The path of becoming a financial advisor is viewed as a very entrepreneurial one, starting from scratch and building a client base who pay you for services, growing over time into a business that can generate substantial income for the advisor/owner/founder. The growing trend of independent advisors, whether in RIA or broker-dealer form, just further emphasizes the entrepreneurial spirit of the financial advisor community, and their desire to build businesses of value... or at least, a practice that can generate substantial ongoing income throughout their working years.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the key distinction between building a business versus a practice. Because while the terms are often used interchangeably, the reality is that they're actually very different roles.
Building a successful practice means getting clients who will pay you for your services, and leveraging your personal productivity to serve them effectively. By contrast, building a successful financial advisory business is about hiring other advisors who will be paid for their advice, and building the infrastructure necessary to support them, and ensure that clients are served well. In other words, it's the difference between delivering financial advice yourself, versus building a business to deliver financial advice.
And the difference matters, because the reality is that a practice can generate substantial income for successful advisors, but will only ever have very limited enterprise value. On the other hand, a bona fide advisory business can become an extraordinarily large financial asset, but comes at a cost of what could be years or decades of lower income as dollars (and a lot of sweat equity) are reinvested back into the business to continue to grow it. One benchmarking study recently found that it takes growing an advisory firm to more than $1B of AUM, just to get the partner/owners back to the same take-home pay that the most successful solo advisors can generate.
Ultimately, the choice is the advisor's about which to build - a business vs a practice - but it's crucial to recognize the difference, to ensure that you're building what you really want!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
Are You Building a Financial Advisor Practice, Or A Business? [Time - 0:17]
This week, I want to talk about the difference between a financial advisor practice, and a business. These are terms we throw around a lot, often interchangeably, but I think they're really not - or at least they shouldn't be - so interchangeable.
I want to start off by talking about a book that had a lot of impact on me around this theme. It's called "E Myth" by Michael Gerber. It's not a new book. It's been out for a long time. Many of you may have already read it. I see the tap-tap hearts from Periscope on the screen... that means many of you have read it!
"E Myth" is a book about entrepreneurs, and as the title implies, it suggests that much of what we call entrepreneurship is a myth; not that many people are actually entrepreneurs. Gerber tackles this issue by telling the story of a hypothetical person named Sarah. And this story left a huge impression on me.
Sarah was a person who loved making pies. She was so good at making pies, that her friends told her that she should sell them. So she decided to open up a pie shop. And as "E Myth" picks up the story, Sarah's challenge is that she loved making pies and was really good at it, but is now a completely miserable pie shop owner! Because it turns out, while she was really good at making pies, she was not good at running a pie-making business.
And this is the key distinction. You can be really good at the job, and not good at building a business around what that job does. In Sarah's context, operating a pie-making business means you have to handle hiring and managing employees, and marketing and selling products, and processing payments and handling the money and cash flows, and lots of other business functions that Sarah didn't like doing or wasn't necessarily good at. Because she simply liked to make pies. That's what she was good at.
As Gerber explains it, there's a difference between the technicians - the people who are very good at doing the work in the business - versus actual entrepreneurs, who own the business and do the work on the business to build it.
The Financial Advisor Technician Vs Entrepreneur [Time - 2:31]
Ultimately, any business owner is going to have some combination of working in the business, and working on the business. Still, I think this analogy holds up very well for financial advisors. Some of us really like being focused on doing the work of being a financial advisor. We like actually being a financial advisor, interacting with and working with clients, delivering our advisory services, and getting paid for them.
Others - and frankly I think it's a smaller subset of us - actually like business a business of delivering financial advice. As kind of "The E Myth" label implies, not a lot of people are truly focused as entrepreneurs.
It's a key difference. Being in the business of being a financial advisor means you are delivering the financial advice. Building a financial advisor business is actually not about you delivering the financial advice at all. It's about you building a business where financial advice gets delivered. Which means hiring other financial advisors to deliver the advice, along with people to market and sell the service, and operations folks to support it, and everything that goes with executing all parts of a business.
So the difference between a practice and a business as a financial advisor is, with a practice you are being a financial advisor. You are getting paid for your time. You spend most of your time working in the practice. With a business, you spend most of your time working on the business, being an entrepreneurial business owner, and doing less and less actual financial advising directly with clients.
Most Financial Advisors Have a Practice, Not a Business [Time - 4:07]
Now, in this context, I think most of us have a practice, not a business. We might own a legal business entity as an independent, and so we throw this label around that it's a business. But ultimately, it's actually just a job that we happen to be self-employed to do.
