect that they will come into this role? So all of these are some of the pieces that we’ll work through in this equation to determine, you know, what that shareholder plan should look like.
Now, once people become shareholders, it gets into the governance questions that you raised. And there’s a few components to it. You know, sometimes we see firms that say, “Hey, I only want to do a transaction if I’m going to be 51% shareholder because I want to call the shots. I don’t want to give up control.” Well, there’s different ways to skin that cat. You could be a minority shareholder and actually have decision-making control over certain things. Many decisions actually shouldn’t be 51%, maybe they should be 66% or 80%. You know, some of these decisions maybe shouldn’t be based on the number of shares that you have but maybe one vote per shareholder. So the governance work that…
Michael: I’ve got to ask, just…
David: Yeah, go ahead. Jump in.
Michael: …you put a piece out there that I think would pique at least some people’s curiosity. Like, how do I keep control of decisions if I don’t own the majority of my firm?
David: Yeah. Well, there’s a few layers. One is, do you need to control everything? You know, which is an important question for people to reflect on. And part of this is related to oneself. Sure, we’d all love to control everything, but we also, you know, realize that other people are going to want control as well. We also realize the diversity of thought and even a situation where you don’t have full control. Maybe even that discipline of having to sell your concept to other people can be really powerful. But we’re also very respectful that, you know, it’s not invalid to want full control. And if that’s the case, you know, let’s structure things in that particular format.
Part of our job too, Michael, you can imagine is, “Hey, what’s the current situation and what do you seek to achieve currently? And then also, how might that evolve over time?” Because someone who wants full control today but they also want to bring on successors, they want to start to create that path to migrate ownership, leadership, management, all these critically important things, you know, that paradigm is probably going to have to shift over time. So, you know, we joke with therapists with spreadsheets and therapists with frameworks, and this is one of those things where it’s not just, “Hey, DeVoe & Company, come in here. Drop your framework down, let’s fill in some numbers,” oftentimes we’re literally having conversations about, you know, people’s fears and aspirations and what they seek to achieve today and down the road. And that’s part of our job.
Michael: And so what kinds of changes end out getting made when you go down this road? Like, I’m just trying to envision, what does a…you know, like, just what does a governance structure look like? Like, I know how to own my firm and call the shots. That’s how most of us start if we’re building a firm. Like, when it’s not that, what does it look like?
David: Yeah, what does it look like? So part of what we’ll start with is talking through, “Okay, let’s start identifying what control means.” And essentially that manifests itself in certain decisions. So there might be a dozen, maybe there’s probably even 25 different decisions that typically might rise to the level of management, or I should say ownership.
Michael: These are, like, senior hiring decisions, how we price our services, launching new service lines, like, things like that?
David: Absolutely. You’re spot on. So, you know, do you want it to be what sort of copier paper you use or what sort of copier you buy? Absolutely not. You know, by contrast, do we want to acquire our firm or do we want to enter this new line of business? Do we want to change the name of the firm? Those are some of the critical things. You know, hiring people at this level, not that level.
So, you know, we’ll often start by saying, you know, “Do you have anything in mind that you want to have as part of those governance decisions?” And then we’ll also get into, “Hey, here’s a laundry list. You know, tell us what’s important to you.” So that process is going through, and sometimes there’s more complexity, “Do you need a board that makes a separate set of decisions or just shareholders? You know, okay, where does the management team fit in here? You know, the CEO or a president, do they have certain decisions that they’re going to influence?”
By Reader’s Digest, it’s a process of determining what those decisions are, and then how those decisions are going to be made. And part of that too is, you know, not just what’s the control for that given individual, but how do you really create, in some cases, the power behind coming to shareholder? Is it just getting a check or is it actually having some decision-making power in the organization, and what does that look like?
Michael: I feel like that would become an issue for a lot of next-generation advisors coming in, where so often the focus on equity is all about like, “I want a seat at the table.” I hear that a lot from advisors who say like, “I want a seat at the table.” Except what you’re basically saying is, and then you add the owners and then you have to have them not have seats at the table.
David: Mm-hmm. You mean, in circumstances where they’re shareholders but they don’t have any decision-making power?
Michael: Yeah. I mean, is that common, and how do you not create embittered next-generation advisors who’re like, “I finally get to be a partner, still not getting to contribute to the decisions?”
David: Yeah, yeah. I think it’s common when we start talking to firms, and then it’s going to depend. And we have, you know, oftentimes, you know, principals, they’re running the business. Their lives are busy with these things and they haven’t spent a lot of time thinking about governance and decision-making. So our job is to create a nice, elegant, efficient way for them to think through that. And in many cases, they shift and they say, “Wow, okay. Yeah, I do see that these folks should have some decision-making power. A matter of fact, part of me being a leader and a coach to them is having them, you know, sit at the decision-making table and being, at a minimum, exposed to it. In some cases having a degree of influence, and in other cases having just as much influence as me. You know, one vote per shareholder. And they can see some value and power in doing so.”
You know, quite frankly in other cases, firms say, “You know what? I still want full control. And I either don’t want to have them having decision-making power, or I want structures in place so that I can still control the outcomes of certain things.” And that’s okay. You know, we’re not here to judge, we’re not here to tell people how things should be done. We’re here to understand what they seek to achieve, and then enable them to craft that structure, but also ensure that they have full knowledge of the downstream implications of that. And in a particular organization like that, again, it’s not the end of the world. Oftentimes, you know, it’s folks that are signing up saying, “Okay, I’m a shareholder, I’m going to get my quarterly check, but I’m not going to have decision-making power at this time.” You know, and that’s still a great work environment for them to be in.
Where To Start When Crafting A Succession Plan [20:31]
Michael: Now, you said you’re doing a lot of succession planning work as well. I would presume in the…I guess this depends on firm size, but I usually think about succession planning, which is, you know, advisor has business, decides they don’t want to run the business anymore, wants to get ready to retire in a couple of years. Go and find a successor to do succession planning. I’d presume kind of the control transition issues look very different in succession plans because we’re in theory trying to transition ownership and control, as opposed to, like, expanding ownership up, retaining control?
David: Yeah. Succession planning, it’s such a vast topic, you know, and it takes so many different elements depending on…there’s literally 30 different modules that can be part of a succession plan. And, you know, firm A might want to tackle 21 of those, firm B might want to tackle 3 of them. You know, “Hey, valuation deal structure, I’m good. That’s all I need right now.” So it really depends on the organization.
I mean, the good news is, I’ve been doing this now, RIA, M&A for 16 years. And when I started in this business, a lot of the succession plans were, you know, when someone was a year or two years away from retiring. I mean, it was actually kind of weird. You know, I was working for Schwab at the time and I got on the road. I was starting to launch this…their transition planning platform. So, you know, I went out and I started talking to a lot of advisors, and learning from them. And I’d go and meet with these folks, and I walk through their office. And as we’re walking through, they’re waxing on about not only their employees but, “Gee, you know, clients just love us, and we love our clients. And quite literally, Dave, I mean, these people depend on us. We provide so much value.” And they talk about just this glorious relationship.
You know, and then we get into their office and we close the door, and after a couple minutes I’d say, “Hey, you know, I’m trying to craft this program, what’s your succession plan?” And they’d say, “You know, Dave, they’re going to carry me out of here in a box. I’m going to die with my boots on.” And I was like, “Wait, three minutes ago, you were talking about how your clients depend on you. They love you. How grateful you are for this life that they’ve helped you create, and suddenly they’re going to get…” You know, I actually literally imagined my cute, little grandma before she died. You know, this little, old lady getting something in the mail saying, “Hey, your advisor died. You’re on your own. Go grab a phone book and figure out who you’re going to use.” You know, just a huge disconnect.
So the good news is I hear a lot less of that these days. And when I do hear it, you know, I delicately and diplomatically talk about the impact that can have on their clients, which oftentimes are, you know, in their 70s or 80s, or even older. And by the way, fiduciary is a whole another topic. That doesn’t sound very fiduciary to me. So the good news is I think the needle has moved. Unfortunately, you and I know there’s not nearly as many succession plans as we should see in the marketplace, but more and more of these advisors are doing the right thing and doing it earlier for a whole variety of reasons.
The Inflection Point That Firms Encounter [23:41]
Michael: And so what does the…like, what does a typical succession plan deal structure look like at this point? You know, if they’re doing this a little bit further ahead, I know like when we’re getting in the homestretch and it’s just like, “Hey, I’ve got to sell my business next year,” it’s mostly about just, “Let’s get the terms of the transfer done,” but for these more gradual succession plans that I’m seeing coming up more often, like, what do these deals look like? How does this come together?
David: Yeah, yeah. So a couple things. I mean, almost like a cheat sheet, because I think advisor should, as soon as you get started, you know, the machine is running. The canoe is not going to sink, right? You’re pushed away from the shore. You know, literally just start thinking through some succession planning. Like, if I get hit by a bus, what’s going to happen? And, you know, I’ve had folks who ask me to speak and create little slides on it.
So, you know, as soon as you get started, just start with taking care of your family and your heirs. You know, put insurance in place. The next thing is to probably have a buy-sell agreement with another organization. “Gee, you know, I’m 40 years old or 35. I don’t plan to get hit by a bus, but if I do, here’s a firm that shares my investment philosophy, they share my client service philosophy, and they’d do a pretty good job with my clients. So let’s rough something out. Let’s have a buy-sell agreement where if I’m hit by a bus they take over the client relationships.”
And then start moving into, “Okay, let’s look around. Do we have potential next-gen in place? You know, do we have a path?” And that gets to what you’re talking about now, which is, how do you start grooming people? How you, you know, determine what the valuation of the firm is. Start to migrate equity over to them. And, you know, I’m happy to talk through some rough terms on that.
One of the things that we are seeing a challenge with and this is another area that we’re doing a lot of strategic work, is to crunch the math in terms of, if a firm is hitting an inflection point, where the firm is getting too expensive for the next-gen, right? So when you first start the firm, you want to have some sort of succession plan in place. Once you get big enough, it becomes a challenge, if not impossible, for the next-gen to be able to afford the firm. So starting to do that math and think through, “Okay, what’s the value of the firm today and the future?”
Why So Many People Offered Equity Reject It [25:59]
Michael: And where does that size inflection point tend to come where it becomes an issue for the next generation to buy the firm?
David: Yeah, yeah. I’d say, you know, leading up to $100 million generally there’s not a successor in-house. You know, so they haven’t hired someone that has those capabilities to run the company. Right around $100 million, and maybe it’s $80 million or $120 million, it depends on the firm, you know, you hire 1 or multiple people that could actually run the firm if you get hit by a bus or at the appropriate time.
Once you hit maybe $200 million, $300 million, it starts to get a little gray. Once you hit, you know, $300 million, $400 million, it can start to become a challenge to sell the firm internally. It’s going to depend on a lot of factors. You know, if you’re 20 years away from retirement and you’re starting the process, great. If you’re 3 years away from retirement and you have a $400 million firm, it might be impossible to get to the right…you know, to get a fair, undiscounted valuation.
So once you hit, like, I would say maybe $300 million to $1 billion, you know, it’s worth taking out Excel crunches of some numbers or, you know, hiring us. We’re nerds about it, so we have a 10,000-cell model to literally, you know…because it gets complicated pretty quickly. You’re saying, “Okay, what’s my firm worth today? And each year it should be worth more. And then how much am I going to sell, you know, this year, or a couple years from now? And Gee, Lisa is a partner too, when does she sell?” And you start thinking through when the sales are going to occur, and you look around at who’s going to buy in and how much money they have sitting around.
And the other thing too which is fascinating is sometimes when people do this, they make assumptions that may not come to fruition. So this is not an uncommon one. You might have heard this, “I’m just going to sell 10% a year to person X, and this will work out.” Well, about three years in, that person and their spouse are like, “Wow, we’re putting every single dollar into this company, maybe we want to put a pool in the backyard. I think we’re going to skip a year or two here. A matter of fact, we might even be done.” And suddenly, that whole 10% of your plan is upside down.
The other thing too is we’ve seen anecdotally enough now that about 25% of the time you offer equity to someone, or let’s say 25% of the people you offer equity to will actually reject it. So suddenly you’ve got a big hole in your plan and probably a lot of emotional turmoil because you’re offended. But yeah, some of these calculations are…
Michael: Why do people turn it down? I feel like, you know, for so much of the discussion, that’s, like, the thing advisors are working toward. Particularly when you come in as, like, a junior associate planner, like, “I want to work up to the point where I can be a partner, or maybe someday buy the firm,” and then they decline when you get there. So, like, what causes declines?
David: Yeah, yeah, it is interesting. Careful what you ask for. No, there’s a variety of factors. And we’ve done this enough now that as we start to move toward…you know, we’ll be working on a succession plan and we’re like, “Okay, great, you’re going to offer these four folks,” you know, and you get the elegant deal structure set up and all this partnership criteria. I mean, that’s another thing is that whole process of partnership and eligibility and all that. That’s a bunch of work we do too.
But we now warn people before they’re about to have that discussion with their staff. We tell them, “Hey, heads up, about 25% of the time, this doesn’t work out. And, you know, you are probably going to have a visceral reaction like anger or frustration if you get a no. You know, and be careful, be aware of that, and let’s talk through it after the fact. Because in some cases, it’s just life is complicated and these people have economic challenges that you weren’t aware of or economic priorities that are more important than investing in the firm.”
Michael: Like what? Like, you know, I wanted to go buy a house? Start a family? Like, those kinds of things? I guess I can envision that, just sort of the age demographic of who’s buying at the time.
David: Yeah, yeah. So I think that’s part of the equation, but oftentimes the owners of the company will already kind of know that about their people, right? Instead, it’s more of, they have an ailing parent and they’ve started to crunch the math and say, “Wow, you know what? We’re going to have to take care of this parent.” And sometimes that’s doing the calculation of, “We’re going to be flying to this city, you know, once every two months, and suddenly it’s going to this.” So that can be part of the challenge. It could be, you know, people have done their own financial planning and in this particular case, they’re not ready in some cases.
And some of these things are, you know, outside the scope. Part of it is economic. And this is where it moves from, “Hey, it’s okay,” and maybe it’s a short-term issue, to, “Hey, maybe you do need to consider this person and whether their partnership criteria…” Because sometimes if someone says no, that can be the first step in a parting of ways with that party. And it doesn’t have to be, but it can be. And sometimes we want to mitigate that if it’s not going to occur.
So oftentimes the other reasons that we see are these people are not wired to be entrepreneurs. You know, you’re an entrepreneur, I’m an entrepreneur. All the clients that we work with, these people are wired to be entrepreneurs. We start to assume that everyone has a similar psychological makeup as us. And it’s a very small part of the population that does. So oftentimes, you know, for someone to bet their life savings on this business or set into that seat, that can be intimidating for them.
You know, in some cases, they actually don’t think the firm is worth their investment. They think, “Hey, I either don’t understand valuation or I’m not connecting these dots,” and they’re not comfortable. I mean, that’s a whole another topic to talk about. But those are all sort of the different components that often drive this delay or decision not to invest.
Michael: So can we delve into that a little? Just, like, the world of valuation and maybe, like, just…well, I guess this is true on the sellers and as well as the buyers, but I’m thinking particularly for the buyer who’s never bought into a practice, maybe even has never really crunched the math and thought through how all this works. Like, how do you talk through valuation and how to understand it and how to think about the buy-in for a prospective junior partner who’s thinking about buying and you’ve ended out at this valuation table?
David: Yeah, yeah. Yeah, so, you know, we’re very passionate about valuation. And, you know, I can nerd out momentarily, we have, like, 30,000-cell discounted cash flow model. It’s not only a powerful tool to understand the valuation, but a diagnostic for the firm. It’s like an elegant work of art for nerds like you and me. I mean, it’s just cool. It’s awesome.
And part of that passion is, like, just nerdiness, but part of that passion is because this stuff is important. We’re talking when we’re valuing a firm, usually, money is changing hands. And we’re talking about junior people quite literally risking their life savings. You know, in other cases, the partners too. They’re monetizing their baby, something they’ve nurtured, you know, from a concept into what it is today. And the retirement can be part of this too, you know, and the viability of the retirement. That’s critically important too. But, you know, clearly, on that other side, people are risking their life savings. And that’s why we’re so passionate about it.
You know, to take two times revenue or, you know, five times cash flow, we’re using math my 13-year-old son could do in his head a couple of years ago, the value of a firm where, you know, life savings are taking place. For me, it’s just irresponsible and wrong. So that’s why we’re so passionate, and we really try to understand that organization and get to the right number.
So a few things. You know, when folks are hiring us to come in and do a valuation like this, one is that can give the next-gen a much greater degree of comfort, you know, in two layers. Let’s assume they’re not involved in that process. It doesn’t take too much google or chat with too many people to say, “Okay, you know, DeVoe & Company, or Dave DeVoe, this isn’t a fly-by-night operation or whatever else. Like, these guys get it.” So that can increase the comfort level.
But oftentimes our clients will have their next-gen come along in those conversations. So the way we do valuation, you know, some firms it’s like a brick over the wall. “Hey, give us a bunch of information. You know, we’re going to spit out a valuation. Thank you very much.” You know, we are going to be having three to six conversations with the client. They’re engaged. We’re talking about the business. What’s the history? “Hey, you had this spike here. You know, you had this turnover there.” Looking into the future, “What’s going to happen with this? Oh, you see here you don’t need to hire new people over the next five years? Well, your advisor to client ratio is going from, you know, 78 to 115, and up front, you said your target was 65. Like, we have a problem. We need to…”
So we’re literally going through with that advisor and thinking through because we’re projecting what’s going to happen with this company. Sharing our expertise, marrying that with their intimate knowledge of their business and what’s going to be happening.
So if their next-gen is coming along in these conversations, which oftentimes they are, they’re not only seeing the nuts and bolts and, you know, gaining a very high degree of confidence, “Okay, this is truly why the firm is valued this way,” they get it, they understand it, but it can be really powerful too because if this is going to be your next-gen, they’re seeing how to run this company. They’re seeing different ratios. They’re seeing, “There’s a leaky bucket here, and we’ve got to close that gap. And man alive, we’re doing this better than anyone else in the business. We need to do more of this and do it better. So here’s how the economics work.” So it can be a really powerful process to have these folks right along through that experience.
Michael: So can you walk us through a little bit more of just how the economics work? Like, I don’t know, maybe we can pick, like, a hypothetical $200 million assets under management firm and just kind of walk through, like, how does this…how would the valuation come together? Or what are some of the factors? And, like, what would a deal end out looking like for a $200 million firm?
David: Yeah, yeah. So, you know, I’ll start with sort of the $200 million firm, you know, a few approaches. One might say, “Okay, let’s start with the revenue, the two times or 2.3 times revenue.” So, you know, I think you and I would agree that that would be wrong. A matter of fact, it’s funny when I started in this business 15, 16 years ago I was like, “2 times revenue.” There’s a firm that’s done a great job marketing like this into the psyche of people, where, “Let’s take a very complex problem and make it very simple, two times this number is great.” And the funny thing is the number has actually moved in the wrong direction. So the new number, I don’t know if you’ve heard, Michael, but it’s now 2.3 times revenue, 2.3. So this is actually…
Michael: We just got 15% wealthier on his podcast.
David: You got a bonus. Yeah. Exactly.
Michael: If you’re an owner. If you’re a buyer, bad news, it just got 15% more expensive for you. So I guess it depends on which side of that line you’re on.
David: Although, unfortunately, that Dave DeVoe guy is about to tear it apart.
Michael: Oh, right.
David: I know. I’m so sorry. I feel bad. So that increase is actually going in the wrong direction because a typical firm is probably closer to 1.7 times revenue. But we can throw out the whole revenue, multiple of revenue because it’s not only inaccurate, it’s just downright dangerous. It’s wrong. I’ll get off my soapbox, but, you know, you could imagine 2 identical firms that are both generating $1.5 million in revenue, but one is a really well-run company. They’re not only growing way faster, but they’ve figured out a machine where they can do it with two less employees and maybe, you know, a couple hundred thousand dollars of incremental cash flow. Well, that firm quite literally is worth at least $1 million more than, you know, the firm that hasn’t done that work and isn’t growing at that rate and can’t run an efficient machine. So that revenue is such a blunt instrument. It’s pretty much irrelevant.