Having a job in a financial advisor practice isn't necessarily a bad thing though. We get to work with the clients, we get paid doing the work with clients, and we can make a really good living at it. I don't mean to knock the income potential of having a practice. But the profits are primarily what we get paid for doing the job of being a financial advisor in the first place, not for being a business owner.
After all, imagine for a moment if you removed yourself from the practice, and hired someone else to serve all the clients and do what you do. What would you have to pay them? The answer, usually, is about 100% of the profits that are there! In other words, the "income" of the business is the income of doing the job of being a financial advisor. You're doing that work, you're earning that income... which means you're running a practice, not a business.
Now, I'm going to say this a couple of times because I think it's a key distinction: Owning a practice isn't necessarily a bad thing. In our industry, I find there's a lot of judging that happens, where we hold up building a business as the Holy Grail, and that building a practice means somehow you're doing a poor job or failing to maximize your value. But the truth is that financial advisor practices can be extremely profitable... unlike Gerber's analogy with Sarah the pie shop owner, where a pie shop is a tough low-margin business.
Financial Advisor Practices Are Extremely Profitable! [Time - 5:37]
The reason that financial advisor practices can still be so successful is that we get paid a very high hourly rate for our time. When we actually look at some of the recent advisor benchmarking studies, top solo advisory firms are taking home half a million dollars a year of take-home pay! That's the equivalent of earning $250 an hour, for all 2,000 working hours of the year. And, granted, not everybody gets to that point, but we see lots of financial advisors out there in the solo realm earning $100,000, $150,000, $250,000. This is two to five times the median household income in the U.S.! These are good numbers.
That income might be for a "pure" solo using some technology to help, or perhaps a single advisor who has a couple of operational staff managers to support and leverage their professional time.
But it's still not what I'd call truly a business. Because if you removed the advisor - yourself - from that practice and hired a replacement, you'd still have to pay them all the income and there would be no net profits. It's a highly profitable practice.
You Can Sell A Business For More Than A Practice [Time - 6:41]
Now, the caveat around choosing to build a profitable practice is, while it can be an income generating machine, it's only an income generating machine. It tends not to build a lot of enterprise business value, because again an independent investor who wants a return on capital who comes in to buy the business and replace you in it, won't get much of any profits out. Because the new investor/owner would have to pay almost all the free cash flow of the business to the replacement advisor to do the advising work and keep the clients in the practice.
I think this was the point that David Grau was trying to make in his book a couple of years ago about succession planning, where he estimated that 99% of practices won't survive the original owner. In part because only one in ten even try to sell, and of the ones that do, often they don't make it because the business still isn't viable beyond the original financial advisor executing their own personal practice.
The fact that so few advisory practices survive the departure of the original owner is a dynamic I've watched play out for a long time. Though I suspect the primary reason that most financial advisors are never going to sell their practice is much simpler. It's not a fear that the business won't survive them. It's that the math of selling just doesn't work.
Because the reality, when you get a practice that's high income but limited business value, is that you might earn as much money by sticking around just two or three more years in the practice, as you would get by selling it. And, of course, if you stick around two or three more years, you get all of that money, and you still own the practice, so you can try to sell it later. Except you get two or three years down the road, and then you still have a practice that you can make as much money by sticking around for two or three years as you can by selling, so you still don't want to sell it. And the cycle repeats and repeats, and the practice never gets sold.
For years we've had a discussion in the industry about a looming financial advisor succession planning crisis, because there are so many baby-boomer advisors who, in theory, are supposed to retire. But it's not happening, and I think this is why. Most of us have practices that are high enough income that it's more lucrative for us to stick around in the practice. Because it's not really a standalone business... which is okay, because you may make as much money by just drawing the dollars out from a high income practice, year after year after year after year, as you would have made by building a business!
And that's before considering how expensive it is to build a business. What we see from some of the benchmarking studies is that you have to build up to a billion-plus dollars of assets under management, with multiple partners and everything that goes into that, just to get partner income back to the levels that top solos make. And that path from being a solo to a billion-dollar firm is a deep valley of lower income, plowing dollars to reinvest back into the business, and taking home less money in the hopes that you're building an asset later.
Now, the potential business asset can get big. Practices may only sell for a couple hundred thousand dollars; maybe $1 million at best was Grau's estimate. A billion-dollar AUM business might sell for $20 million. Granted, that value may be spread across a couple partners, but still - it may sell for $20 million. Ric Edelman's firm is $15 billion, closing in on $20 billion, and there were rumors that the last transaction he did with the business was valued at $800 million! Granted, he's the standout extreme, but the point is simply that you can build a huge business value when you actually separate out being the financial advisor, versus building a business of delivering financial advice.