Now, by contrast, one could say, you know, “Hey, a multiple of cash flow.” Well, the good news is we’re now talking about cash flow and profitability. And profitability, not revenues or AUM, profitability is what pays back an investor on an investment. So we’re getting closer. That’s good. And they might say, “Okay. Well, let’s use a multiple of that cash flow number.” And, you know, honestly, Reader’s Digest, when we’re spitballing with someone, we’ll use multiples because you can’t talk through a 30,000-cell discounted cash flow, you know, in a conversation.
Why Multiples Based On Free Cash Flow Help Give Better Valuations [38:35]
Michael: And so how do I think about multiples of free cash flow? You know, if the going rate was 2X revenue but now it’s 2.3, like, what’s a going multiple rate on profits or free cash flow?
David: Yep, yep. And by the way, that 2.3 might be appropriate if you have maybe $50 million or $60 million in AUM, you’re exiting the business within 6 months of selling, it’s on a bidding online eBay-type site, you know, then there could actually be logic behind that 2.3 being accurate. But for the most part, we should assume it’s more like 1.7.
So for the multiple of cash flow, you know, for a $100 million firm, we’ve seen it creep up. And I could talk about the trends in valuation. You know, we’ve studied that. So we’re, you know, off the peaks, but we’re way off the nadir that we saw in 2009. And right now it’s creeped up to be above, say, four to six times cash flow. So it’s probably about 66% of the firm, two-thirds of the firm, we could assume, for a $100 million firm will sell for, say, 4.3 to, say, 6.3 times cash flow. For a half a billion dollar firm, it’s going to be probably 5.3, maybe 5.4 to, say, you know, 7.4 times cash flow. As you get bigger…
Michael: The larger firms literally get higher multiples. Like, not just that you’ve got more revenue and free cash flow because it’s just a bigger business and more dollars are flowing through the funnel, but literally the multiples get bigger as the firm gets bigger.
David: Yeah, yeah. And there’s a technical reason for that. What’s happening is as you get bigger, the risks of your company are going down. That’s the primary factor. So there’s three things that drive valuation. Literally, there’s about 1,000 things that go into it, but they fall into three categories. And one of those categories is risk. And as you get bigger, you’re going to have more processes in place, right, generally. As you get bigger, you’re going to have more employees.
You can imagine you have a very small firm with six people, you know, and someone is sick, let’s say they get mono and they’re out for a couple of months, you know, you are scrambling to try to keep the train on the tracks. It’s like pain and suffering everywhere. You know, you have 30 people, and it’s like, “Oh, no, Mary Ann has been out sick? I didn’t know she had mono. She’s been out three weeks. I didn’t even know. We should send her flowers.” You know, it’s like you get bigger, that this impact, especially, you know, step function-type items like employees has less of an impact. So the reason those multiples go up is, as you get bigger, a number of different risks are mitigated. The company is generally moving toward more and more industrial strength.
Michael: And then what are your other two factors that are driving valuation or categories? One is risk.
David: Risk, growth, and profitability. So on the growth side, you know, growth is critical. And, you know, you start…clearly if you’re going to invest in two businesses and one is growing, you know, at twice the pace, you’re going to be willing to pay a lot more. And, you know, I know some…
Michael: Because profits are going to go up faster.
David: Profits too. Yeah.
David: Absolutely. And, you know, growth is good. Growth is how we become better and better at what we do, in most cases. I mean, growth, there’s a counterpoint too, which it will be fun to talk about. And, you know, even then I know some folks are probably listening and they’re thinking, “Hey, I’m going to sell my firm in a couple of years, you know, what can I do now?” And I think with growth, it’s not just the number, it’s what’s driving that number.
And, you know, two identical firms and I ask, “Hey, jeez, you have, you know, top decile growth. How are you doing this? This is just phenomenal.” And, you know, the first person I ask they just say, “Oh, I’m so glad you asked. We’re doing this great stuff. We did all the segmentation work and now we’ve actually, you know, refined the value proposition that we have for each one. We’ve also really got into digital, you know, marketing and we’ve segmented the market base, and we’ve done this. And gee, you know, we brought in two new business development people and we’ve trained them this way. And the referrals. Let’s talk about…” You know, and they’re just going on and on and on. And you’re like, “Wow, okay.”
Michael: Awesome. Yeah.
David: “You have exceeded the machine.”
Michael: For that. Yeah.
David: Yeah. And then you talk to the second firm, you say, “Wow, you know, top decile, how are you doing it?” And they’re like, “I think I’m just very charismatic. You know, people like me.” And you’re like, “Okay, I’m not going to pay as much for that firm.” So, you know, if you’re…
Michael: You realize the growth thing, like, I’m buying you out. The growth is your charisma and you’re going to be gone because I’m buying from you.
David: Exactly. Exactly. Or they just have no clue. They’re like, “I know. Isn’t it great? I have no clue how we’re growing so quickly.” But, wow. Okay. Hmm, that’s a little concerning.
So I’d say, you know, for those that are thinking through whether you plan to sell 2 years or 20 years down the road, you know, really thinking through that growth machine. How are you doing this? You know, it’s also closing leaky buckets. You know, it’s the downdraft of folks decumulating. Sometimes it’s beyond that. They’re moving assets away for this reason. But someone who’s really been thoughtful about their growth trajectory, their story is going to resonate more. And you saw where the puck is going too. It’s not just growth. It’s ultimately the optimal profit, not just maximum profit. You know, it needs to be optimally managed, but that profitability is critical. That’s what pays back the investor on the investment.
Michael: And so, you know, you’ve kind of talked about pricing off of revenue, you know, slightly better to price off profitability and free cash flow because at least it’s less of a blunt instrument because you don’t miss out on things like two firms have the same revenue but one of them has got, like, five more staff members, so they’re just less efficient and driving less money at the bottom line. But I take it you don’t view it as the endpoint of refining valuation. So, like, what’s next beyond looking based on free cash flow and multiples of free cash flow?
David: Yeah, yeah, you’re spot on. So we went from that revenue to that cash flow. And what you’ll do with that cash flow too in many cases is you’re making some adjustments if you’re using that blunt instrument of a multiple. You’re saying, “Okay, wait a sec, you know, that principal is going to be leaving, so that’s going to free up another 250k,” or whatever it is. And gee, when they come, you know, the country club and stuff is going to come out. And sometimes people will make those adjustments.
Well, what’s better yet is not just making those adjustments for a given year and then, you know, doing some very basic math on it, instead to say, “Hey, those adjustments are going to kick in next year and the year after and the year after.” So by doing that, if you start looking forward and you say, “Okay, let’s actually start to forecast what’s going to happen with assets and revenue and expenses, start creating a methodical assessment of what’s going to happen with this firm over the next five-plus years,” then you’re starting to create what’s called a discounted cash flow. So quite literally, you’re starting to model the growth trajectory of the firm.
And we nerd out, we break it into 16 different components. You know, what’s the market going to do? How about new business coming in? Gee, you have a referral relationship that’s probably at a different growth rate. What’s your attrition rate? All these different things. So we can start to nerd out and say, “All right, what’s going to happen with this growth trajectory? Some folks, you know, believe fees are going to compress. Others don’t believe they’re going to compress. You know, gee, what’s going to happen? Are you going after bigger clients?” Because if they are, if you are, then they will compress because of your fee structure, etc. Most firms have these tiers of fee structure. So you start thinking through all these elements: when you need to hire people, how things are going to change, your real estate, and you’re able to methodically think through, you know, what economically is likely to happen with this organization.
So when you do that, this discounted cash flow, which is, you know, blessed, a well-regarded technique to valuing firms, especially cash flow firms like our industry, you know, you’re able to create really a mini-business plan to project what’s going to happen with this organization. What those cash flows and that profitability that you know is so important are going to be. And then we discount those back to present day based on an assessment of the risk. You know, how likely is this to occur? You know, how well is this company managing different risks? What’s called a discount rate is what you discount those back to present day up. And it’s assessment of the risk or the reward that you need to be able to invest in this company.
Michael: And what kinds of discount rates get used when advisory firms value themselves?
David: Yeah, yeah. So, I mean, that’s another element where for years at Schwab I knew all the different consultants and bankers. And, you know, when I talked to them, because I’d created my own little models, I’m like, “What are you using for a discount rate? Let’s talk about it.” And oftentimes they’d be like, “Oh, you know, I’ve been doing this for a while. I have a pretty good idea. My gut check is this.” And you know me. By now you know I’m a nerd, so I created this very methodical buildup of all these different factors. What you start to build up is, believe it or not, these are very risky businesses. So, you know, 16%, 17%, 18% is at the very low end. You know, we’ve seen firms where they’re just very risky, and you’re getting up into 35%-plus.
Michael: A 35% discount rate. So like almost all the profits past three or four years basically just count to nothing at that point. Like, that compounds them down pretty quickly.
David: It compounds them down pretty quickly. So yeah, and it’s appropriate. You know, if you’re an organization that has no succession plan in place, the entire company is dependent on you. Let’s say you don’t have non-competes and non-solicits, the weighted average age of your clients is 10 years above the average. A matter of fact, you have a concentrated client that takes up, you know, 30% of the business, where we know that the top 1% of your clients should take up 8.2% of your business in terms of revenue. You know, litany of different items where you have these open gaps, that’s a very risky proposition. And it’s not going to take much to disrupt that entire organization. And rightly so, the valuation on that firm is and should be low.
So oftentimes what we’re doing with firms is, you know, we’ll do a valuation. It’s $11,000, $16,000 or $21,000 to do our valuations, and it’ll take 3 to 6 days. And I know you asked earlier, I haven’t gotten to it yet, but I’m happy to talk through that arc that we take someone through. But, you know, oftentimes it’s like, “Okay, great, you have all this information in this 30,000-cell model, you know, now let’s talk about how I make this more valuable.” And it’s like, “Okay, well, on the risk side, close this gap tomorrow morning. Close that gap two weeks from now. You know, let’s close this leaky bucket. Find out why your clients are not either trading or why they’re drawing down their assets so much.” You know, all these different things. It’s so neat because it creates this tool to help you optimize your firm.
You know, benchmarking studies. I love benchmarking studies. You know, all the custodians do them, Dimensional, all these different ones, they’re such great, rich data sources. But this is even cooler because, you know, with keystrokes, you can run scenarios, you know, you can compare it to benchmarks, and it becomes this diagnostic for your firm. It’s really cool.