Do You WANT To Build A Practice Or A Business? [Time - 10:09]
So point of all this discussion, first and foremost, is to recognize that there's a difference between building an income-producing practice, or a business that's an asset. And, again, I feel like I have to keep emphasizing it: there's nothing wrong with building a practice. I think a lot of folks in our industry try to make an implied value judgment, that if you're not building a business that has all this value that you can sell someday, you're bad or you're doing something wrong, or you're leaving tons of money on the table. Failing to recognize the incredible income a solo advisor can still make... and without the stress of building a big business!
Of course, there are a few standouts that can build mega-businesses, and maybe they're undershooting if they stick with a practice. But building a business is hard. It's messy. A lot of people plow all those profits back in and don't fully succeed in growing a bigger and more valuable business than what they would have had with a successful income-producing practice. And of course, with a practice, you still get at least some terminal value. It may not be "huge'', but it will sell for something, to a new advisor who wants to start their career as a financial advisor by buying a practice. Or you may be so comfortable with a practice that you simply continue to do it to an advanced age. I think the reality is, a huge number of the financial advisors that have practices right now, they're never going to sell. They're going to do it until the day they just physically or mentally can't anymore; in the Old West terms, they'll "die with their boots on", and will make some great income through that phase from the cash flow of running a successful practice.
But if there's one takeaway that you have from this discussion, it's just to think, in your own terms, about what are you trying to build? At the end of the day, are you trying to build a business where over time your primary role should be not doing financial advising, it should be working on the business... or are you trying to build a successful practice where you want your primary focus to remain doing the financial advising and having the client relationships directly, and you're simply trying to leverage yourself to be as efficient as possible in building that practice?
Because there are huge differences in terms of who you're going to hire, and what you're going to be doing, in building a business vs practice. Highly successful practices don't necessarily need partners, and they don't build out a lot of staff infrastructure. You don't need to. If you're trying to build a business, you absolutely must. The ongoing question for a business owner should always be, how much revenue do we need so we can do our next hire and keep growing our business?
So I hope this helps you to recognize and think about that difference. Think about it in terms of your own practice or business and what you're trying to build. And if you want more thinking about this, I really do recommend Michael Gerber's "E Myth". I found it really helpful for framing some of my own thoughts and perspective around this. I actually read it many years ago when I was just coming into the world of financial advising, but found it so powerful that it's still with me. That Sarah the pie maker analogy is still with me, because I think it really is a fantastic analogy for our financial advisor world as well.
So, I hope this was some helpful food for thought this morning, thinking about a financial advisor practice versus business, and what the difference is. This is Office Hours with Michael Kitces. I'm normally 1:00pm East Coast Time on Tuesdays. We were a little off on our timing this week because of my travel schedule again, but we'll be getting back to the normal schedule for the next couple of weeks here. Thanks for joining us, and have a great day, everyone!
So what do you think? Do you believe there's a real difference between a "practice" and a "business"? Which one are you trying to build? Will you be thinking about the challenge differently going forward? Please share your thoughts in the comments below!
Mike Branch, CFP says
Hi Michael. So if a business with $1 billion in AUM sells for $20 million, what does a practice with $100 million sell for? My understanding was 2x recurring annual revenue which if you assume a 1% average fee would suggest that a $100 million practice might sell for $2 million or 1/10th the amount of the much larger “business”. I guess my question is this: does a business sell for a better multiple than a practice or does it sell for more money simply because its bigger?
Michael Kitces says
There’s some of each. The larger firms sell for more in part simply because they’re larger, but also because they tend to garner larger multiples. There have been a number of multi-billion-AUM firms lately that have been rumored to sell for more like 2.5X, while the 2X multiple has been more common for $1B-ish firms.
Smaller firms appear to trend lower on valuations, with the caveat that there’s also more variability because some smaller firms are VERY lean and profitable while others are not. I’ve seen $300M AUM firms with 8 staff, and 28 staff. That’s a monstrous difference in profitability (and associated valuation multiples) that you can’t identify from the AUM number alone. Certainly larger firms can be run more-or-less profitably as well, but staff infrastructures seem to converge in practice as advisory businesses grow larger.
But to answer the direct question, yes bigger advisory firms do seem to sell for somewhat higher multiples. Though the data is a bit ‘messy’ due to the huge variability in how advisors run their businesses and practices.
Mike Branch, CFP says
Thanks. I think another factor is time. Maybe I am naive but it seems if you build a business you may also be freeing up your time to focus on other things in life besides just managing a practice. Maybe its possible to blend the two ideas: manage a small private practice and build/run a larger business.
III Financial says
I think it’s a chicken/egg situation. I look at running my practice as a way to free up time that I would be spending building up and maintaining a business! It all comes down to differing goals and personalities (just like with our clients).