Michael: I’ve always been fascinated with the idea of, like, using valuations essentially as a business management tool. It’s sort of a standard thing in Wall Street world and publicly traded companies. Like, if you want feedback on whether you’ve got a good vision for your company in the long run that’s generating enterprise value as, like, the CEO of a publicly traded firm, just look at what’s happening in the stock price of your publicly traded firm and, you know, ask the analysts that are buying and selling it, you know, what they’re bidding it up for and what they’re bidding it down for. And it’s like it’s a powerful feedback mechanism. You know, obviously it makes some Wall Street CEOs maybe be a little bit too short-term-minded about managing their stock price, but, like, it’s a powerful feedback mechanism.
And it’s always struck me that one of the challenges of just advisory firms, I guess small businesses in general not being so easy to value, therefore we don’t value them very often or many firms at all. And if you’ve never gone through a valuation process, like, you may not even realize either the firm is worth more than you thought or sometimes the firm is worth less than you thought. Or sometimes the firm is worth less than you thought, but if you just did these couple of things that help improve profitability or improve growth, or even just reduce, you know, business risk, suddenly your business gets way more valuable.
And as you said, I can envision the valuation just becomes a roadmap for your business strategy for the next year. Like, “Okay, if we put these things and we put some non-competes in place and we build out a little bit more process, and I’m going to, you know, add another…I’m going to add a formal ops manager because the stability my business gets with an ops manager, I’ll make back his or her salary and increase the valuation by improving the stability of my business.”
David: You’re so spot on. Nearly every time we value a firm for the first time, invariably it’s, “Wow, you know, this is great. It’s so powerful to know what our firm is worth, but Dave, I got as much or even more out of the journey you took us on. I now look at my company differently.” You know, we are quite literally tearing a company apart economically and putting it back together.
And, you know, everyone on the team, we’re like, “Hey, heads up.” It’s in passing, right? Because our job is to value the firm, but we’re talking as we go, and we’re going, “Hey, heads up, I know, you know, you feel good about your retention rate and things like that, but just so you know, you know, you’re at 3.2% attrition, which isn’t horrible, but, you know, for a firm your size in the industry, these three benchmarks say you should be at 1.5%. And by the way, if you were at 1.5, let me hit a keystroke, your valuation would shift in this direction.” So, you know, anecdotally, we’re going through it and we’re mentioning those things.
And as a result of that, you know, it won’t be a shock to you, more and more of our clients see it and they immediately say, “Okay, we’ve got to do this every year.” This is now our dashboard to run the company. So we now, you know, actually have valuation scheduled because folks are finalizing their information. They’re integrating this into their annual planning. And, you know, it’s just such a great, powerful tool.
And the nice thing about it too is I think you’re spot on Wall Street. All this data is out there. All these analysts are sort of tearing it apart and things like that. And there is this bad behavior that can occur with the CEOs that, you know, are trying to placate the analysts. Well, the nice thing about privately held firms is you now have the data, but, you know, you’re not beholden to this person or that.
Michael: Yeah, you don’t have to worry that if you’re not generating enough shareholder value in this quarter, the shareholders will go to the board and try to have you removed. It’s your company. You’re kind of stable here. You just get a direct line of sight into what will literally make your business more valuable.
David: Yeah. And it’s interesting too, though, in some cases we’ll see folks that, you know, so far it’s all been positive. It’s been, okay, they’ve gotten the light and they’re valuing the firm in many cases for succession. They’re like, “It’s time to do this.” And they also realize that making investments in their firm, I think in some cases they want to be disciplined in terms of how they do things. They want to discount it for their staff as well. And in some cases, you can think through how you want to manage expenses that can have an impact on the valuation in the near term as well. So, you know, that, I don’t know, it’s interesting. We get into some of the complexity of how folks are managing their business and are disciplined.
Another interesting facet is when folks have projections and growth goals, do you actually use those growth goals that are stretched and you actually put them in the valuation work, you know, or do you have a more realistic thing of what’s going to happen? So it creates all these interesting downstream implications to run the organization.
Michael: You know, that was going to be my kind of next question to this is, like, how you come up with these assumptions, right? I mean, things like swinging a discount rate, well, even just from 16% to 18%, when you start applying that to a long-term multi-year cash flow, that’s not trivial. Much less, you know, a discount rate that can go up to 35%. And, you know, even just things like growth rate, right? Like, “You know, I think we’re going to grow at 10% or 12%.” Or like, “Hey, if you tell me we should grow at 14% and my firm is more valuable, I’m going to put 14% into the spreadsheet.” Like, how do you get to reasonable assumptions or even define what assumptions are reasonable in the first place?
David: Yeah. So there’s a couple components to it. And we’ve even had the extreme…well, I’ll talk through a couple components. So one, it’s collaborative to a degree, right? We are experts in this industry. We’re experts on valuation. We’ve torn every, you know, sub-component of the model apart to be very disciplined in terms of what works and what should work and what’s reasonable. You know, conversely, that advisor that’s running the business, they know their company and some of the specifics better than anyone on the planet. So, you know, it is a dialogue where we’re going back and forth. And I think the good news overall in this industry is people wear white cowboy hats, so the good guys are doing the right thing, etc.
Our approach too by splicing and dicing things into such small numbers is, you know, it creates another layer of discipline. So for instance, with the stock market, you know, that’s 1 item out of 16 that could go into the growth trajectory of selling. Well, you know, we’ll say, “Okay, well, gee, what do you…” I’ll oversimplify. It doesn’t work this way, but for kicks or for clarity, we’ll use it as an example. “What do you think the market performance is going to be?” And someone says, “Well, gee, you know what? If you look at our history, we’ve been bumping up against double digits. I mean, I think it’s going to be 9.5%, maybe even 11.5% for the next 5 years.” And we’re like, “What?” And they’ll say, “Well, look at the history.” We’ll say, “Okay. Well, let’s talk through that because if it’s in data, for the long-term average it says this and a typical firm has, you know, the split of equities and large cap and small cap and fixed income, and when you do this blended, it comes up with this zone and this range, can you please help me understand what’s different about your model that would enable you to have different performance than this?”
And, you know, it happens rarely that people are throwing around numbers that are outside of that range. A matter of fact, advisors tend to be pretty conservative overall. Many want to take market performance out of the equation. But then we can have a dialogue and understand if they have, you know, something that is extremely unique, that’s going to create above-average results, or, “Hey, we’re going to be in this range or that.” So part of it is thoughtfully thinking through these different items. And that’s why we’ve spliced and diced things.
On the risk side, I mean, we’ve gotten very detailed. So we’ve done a ton of calculations to determine that, you know, for someone who has a weighted average age of their client base that’s above or below average, what the impact should be on the risk. I mean, we’ve literally gotten into, you know, mortality tables and thought through the…we’ve done analysis to determine what the drawdown rate is as people get older. Depending on the client, we’ll even get into whether or not they have relationships with the next-gen. If it’s an ultra-high-net-worth organization, you know, the drawdowns are going to be less, but philanthropy and things like that kick in. So in each element, depending on what it is, and, you know, after doing hundreds of hundreds of these, we’ve gotten very particular in terms of what the tax or the benefit of a given item should be.
Michael: And so, like, in practice, it’s you guys that ultimately become, like, the final arbiters of what is or is not a “reasonable” assumption or not?
David: Yeah, yeah. So, you know, both Tim Forest and I were trained by McKinsey folks. You know he was at McKinsey for four years out of business school, and I was trained by ex-McKinsey folks at American Express’s business strategy team. And yeah, with that, there’s the bottoms up and the tops down. That’s one of the key concepts. And everything we do is mutually exclusive and collectively exhaustive. So these very methodical, sort of classical business strategy consulting techniques. And one of those is what we call forest and the trees, which is also bottoms ups and tops down.
So during the discussion with a given client, and, you know, this is over the course of three to six meetings. We’re talking about the history. We’re going line item by line item. You know, based on these three-year, four-year, two-year CAGRs we think it’s going to bend in this way or that. What do you think? And we have a dialogue with a client on different line items. And we’re going to go through and determine what those line items should be. We’re also then going to take a deep breath and we’re going to say, “Okay, once we step back, how does this look based on what we know of the organization and the hundreds of these and the 150 years of experience that the team now has, the 5, you know, consultants on the team?” And we say, “Wait a sec, you know what? We think this is bending in this direction or that.” You know, it’s rare that we have to put on the arbiter hat, but it does happen. And here’s two examples of how it can play out.
We did one where it was, you know, probably a $1.6 billion firm, and it had a lot of partners. And it was quite an experience because a lot of partners wanted to be on every call. And it was a migration of equity. And it wasn’t long before every line item we went through we found that about four people were pushing in one direction and six people were pulling in the other direction.
Michael: Well, I would think in general, the nature of this exercise is like, if I’m a buyer, I pull the number in one direction that makes the valuation better for me. And if I’m a seller, I pull the number in the other direction that makes it go in the other end, right? You know, the seller says, “Well, you know, last year was a little low on our growth rate, but we’ve been pretty strong in the long run and I think it’s going to rebound.” And the buyer says, “Oh, no, no, last year’s growth rate, it was low. Like, we have to pull all the growth rates down going forward because we’re not growing like we used to anymore.”
David: Yeah. There is that natural sort of pull. And if we had two, you know, mobsters that we were negotiating with that might be that extreme, the good news is I think, you know, most people…a few layers. You know, and that does exist, and it’s a natural thing. And by all means, we are hyperaware of it. Not just from a negative, but also we see the reverse, where people are almost too giving and we say, “Hey, that’s fine. We just want to give you a heads up that on all these different factors, you know, everything is pushed in one direction, and this is starting to discount the firm,” or whatever else. So we’re calibrating. We’re thinking about this. We’re not just sort of… And look at the team, I mean, everyone is in their 40s, 50s, 60s-plus. So we’re all either peers with the folks that we’re working with or very grounded and have no consternation to say, “Hey, we think it should work this way or that.”
And the way it all manifests itself is… And also, the good news is everyone we’re working with is smart people that are also very quantitative. So they’re getting the math. We’re able to have very logical discussions on how this particular item should work or not.
In extreme cases, I mean, two things that we’ve done, we’ve created a model where it’s a black box, and we say, “We’ll take your input, but we’re not going to negotiate every item or let every, you know, people pull in one direction or another. We’re just going to go in a room. We’re going to come out with a valuation and we’re going to let you know what it is.” And it’s less collaborative. And it’s intentionally for…you know, this happens. Life is messy.