Peter J Miller, CFP says
Michael. Love this book and the insights you applied to our field. Yes, I like making pies and serving them piping hot to my clients. I am OK with this and rather happy you unearthed the subtle pressure to raise the bar and reach for the stars. Many years ago I learned an invaluable lesson about “effort per hour” (i.e. ROI for labor expended). Being a certified financial professional gives me the flexibility to adjust my work load as I determine, whether by limiting appointments, number of additional clients added per year, or level of expectation I deliver on an on-going basis. My goal: happiness.
Coach Maria Marsala says
and the Emyth for Financial Advisors are the #2 and #3 business books I
recommend to financial advisors. That pie story does ring so true
for all businesses. When a practitioner makes the mind shift to business
owner, they create systems within their firm (including a niche, business plan,
marketing plan, writing down how they do just
about anything, etc.) and hire other people to help them run
their business. Some hire others in their field (i.e. other advisors of
various levels, partners, even hires from other fields who can also help their
clients, or another business model) but IMO, hiring advisors
isn’t necessary to run a business. Running a business starts it
a mindset, and is often followed by the action of putting the parts
of a business in place. When I meet an advisor with that
mindset, they do stand out from the crowd of practitioners. As I say… shift and get off the pot! 🙂
Michael, would love to see a post on what it takes to go from building a practice to building a business in terms of hiring, infrastructure, processes, systems, etc. I know you reference E-Myth, but a discussion that is in the context of financial planning would be very helpful
Michael Kitces says
Thanks Jason, I’ll keep that in mind for a future topic! 🙂
Coach Maria Marsala says
Jason, check out the book “Tested in the trenches” by Carson and Sanduski I read it years ago and like the lists and templates. Michael have you read it? The other book on the subject is The Ensemble Practice (more of a team firm).
III Financial says
I thought long and hard about this very issue when I started my firm. I had managed projects and teams before, and never liked it (Type A introvert, etc.). I thought about the extra work that building a business would take (taking away time from my clients)…compliance, hiring, training, managing, infrastructure. It sounded miserable to me (and part of the reason I left a successful career in corporate America!).
By running my practice, I have control and flexibility. I work with who I want, how I want, when I want, where I want. I use the software I like, the processes that work for my clients and me, and have an amazingly low overhead. I spend time with my family, have no commute, and can build a business that provides enough income for my family to be happy.
My dad traveled a lot when I was growing up, and I promised myself I would be there for my own boys. By not running a business, I can.
Diane MacPhee, CFP PCC says
Great article to encourage everyone to stop and give this the careful thought it deserves. Incidentally, eMyth Revisited (a later edition) is actually better as the author himself readily will agree as he enhanced his original work. As for solos between say 30 Million to 100 million – yes I have coached transactions in this realm where as Michael suggests “other factors” improve the value of a practice for sale. Thanks for the dialogue in an area I find fascinating to watch unfold over the years.
As an aside (other topic) a book that I enthusiastically recommend for Marketing is “Never Eat Alone” by Keith Ferrazzi – what a great read. Everyone – Have a great weekend.
Dennis Markway says
Having at once been part of a practice (and having seen the futility of a practice that thinks its a business but would die on the vine if the advisor(s) were no longer there), when I launched my company several years ago, I was dedicated to the notion of building a sustainable business that would be functional long after I had faded off into the sunset. Do you take on new challenges and different headaches? Sure! Is it worth it? Some it feels like it, others it doesn’t! Will it be worth it from a long term planning perspective? Definitely.
Steve Smith says
SINCE almost all of us have practices and not businesses. AND many of us will keep working because it makes more financial sense to do that than to sell — the question becomes: What is the best way to run and position our practices so that they have continuity in the event of death or disability? Both, for the benefit of the families we are serving (so they are not left out in the cold) and for the financial security of our survivors. Even with advisory BUSINESSES, the most valuable asset is the clients. With a practice, the ONLY asset is the clients. And, perhaps, the way the clients are organized – in the sense that all their information is in one place, all at one custodian and they all have plans informed by similar philosophies and strategies, reflecting the philosophy of the existing advisor.
Michael Kitces says
Indeed, I’ve pounded the table for several years that we talk too much about “succession” planning, and not enough about “exit and continuity” planning instead, which is the natural course for those who want to work as long as they can (because it makes personal and financial sense to do so) but need a backstop for clients.
See https://www.kitces.com/blog/the-succession-planning-mirage-and-the-rising-need-for-exit-and-continuity-planning-of-lifestyle-practices-instead/ for some further discussion of this.
Though I’m a bit biased now, because ultimately our advisory firm actually decided to be a solution-provider for exit planning as well – see http://www.pinnacleadvisorsolutions.com/services/prism/