Michael: Right. So, you know, “Just let us be the arbiters. Give us the inputs. We’re going to go in a room. We’ll come up with a reasonable number. You’ll probably both dislike it, which means we found a good number in the middle, and we’re moving on.”
David: And we’ll have a lot of defensible reasons for that.
Now, the other scenario is, in some cases, you know, folks will have passion about the number being this or that. And you can imagine a lot of folks, as I mentioned, it’s used as a valuation, in other cases, it’s used as a diagnostic. So a few things. One is if certain things get out of whack, it will actually start to influence the discount rate. And early on if someone is no longer with the company but they had a bias, so like, “Oh, well, if they’re going to push these numbers in this direction, I’m going to push the discount rate in that direction and I’ll, you know, sort of offset that.” And I’m like, “No. We don’t do that. That person doesn’t share the values of the firm. They weren’t here very long.”
And instead, we have some things where if a firm is growing extremely quickly, it actually creates a risk profile. You know, and the analogy I use sometimes is if you’re driving down the street at 40 miles an hour, you know, the wheel gets bumped, it’s going to be fine. If you’re going 120 miles an hour and you make any mistake, you know, you’re going to be in a ditch, you’re going to be rolling. So as firms grow extremely fast, there’s actually a greater risk profile that’s part of the equation.
But we also will get to a point where we’ll say, “Hey, you know what? We are going to have to make a note of this in the valuation document that on this item or these items, it’s outside of the scope of what we believe is appropriate and defensible, and blah, blah, blah.” Like, some around that. So, fortunately, this sort of stuff doesn’t come up much, you know, and we’re working with smart people, and we have a strong enough spine too that that’s not going to be a pain point.
Michael: Now, I do have to ask as well because I hear this as a criticism or a concern sometimes around just kind of the discounted cash flow model kind of framework. Like, do you end out too reliant on kind of just all these forward-looking assumptions that are hard to pick the numbers on because the future is relatively unknown at the end of the day? Is there a risk we just get overly reliant on assumptions you can’t really know that much about the future on?
David: I don’t think so. Well, let’s put it this way, this is the very best, the very best way to value your company with the characteristics of an RIA. You know, book value doesn’t apply, even the multiples. How do you pick a multiple? I mean you talked earlier about audited, you know, publicly traded firms, and P/E ratios are an example of, like, a comparable, right? And they’re really rooted in something. They are rooted in, you know, comparing firm X to, you know, 40 other companies that have some of the same characteristics: audited financials, analyzing these folks, thinking through, “Okay, should this be in the third decile or on the seventh decile?” These are publicly traded firms.
With privately traded firms, you don’t have any of that information. You can’t compare to determine whether or not someone should be at a four or a 4.3 or a 9.7 multiple. You know, there’s just no comparison. That approach just actually technically does not apply even though people still use it. So that’s another, you know, sort of flaw in that ointment.
So this projection and this approach, we believe is the very best way to value an organization. Now, is it perfect? No. Is it defensible? You know, is this 30,000-cell model, was it created by, you know, 6 Ivy League-level MBAs with 2 CFAs that worked on it? You know, it’s on our 15th iteration. Have we peeled the onion on item after item after item? Do I think it’s very defensible and powerful? Absolutely.
However, I’m also mature enough and humble enough to know that I can come up with a valuation. We can have Jeremy Siegel from Harvard bless, you know, the model that we did and say, “All right, Michael, your firm is worth X.” And Michael might say, “Too bad, I’m not selling at that price.” Or the other next-gen might say, “Too bad, I’m not buying at that price.” You know, so the reality is we’re going to come up with the very best valuation. We’re going to have defensible. Oftentimes people will have a lot of confidence on what we do, but then there’s the reality of, you know, these are adults that are making their decisions and that transaction might be at a different price.
Michael: So help us understand, I do want to come back to this kind of hypothetical example that we talked about earlier. So, you know, you’ve got a $200 million firm. I guess just to make the math easier, I’ll assume it’s worth two times revenue, just because it makes the numbers round and easier. It’s a $200 million firm. If they’re billing the classic 1%, they have $2 million of revenue. So if they’re going to get valued at 2X it’s a $4 million firm. So, like, that’s the number. So I’m junior partner, I’m interested in buying in, like, how does this $4 million purchase price typically get carved up for me? Like, how would this deal typically get structured?
David: Yeah. So first you’ve got to figure out okay, how much is that person buying in a given time? And let’s say they’re buying 10% on day 1 or something. So you’re like, “Okay. Great, one is there’s a minority discount that should potentially take place here,” right? There’s what’s called a control premium and a minority discount. It’s driven by a number of factors but the punch line is you have less control, i.e. maybe no control over this company. So one is, is there a discount that’s going to apply or not? We sometimes see firms that say no. You know, one of the most respected firms in the industry with $10 billion in AUM says, “We don’t discount it,” you know, and there’s some logic behind that’s nice and airtight.
Michael: Not to share their, you know, inner workings if it’s super-secret but, like, what is the rationale for not offering a minority discount on I’m presuming what is clearly a minority share? Like, what is the rationale?
David: Yeah. So the rationale is that…so you can use it in a couple different ways, or there’s a couple different scenarios. One is to say, “Hey, you know what?” Let’s say it’s an organization that’s going to go on for years and years. One of the challenges that firms have in that scenario is, you know, “I’m running my firm today, you’re a younger, smarter person than me, I’m going to sell my firm to you.” And she would. “You know, I really like this person. I’m going to give them a discount on it. You know, they’ve helped grow the company and all the stuff,” or whatever. For some reason, I do that. And then suddenly you become majority shareholder and you say, “Wow, this is great. I’ve been buying this thing at 25% off, or whatever else, I think I’m going to go sell it now.” And suddenly there’s a huge arbitrage opportunity, right?
Michael: Because if they get enough control they…or I guess if they get enough control quickly enough, like, you flip that thing. It’s like house flipping but with better leverage.
David: It could be, right? You know, they get a discount for this reason or that, or they bought these many shares and then they go sell. So it’s not uncommon. You know, this is a common fear for advisors. So that’s why we have things like clawbacks that says, “Okay. Well, if you do that then you’re going to have to pay me the delta because I didn’t sell it to you for a discount for this reason,” or you have other legal things. You know, people, when they’re building these firms, you know, they have a lot of love and pride and nurture that goes into it, and they’d like to see this thing sustain itself, etc. So in either case, you can have these clawbacks.
So a counterpoint can be, wait a sec, you know, back to that Jeremy Siegel, “We don’t want to sell the firm at a discount. We don’t think it’s appropriate. We know on the common market it’s worth this. We have a high degree of confidence that this is going to be worth more and more over time. You’re an adult. You’re welcome to buy in or not. We’re not forcing you, but we’re going to sell it at the going rate, and that way we mitigate the risk that, you know, tomorrow morning there’s some sort of uprising and everyone sells the firm, etc. And so that’s part of it.”
You know, with the discount, there’s a number of different factors. One could, you know, argue logically that there’s a, you know, control premium or since you don’t have control there should be a discount. Other components that go into that are related to either emotions. “Gee, I like this person or whatever else, so I want them to be successful or I want to share.” Others and this is one too that we often find ourselves countering, is the next-gen even saying, “Hey, it’s my blood and sweat and tears that helped grow this. I’ve been doing this for six years and I helped this. You owe me for my blood, sweat, and tears.”
And, you know, we delicately and diplomatically share our counterpoint in many situations, which is, “Yes, your blood, sweat, and tears did help make this company what it is, and we are so grateful for what you’ve done, but that was your job, and you got paid for it. And now we’re talking about you becoming a shareholder and buying into this wonderful, elegant machine that you and me, and all these other people have brought together and created. But everyone was paid for their work and now you have this opportunity.” So, you know, sometimes we’re brought in and part of our job is to make sure that the folks are thinking through all sides of that equation. You know, we have no dog in the fight. Some folks, you know, want a discount 50% or so, fantastic. You know, here’s the pros, cons, and implications. Other times there’s logic or rationale for decisions that we need to raise a flag and say, “Hey, that might not be, you know, airtight logically.” So all part of the equation.
Michael: So if I’m going to buy my 10% initial stake, so, you know, I’m going to buy a $400,000 initial slice if we’re not doing a minority discount.
David: Yep, what does that look like?
Michael: So, you know, what does that look like? Like, what checks am I going to be writing and when?
David: Yeah. Yeah, go get the checkbook out. So for our industry, you know, we’ve had a history of being seller-financed. And what that’s…you know, historically it was about 25% down. That’s creeped up over time. So if it’s an internal transaction, it’s common to have a 30% down. And the rest will be a seller note maybe over the next five years that will be paid back. So, you know, in this particular scenario, I’m buying my 10%. It’s 400k. Maybe it’s discounted, maybe not. And then I’m writing a check for 30% down. And then often the seller is saying, “Okay, you owe me money, here’s the promissory note, start paying me now.”
Michael: On my 400k slice, like, I’m in for $100,000 to $120,000 down payment, and then I’m making payments on the remaining $300,000 over the next 5 years. So, you know, $60 grand a year plus interest, however that amortizes down I guess.
David: Yep. Interest typically, you know, prime plus 150 or 200 basis points. So yeah, you’re spot on. You’re digging through the seat cushions coming up with $120k. But again, these are all typical. They’re all over the map, but this is a pretty traditional deal structure. And then you’re paying back the advisor. So this can be attractive because, you know, you’re writing a small check but you’re getting the, you know…and in that case, it’s appropriate. You would now get 10% of the profit distributions, right?
Michael: Which is the key part of this, right? So if I’m a $2 million revenue firm and, you know, say running, like, healthy 25% profit margins that a lot of firms get to, at that point there’s $500,000 a year of profits. So the bad news is I owe $60,000 a year of no payments plus interest, but I’m getting, like, $50 grand a year of profits plus growth. So my, like, slippage is $10 grand or $20 grand a year.
David: Yep. And you can almost see how back in the olden days, you know, this structure probably came to be. It was, you know, nice principals that were saying, “Okay, I need some skin in the game. I don’t want to break this person’s back, you know, or this person doesn’t want to take on risk, or whatever it is,” and the numbers are in that zone where, you know…
Michael: You’ve got a little skin in the game, but…I mean, I guess for most people, overwhelmingly the hardest part would actually be the down payment part, not the ongoing note payments because the profits are covering 75%-plus of the note payments.
David: So that’s it. And you can see the math too. You know, earlier we talked about what we call the cap table engineering, where, you know, someone who says, “Okay, I’m going to sell 10% a year for the next 10 years, this person will buy it,” and, you know, year one, you do this deal, you just dug through the seat cushions and got $120k. And gee, whereas you’re digging into your pockets during the first year because it’s not quite covering it, and then uh-oh, they want another 10%, so let me go borrow some money from my uncle. And then that gap on my new chunk is not being closed. The next one is starting to close a little bit.
So it doesn’t take long before someone is either out of capital to deploy, you know, “Gee, I now blew through 400k, I just don’t have any more savings to put down. But we’re also sick of tightening our belt and not taking vacations.” You know, and that’s where suddenly it can get upside down where this person doesn’t have the appetite to buy additional shares at this point.
Why It Is So Important Not To Procrastinate Success Planning [1:15:28]
Michael: And I guess that’s part of the point of the discussion of buying these things gradually, like, trying to do share transitions gradually over time. Because if you did 10% every few years, this gets a little easier because if there’s some growth, by the time you get to the second or third buying the first one has paid off and now that’s free cash flow, right? Because, like, if I’m getting my $50,000 a year profits for 5 years, I immediately hand that money back to the firm to pay the note. But then in the sixth year, suddenly I keep all the money. It’s like all this money is flowing in at you, which you can I guess either take some nice vacations or something, contribute to the kids’ college account, or plow the money back in to buy your next tranche voluntarily.
David: And Michael, this is why it’s so important for people not to procrastinate on succession planning. Because if you start early enough and you get that flywheel going, you know, identify those people, make sure they’re the right people but don’t delay, you know, we see cans, unfortunately, kicked down the road, and you forget about this for two years, and you just lost that employee’s ability, you know, to be able to buy in future shares. You know, the stock market is growing. These companies are growing. The longer you wait, the more expensive it is. The sooner you start the more cash flow they have to invest.
Michael: But I guess, like, playing devil’s advocate from the seller’s end, like, at what point does it just feel aggravating that you’re selling the firm that is being bought from you using the cash flow that you would have had if you just kept it and didn’t sell the firm?
Michael: Like, yeah, I don’t feel like I’m making progress here.
David: Exactly. Exactly. And this is the emergence of different things that are occurring in the marketplace. And one of them is very much related to that, it’s advisors that are saying, “I didn’t get into this business to be a bank. I didn’t get into this business to lend people money to buy my shares.” So there’s a few things that are happening, which is, “Hey, go get a loan and pay me. I don’t want…” And, you know, part of it is the risks they’re taking on, part of it is they’re doing this down payment up front, etc. But instead saying, “Hey, you go get the money, pay me upfront,” and then they’re not worried about, you know, the holidays and someone sort of looking at their toe saying, “Hey, can you give me a break? It’s been a rough year. You know, this happened,” etc. And they don’t have to defer payments, etc.
So we’ve seen the emergence of a lot of lenders in this space. You know we have SBA loans that are now part of the equation, and advisors feeling more comfortable telling their staff to look into those. Or there is commercial loans that have come into play too. And advisors are saying, “Hey, go look at these.”
Michael: And for those who aren’t familiar, what’s the difference between SBA loans and commercial loans?
David: Yeah, yeah. A matter of fact, I guess I’ll say it live, we haven’t launched it yet, but by the time you post this, maybe it’ll be launched. We’re launching something called DeVoe Capital Services, which is for people who just asked that question, “How do I call up DeVoe & Company?” We’ve been doing this informally for a couple years now. And say, “All right, this is my situation, what loans can apply?” Because SBA loans, you know, that party that’s selling the shares needs to exit the business really within a year. There might be some logic to make it go longer but not much. So they need to be exiting the business. There’s also a floor and a top end of how much can be loaned for something like that. So SBA have certain constraints. You know, if I want to stay in the business for another 10 years or I want to take an SBA loan to go acquire a firm and that person wasn’t exiting, you know, it can’t apply. So there’s commercial loans.
So commercial loans, again, this is…you know, when I was at Schwab, several times I went to the lending market because we at Schwab at the time had said, “Okay, let’s help advisors with loans,” and there wasn’t an appetite, you know, for folks to come in and make loans. It’s because these are what are called cash flow businesses. There’s no what’s called a secondary source of repayment. And what that means, if I’m a bank…
Michael: There’s no collateral, right? Like, if you don’t make the payments, what am I going to do? Come take your laptop?
Michael: Like, I can’t take your factory and your machinery. I can take your laptop and the shingle outside the front door.
David: And that’s not going to cover it. Yep. Yep. So there was reticence. You know, I stubbed my toe a bunch of times trying to get some players to come in. But the good news is that shifted. So there’s a number of firms and a growing number that are now, you know, open to and curious about making loans to advisors.
Why Interest Rate Is Arguably The Most Important Factor For Determining The Affordability Of A Deal [1:20:06]
Michael: Who’s popular in this space? Like, are there certain lenders or players that you’re seeing come up most often in the RIA space now?
David: Yeah, yeah. There’s a couple. So SBA, I mean, there’s an interesting thing about SBA is it can be such a headache. You know, with all due respect, the government isn’t always the most efficient machine out there. And to go through the Small Business Administration to get a loan, even though they can be great tools, was literally, like, months and months of time. You know, I would actually track and check in and they were like, “Yep, sent the paperwork, haven’t heard a thing.” Well, there’s about a dozen-plus firms that do enough of these loans, that they can actually bless the loan right away. And there’s a company called Live Oak Bank which has done a lot of these…that fits that criteria now.
Full disclosure, we did the business case for Live Oak to enter this space. And it’s funny too when I first met with these guys, you know they were like, “Hey, yeah, we’re interested in doing SBA loans.” And I think they said, “We’re the fourth largest SBA lender in the U.S.” I was like, “Wait, what?”
Michael: That’s a lot of loan volume.
David: “Bank of America, yeah, Wells Fargo, yeah, Live Oak, I’ve never heard of you. Are you…” They were like, “Yes, legit.” So, you know, very focused on segments. They really bring in experts like Jason Carroll from Schwab, you know, who I used to work with back in the day. They bring in experts. And they only focus on certain niches. So they were contemplating several years ago making loans to the RIA space, you know. So they’ve come in with a big bang. So they’re doing the SBA loans and variations on other loans as well. There’s another firm called, you know, Oak Street which is doing commercial loans, non-SBA, you know.
Michael: Okay. And the commercial loan side is just more flexible? Like, what’s my difference here? I guess you said, like, SBA loans, if we’re going to do the loan I have to be exiting in a year. So I guess a commercial loan I’ve just got to convince the bank to lend me the money under whatever term. So if I’m staying, that’s fine. I just have to convince the bank that it’s a good deal for me to stay.
Michael: Do you necessarily get better or worse terms? Like, they’ll loan you more or the interest rate is lower or things like that, or is it just, like, it’s the other, like, lending and underwriting constraints? Like, want to stay in more than a year, got to go commercial. Ready to get right out, SBA will carry you through.
David: Yeah, yeah. So there’s certain characteristics, and that’s why we formally went through this, and we’ve sort of created a decision flow that we walk folks through. Because they’re coming in and there’s these loans, there’s a new capability that Dynasty has, there’s…you know, private equity folks are always curious about but it doesn’t always apply. And it’s shifting on an ongoing basis.
So what we’ve created is really a decision tree to walk folks through and say, “Okay, tell me about this. What about that. What are your needs here? What are your constraints there?” And we can logically walk them through. You know, it’s going to take 20 or 30 minutes of time. And we do it free of charge. But logically walk through these constraints so they know the right set of options that they have, and then some of those characteristics within. But yeah, be prepared. I mean, with the lending process too, there’s a lot of different variables. And that’s why it’s important to talk to a couple lenders in many cases as well.
Michael: So if I’m doing some bank loan thing like Live Oak Bank is doing it, does the core deal change for me as the buyer? Like, I get it from the seller’s end, “Oh, no, no, you’re not seller-financing with me, you’re buying it from the bank, or you’re borrowing from the bank.” It’s like, from the seller’s end, I give you the shares, you give me my $400,000 on day 1. You can settle up with the bank about how you’re repaying that $400,000, but, like, I get my money now. So I get it from the seller end. From the buyer end, is it necessarily all that different or am I still basically going to be paying 25% or 30% down and then paying a seller note over the next 5 years at prime plus 150 or 200 basis points?
David: Yeah, yeah. So let me answer that by starting to take a step back with the loan and those components, with the deal structure and those different components. And we’ve ticked on a couple, but there’s, you know, and I guess with the merger it’s more complex too, but there’s probably 20 different deal items, etc. With even the valuation, how the valuation might shift on these terms, there’s a lot of different moving parts. So what we do when we work with clients is we start with thinking through and understanding and helping the advisor understand the goals and objectives, the fears and aspirations, and then crafting something that really makes the most sense for that particular transaction.
So in this particular case, one could say, “Hey, if that’s a traditional deal structure and I’m able to give you 100% down,” or, you know, whatever it might be. And there’s different hybrids that we see, etc. But one can say, again, back to valuation, it’s risk, growth and cash flow, “If I’m able to mitigate a risk associated with this transaction, i.e. you’re getting cash up front, then the valuation should come down because the risk profile has shifted.” So it’s appropriate to say, “All right, gee, you want no down payment, the valuation should go up. You’re pushing more risk on the seller. A, you’re going to get all your money upfront, the risk profile is going down, the valuation should go down.” So, you know, all these things can be part of the…is part of the math and how to really craft something that makes the most sense for that particular situation.
Michael: But my payments as the buyer probably won’t be that different. I mean, I get, like, the valuation may shift a little from the valuation but…
David: So the other thing that’ll be different, and this is powerful too is, you know, I say, “Okay, rather than doing this traditional, you know, five-year to the buyer, or the seller, instead I’m going out to market to get a loan. Maybe I want seven years to pay it back. Maybe I want 10 years to pay it back.”
A matter of fact, it’s interesting, you know, this is another insight into it. One of the first clients we worked with, I should say I worked with when I launched DeVoe & Company because initially, it was only me. Today we’re eight people, but initially, for the first six months, it was just me. So the first client that I worked with, one of the first two was a firm that was looking to acquire a business. It was a billion-dollar RIA that was owned by a bank. And there was a lot of fixed income and things like that. But the bank had acquired the firm years before, probably three or four years before, and we kind of knew what they paid for it, and we kind of knew it was a high price, and we kind of knew that it wasn’t worth that anymore.
So sure enough, X discussions in, you know, I’m representing those folks, we’re talking to the CEO of the bank. And he says, “And by the way, you guys should know this, I can’t sell it for less than I paid for.” And we were like, “Come on.” And he’s like, “And I hope you understand, you know, this is a publicly traded firm. These are events that have to be disclosed. And this is not…the analysts aren’t going to appreciate this, the shareholders aren’t.” And we sort of started, you know, deflating, and he’s like, “But I can make a very attractive loan to you. I can make you loan payments that will stretch out 20 years or more at a very low interest rate.”
Michael: Oh. Oh, yeah, like, you know, “You want to give me near-free financing terms indefinitely. I’m going to lots of numbers now.”
David: And quite literally it was like, “Okay, wait a sec. Well, let’s not pack up our books yet. You know, we might have a deal here.” And quite literally, you know, that’s some of the mechanics of the deal, where, you know, for other reasons, the deal didn’t work out, but that economic construct, i.e. the valuation is this, was still doable.
I mean, a joke amongst us investment bankers is, you know, if you’re a buyer, hey, you know, either tell me the price and let me figure out the deal structure or tell me the deal structure and let me figure out the price. You know, like, these things are intimately related, and shifts on one will make shifts on the other.
Michael: Well, and I think it’s an important note that I think is not often understood, particularly by buyers, of just how unbelievably crucial that payment period is. That, you know, if I’m buying my, you know, $400,000 slice with 25% or 30% down, so I’m putting call it $100,000 down, I’m financing the other $300,000. So if I’m making my payments over 5 years, I’ve got to pay $60 grand a year plus interest. If I’m going to make my payments over 7 years, it’s only $42,000 plus interest. If I’m going to make my payments over 10 years, it’s $30,000 plus interest.
And, you know, the slice at 25% profit margins was kicking off $50,000 a year in cash flow. So, you know, in five years, I’ve got to have at least some annual cash flow skin in the game, or at least until the profits grow more. At seven years, I’m probably pretty close to break-even, even once you stack the interest on. At 10 years, I’m cash flow positive from day 1. I did write a big down payment check, but my ongoing notes are cash flow positive from day one as long as the profits don’t collapse.
David: Yep, yep.
Michael: All this driven by financing period.
David: Yep, absolutely. And that’s part of our job is, you know, there’s a set of tools out there. And for anyone contemplating deal structure, you know, start with those goals and objectives, and then start to look at the tool chest to say, “All right, if we do it this way we can achieve this result or that result.” You know, it’s so common for folks to come to us and they say, “Hey, we want to hire you,” or, “Gee, we don’t need to hire you, we’re just going to do it the way our friend Bob did it. He’s a buddy of mine and I golf with him, and he just did a deal and we want to rip his page out.” Like, guys, it’s probably not going to apply to your firm. There’s not a single best practice. There’s so many moving parts. Which is good, it enables deals to get done that should get done, whether it’s M&A or succession planning, if you use these tools properly.
Michael: So one more piece I’ve got to ask about this section, the down payment. As we said, like, if you can stretch the payments out over long enough, if you can either, you know, get the seller to do it or get the bank to do it, if you can stretch the payments out over long enough, it gets really manageable to cash-flow the ongoing payments. But if you just don’t have the cash for the down payment, you just don’t have the cash for the down payment. So, like, are there deals where sellers finance way less and only finance, I don’t know, 5% or 10% or 0%, or are there banks that will do commercial loans with much, much lower down payments? Or is this still just a reality I have to deal with if I want to buy in as a partner someday? Like, I either have to accumulate a sizable down payment or I’ve got to try to start getting some slice as early as I can so that I can get through the initial five years, pay that piece off and then use the free cash flow from that to buy the next one and kind of snowball it from there?
David: Yeah. I think…what’s a good way to answer that? We talked about those different tools in the tool chest, and you’re spot on in sort of thinking through the different things that.
Michael: I mean, can I get deals with no down payments?
David: It’s pretty hard to do. And, you know, there’s a trade-off there. So one concept is eventually there’s tools in the tool chest, and it’s like, “Okay, we don’t have the tools to build this cathedral,” right? There’s a certain point where it’s…and that’s why we have that 10,000-cell model. We have a number of things that we can tweak and play around with. We worked on this one, you know, succession plan for a company. They had, like, $1.2 billion. And we figured out a way, because, you know, we’re now tweaking, “Okay. Well, what if we only did 20% down? You know, that fits this. And what if we drew the payment out this way? And what if they brought…” And, you know, we start playing around, and it kicks out this output, and then this output.
And eventually, on this one, we crack the code on it. And then we had to create a new visual to say, “Alert, we cracked the code on it, but if your growth is too slow and different from what we modeled, we just played around with the modeling and it’s going to go squirrely this way, and it’s going to run off the rails. A matter of fact, if you grow beyond this rate and you grow too quickly, suddenly it has these implications.” So it’s one of those things where, “Good news, guys, is we played around enough that we have something that looks like it will work to keep you independent, but the bad news is if you’re outside of this zone, you know, you’re going to have a problem.” And sometimes the reality is just the toolkit isn’t right to build the cathedral or the mail truck has gotten too far away from the dog. The dog is just not going to catch it. So, you know, that’s a reality.
The other thing too that I want to pull on is, you know, there’s a certain point too where it’s like, “Oh, gee, I want to make it work. Gee, I want to make it work. Okay, no down payment. I’m going to take on the loans,” all that stuff. I mean, you also want to make sure that the next-gen has skin in the game. You know, we can get far enough away that we forget that we all left the nice, warm confines of a company and started our companies from scratch, and had to eat Top Ramen and make really hard decisions and just invest our blood, sweat, and tears, our entire psyche into nurturing this thing into what it is today. And there is a psychological component to that. That is important for a shareholder. And if shares are gifted, if shares are, you know, provided to the next-gen in a way that there’s not much skin in the game, there are some risks and potentially some profound risks associated with that.
So, you know, again, lots of different components that go into this decision, but I don’t think the solution set should be, “Gee, if we can get it down to a zero down payment, you know, let’s go do that,” there’s going to be some trade-offs for that decision as well .
Michael: Is there kind of a threshold of just how low it realistically goes? Like, is 25% to 30% as low as it really goes, or are their banks at least that’ll do 15% or 20%? Like, what are realistic expectations for people?
David: Well, I was less focused on the banks in that component. I’m more focused on the…
Michael: Okay, seller finance terms?
David: On the seller. And, you know, granted, you know, people still…that’s the nice thing about loans is guess what? It’s not just kicking, you know, the door jamb and saying, “Gee, I can’t make your payment this month,” you now have, you know, your…depending on how this is structured, and that’s another complicated component, are the buyers on the hook for this or the seller? Is the company? You know, there’s a lot of components that go into that. And, oh, by the way, there’s also personal loans and there’s HELOCs and different things that people can leverage too to buy into the firms. But, yeah, so there’s different components to who will lend the money and what that looks like, and then the trade-off too for skin in the game for those principals to feel confident that this person is going to walk through walls to make sure this company succeeds.
Trends In The M&A Industry Right Now [1:35:45]
Michael: So the last thing I just wanted to touch on briefly before we wrap up is I know you…you know, the third piece of what you do you say is investment banking, which is basically about kind of trying to facilitate matches between, either firms that want to sell and you help them to find a buyer, or firms that want to buy and you help them to find someone who’s selling, and then assist in kind of setting terms and brokering a deal. So you see a lot of trends of what’s happening in the space just doing that over time and seeing what buyers are coming to the table and what sellers are coming to the table. And so I’m curious from your end, like, what do you see is the trends right now in the industry in buyers and sellers and the valuations that they’re agreeing to?
David: Yeah, yeah. I think, you know, so M&A is very active in this industry. 2017 was the fourth successive record year of M&A activity. And this is something I’ve been tracking for 16 years, and I had 3 years of data at Schwab, you know, when I started doing it. So we are at all-time record levels of M&A activity. It was interesting because 2017 actually had a really weak second half of the year for a variety of reasons, but we just came out with the Q1 numbers for 2018 and they were, you know, very robust. It was the biggest quarter that I’ve ever seen on record.
So the M&A activity is strong, and I expect it will continue to be strong for years to come. There’s a number of, you know, just slow structural changes to the industry that are going to drive mergers and acquisitions to come for years. You know, just the thought I concluded our last, you know, deal book on, RIA M&A Deal book, was that it’s a seller’s market, and it’s a buyer’s market. So what do I mean by that?
Michael: I was going to say, how does that work?
David: Yeah, how does that work? How does that work? It’s an interesting… So, on the seller’s side, you know, we’re seeing valuations that are at, you know, solid levels. They’re off the all-time highs, but they’re getting pretty close to them. And, you know, I can share more about that as appropriate. But the valuations are high, the deal structures are attractive.
So the deal structure we just talked through with succession plan, it’s going to be more attractive if an RIA is buying you. It’s going to be even more attractive if, you know, a deep-pocketed multibillion-dollar firm or, you know, a consolidator is acquiring you. So valuations are good, deal structures are attractive. The buyers are pretty darn attractive too. They have capital. They have smart teams. They have strong value propositions. Very few of them are sort of fly-by-night, for lack of a better word, that, you know, we saw quite a bit of 10 years ago. So those are all attractive attributes for sellers.
On the buyer’s side, it’s actually a really good market too. The openness and interest of RIAs in having discussions and doing deals is the highest I’ve ever seen. So advisors in today’s environment, and it’s not just for succession planning, they are taking calls from buyers. They are open to doing transactions and giving up degrees of control to gain benefits as well. Unlike what I saw, you know, 4 years, 8 years, 16 years. There’s been a shift within the RIA community in terms of their interest and openness to partnering up or doing some sort of transaction. So yeah, I honestly believe it’s about the seller and a buyer market.
Michael: And to what do you attribute that? Is that, like, the infamous, you know, advisor retirement wave finally coming to fruition? Is that, like, sellers looking and saying, “Hey, I’m really concerned about robo-advisors and fee compression, all this stuff and I’m afraid valuations are going to go down so I’m getting out while the going is good?” What do you see driving this kind of rising tide of seller activity?
David: There’s a number of things that are driving it, but a core component is scale. And scale can solve a lot of problems. Right now, you know, you’re an advisor, you just ticked on a couple of them. You know, folks are sitting there going, “Robo-advisor, like, what’s going to happen with this? You know, what should I be doing? Is this going to affect my business and take my clients? Is this going to push down my fees? You know, do I need to have my own robo-advisor piece inside?”
You know, we have companies like Target that are being hacked. I don’t know the budget that Target spends on cybersecurity. I’m guessing it’s pretty darn high. You know, we have these Fortune 100, Fortune 50 firms that are being hacked. And granted, a lot of the advisors, they have ninja custodians that are doing a lot of great things to keep them from being hacked, but it’s still something that cannot help but wake people up in the middle of the night.
You know, the compliance headaches, the administrative stuff, running the business, the competitive landscape. Gee, you know, 15 years ago, you’d throw down a business card and describe what RIA is and unconflicted and open architecture and fiduciary, and you’d immediately have a new client. Well, guess what? Now, they’re like, “Well, that’s kind of what Merrill Lynch and Morgan Stanley say. Are you guys any different?” It’s like, “Oh, yes, we are different.” “But you don’t sound so different anymore.” So the competitive landscape is shifting.
So, you know, what we’re seeing now as advisors, back to that scale equation, you know, I can keep running my $200 million, $600 million, $1 billion firm as is, or I can sell to a firm that’s 20, 50 or 100 times the size of me, and they have a full-time person thinking through robo and cybersecurity and every other technology thing that’s coming down the pike, mobile, whatever else. You know, they have a full-time person worrying about all the compliance headaches and all the stuff that people hate.
And, oh, by the way, you are now part of a multibillion-dollar organization that can help you with marketing, can help you with human capital, how to manage your employees. You have trust capabilities that are in-house or CPA. You have a broader set of…you know, just the value proposition that you have is better and better. So it’s not just a business decision. Business is key, it’s scale and it’s a business decision, it’s also a personal and professional decision. We have folks that are in their 60s and 70s, but we have folks that are in their 50s that are saying, “You know what? Life is short, and do I want to deal with some of this day-to-day garbage? And if I hook my caboose to that train, a lot of this day-to-day garbage is going to come off my plate.” So those are some of the key elements that are creating this listening and transactional environment.
David’s Predictions For The Future Of M&A Activity [1:42:29]
Michael: So from your end just as the expert that’s followed this for the years, like, do you think there’s risk that advisory firm valuations are coming in or are they going to stay strong where they are or do you see them getting even better from here? Like, what’s your outlook?
David: Yeah, a couple things. I think one of the…there are some risk, right? Anecdotally, it’s becoming more of a trend. It’s becoming more common. Advisors are contacting us saying, “Okay, you know what? We’re 9 years into a bull market, and I lived through 2008, and I remember reading what happened to valuations, and I don’t want to time the market to sell, but I surely do not want to have an unexpected delay of 2 years or more, maybe longer. If a 2008 hits and I’m suddenly on the sideline. So that’s not part of my plan. That disrupts my plan.” So some advisors are looking at that.
I think another component to consider is there’s a number of buyers in the marketplace and a lot of them are very experienced. And, you know, it’s a total hooey. Some people are like, “Oh, seller market, there’s 50 buyers per seller.” I mean, it’s garbage on a couple different levels if you get into qualified buyers, you get into all these different things. And that ratio of sellers versus buyers has almost zero impact on what valuation is. These are sophisticated buyers that are not buying tulips in 1800 or whatever the year was. You know, these are sophisticated people that are crunching cash flows and they’re thinking through the equation.
But instead, my point is if we saw a doubling or a tripling of the number of sellers in a given year, which I think is possible and might even be likely over the course of the next five years, if we saw that, the buyers in the marketplace could not actually absorb them. I don’t think there’s enough hours in the day, I don’t think there’s enough smart people that are buying firms. They could actually just take on that deluge.
Michael: Is it because they don’t have the capital or just because they don’t have the bandwidth to do all the work it takes to merge and assimilate that many firms?
David: Bandwidth, absolutely. It’s not the capital. A lot of good capital out there. And, you know, I talk to, you know, Carlyle, Bain Capital. You pick any…throw dart at the bluest of the blue chip private equity or all the boutiques. I was honored to listen to the CEO of Carlyle speak. And, you know, he was talking about private equity being an all-time high, which many of us know anyway. So there’s no shortage of private equity in this space. There’s no shortage of capital, you know, for these acquirers. We can tick through some of the parties out there and the recent capital raises.
Instead, it is the bandwidth, and it’s multifold. You touched on the integration side, which is no small feat, right? And fortunately, these teams are getting better and better. We worked on three transactions in Q1, two were sellers and one was a merger. And those two sellers are probably, out of the last five sellers that we’ve represented, three of them one of their criteria is, “We only want to sell to a buyer that’s done,” I think one said two, one said five, and one said six deals already. They only want to talk to folks that had already done deals because they know that there’s bumps and bruises and a learning curve that you ramp up on.
So part of it is to absorb these firms, I think it’d be overwhelming, but even to get deals done. I mean, it just takes a lot of time and energy and care and feeding. It’s an emotional decision as well as a technical and economic decision. So I think just the number of bodies that are able to negotiate these transactions and get them done would be overwhelmed.
Now, if we had that scenario where we had two or three times the number of transactions, valuations would then be impacted. You know, they would get pushed down. Deals wouldn’t be getting done. And I think that could have, you know, an impact on valuations and other things.
Michael: So as we come to the end here, I’m just curious, with all this stuff going on in the space and, you know, your team has grown over time, like, what comes next for DeVoe & Company from here aside from launching your capital services line? Like, what else comes next for you guys?
David: A lot of it is we just…we love what we’re doing, and I feel like we’re doing a great job. We take the nerdiness that we use on everything that we do and we even apply it to client engagement. So we run CPS or NPS scores, whatever you want to call them, ratings on every single thing. And we are off the charts. People love our work. And when we get anything below, you know, a seven, I’m picking up the phone and calling too. And it’s funny, as soon as I decided…
Michael: See how we’re going to score on that.
David: Yeah. Or it’s like, “Hey, what went wrong? Like, let’s understand it.” And those happen rarely. I mean, the funny thing is is I decided, “Hey, maybe we should start marketing our CPS scores.” And literally, the next day we got, I think it was a six. And I called up the guy, and it was funny too. Well, it’s another story, but he’s like, “Yeah, it took a while to get everything done.” I’m like, “Oh, wow, okay. Well, what can we do better?” And he’s like, “Well, I mean, it was my fault it took a while.” And it was like, “Why do you guys do that? I don’t get it.”
But conversely, it’s kind of nice. You know, it, like, gives you this energy to focus more. So in either case, you know, it’s neat what we’re doing. You started the conversation by saying, you know, these are some of the most important business decisions people will ever make in their lives. And, you know, that is what gets me and Tim Kochis, and Vic Esclamado, and Francine Miltenberger, and Tim Forest up every day. We get fired up on the work that we’re doing. It’s important. It’s critical. And by the way, it’s kind of funny too when people are like, “Hey, it’s the most important business decision of my career, I should do it myself.” You know, it’s like, “What? You count to your clients every day to use an advisor with such important decisions.”
So I think part of it is, you know, honestly just doing what we do. We naturally keep expanding. I’m wondering if there’s new things we can expand into because we do all the consulting I want to do now. I don’t think we want to get into operations or technology. We don’t want to get more into legal or tax. So I’d say, you know, I don’t necessarily see new places we’re going to go. We’re just going to keep doing it better and probably, you know, keep growing the team. You know, we’re growing at a pretty good clip. And we just hired a new person three months ago, but I’m ready to hire someone again. So if you’re really good at consulting for RIAs, give me a call.
Michael: Yeah. All right, we’ll make sure we’ve got links out to you in the show notes as well if anyone is excited to go into the RIA valuation and consulting business. So this is episode 72, so if you go to kitces.com/72, you can take a look at the show notes and get contact information for Dave.
So Dave, as we wrap up, you know, this is a show about success, and one of the things that we always observe on the podcast is just success means different things to different people. It’s kind of a loaded word that we all come out in our own way. And so, you know, as someone who’s built a successful business of your own doing this for advisors as well as watching advisors build their businesses, I’m curious just for you at a personal level, like, how do you define success for yourself?
David: Yeah. I think…you know, it’s funny, we sometimes joke that we need to do the consulting for ourselves that we do for others. You know, probably. I think success on a couple different levels. For me, happy clients has always been paramount. You know, the last 16 years but clearly the last 6 running my own company. And that’s been critical.
I’ve now enlarged that. And I’ll be honest, it’s been a growth experience to me to make the environment of DeVoe & Company, the people that are doing all this work to be, you know, as or quite frankly as or even more important than the clients. And I am doing more and more strategic work on DeVoe & Company, and I am buying into that concept that, you know, if your people come first in many regards and, you know, they’re happy, they have the tools, they’re, you know, incented in the right way, they’re just going to create more work, which only makes the client experience even better. So I think a growth opportunity for me has been to move beyond just, you know, the client, the client, the client, making that great, and instead, you know, doing my best to create a really good work environment for everyone who’s part of the gang.
Michael: Well, very cool. Just probably an interesting just parallel experience since that’s the same journey that occurs in the advisor world, right? Like, we try to serve our clients and make sure we have happy clients, then as the business grows, I know a lot of advisors where the focus starts to shift and it’s not that, like, clients take a backseat or anything, but that focusing on how you’re building your own team takes on kind of a renewed focus as the business just literally grows beyond you. And then that becomes part of what you’re doing as a business owner.
David: Yeah, yeah. It’s so important. I mean, at the end of the day it’s not only 75% of the expense structure, right? The employees and the assets that come in. But it’s such a key differentiator. And the ability to have, you know, a team that is excited, engaged, comes into work, you know, walks through walls not just to help client achieve their success but help the business itself continue to excel is just a key differentiator in the marketplace. And it’s not easy to do it, but it’s so critically important to do.
Michael: Well, very cool. Thank you for joining us and sharing that story and experience on the “Financial Advisor Success” podcast.
David: Oh, my pleasure. I think it’s a great thing you’re doing, and I’m very honored to be part of this. So thank you for having me.
Michael: Thank you.