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Also available as podcast (Episode #105)
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Will my practice have a higher valuation in the RIA model?
Advisors have various motivations for transitioning their practices to the RIA model. Increased flexibility with how they can run their practice, and better economics are the two leading factors. Within the economics bucket, achieving a higher valuation of their practice by transitioning it to the model is appealing. There are several reasons why the market generally assigns a higher valuation to an advisory practice in the RIA model versus other affiliation models.
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Full Transcript:
Will my practice have a higher valuation in the RIA model? That is today’s question on the Transition To RIA question & answer series. It is episode #105.
Hi, I’m Brad Wales with Transition To RIA where I help you understand everything there is to know about why and how to transition to the RIA model.
If you’re not already there, head to TransitionToRIA.com where you’ll all the resources I make available from this entire series in video format, podcast format. I have articles, I have whitepapers. All kinds of things to help you better understand the RIA model.
Again, TransitionToRIA.com.
On today’s episode, we’re going to talk about if you were to move into the RIA model would your practice have a higher valuation for at the end of your career when you’re looking for your liquidity event.
When having conversations with advisors that are looking into the RIA model, I often ask, “what are your motivations for looking at this? Let’s make sure you have the right motivations. Let’s make sure the RIA model would satisfy whatever those motivations are.”
No matter how it’s phrased or how it’s articulated, those answers generally fall into one of two buckets, with advisors often seeking them both.
It’s usually a desire for more flexibility with how they can run their practice, the services they can provide for their clients, the investment solutions they can use, those sorts of things.
The other bucket is economics. That is current-day income, versus whatever affiliation model or firm you’re at now is. And then also the enterprise value of your practice down the road at the end of your career. Which even if that’s a ways off you want to be thinking about it because this is your life’s work. You’re putting all these years, possibly decades, of your time and effort, you want to be able to get the most value for everything you’ve built. And so another motivation for the RIA model, again on the economic front, is a higher valuation.
What we’re going to talk about on today’s episode is why practices typically have a higher valuation in the RIA model.
First, just by nature of you maybe transitioning your practice into the RIA model, you’re either predominantly, if not entirely, fee-based. Now as I’ve said multiple times – and this is a common misunderstanding – you do not have to be 100% fee-based to go into the RIA model.
There are ways to accommodate, often thought of as, legacy commission business. Maybe you’re not desiring to do new commission business, but perhaps you are sitting on a fair amount of often the case variable annuities that makes sense for the client to stay in those positions. Those positions are paying you a trail.
Maybe you’re saying, I’m not going to do any more of that going forward, or if I am going to use variable annuities I’m going to use fee-based versions. I’ve done episodes on how you can solve for that essentially in the RIA model.
But the idea being that your practice is predominantly, and when I say predominantly, 60% to 80% or more fee-based. Just that alone will drive a higher valuation for your practice. Now, yes, you will still get that same dynamic no matter what kind of model or affiliation arrangement you’re in. But a practice tilted more towards fee-based is always going to have a higher valuation. It just is what it is.
When valuations are run, there’s a higher multiple put on the reoccurring revenue of fee-based relationships versus transactional commission-based relationships.
The fact you are a candidate to go to the RIA model means you are already predominantly, if not entirely, fee-based. Or that’s where you’re moving your practice to. That alone will increase the valuation of your practice. And again, you can experience that in other affiliation models as well. But certainly, it’s relevant in the RIA space.
That is in part why there is a flow of advisors, as I say the river only goes in one direction towards more and more independence, why advisors are going down the path of the RIA model. They are choosing to become, for whatever their motivations, increasingly a fee-based practice. The RIA model was built to accommodate that sort of advisor.
So, that’s number one. The more fee-based you get your practice, it is what it is, the higher multiples, the higher enterprise value you are going to have at the end when you go to have some sort of liquidity event.
Next, I want to talk about how affiliation models compare on enterprise value to what what you might be able to accomplish in the RIA space.
For starters, we’ll take the traditional wirehouse firms. You could also put W-2 regional firms in this bucket. We’re talking about the W-2 employee model.
If you ride out your career in that model and then go to exit, they typically have programs that are informally referred to as sunset plans. The idea being that if I am an advisor nearing retirement, I have hopefully orchestrated this years-long sunset plan. I have found a junior advisor, or team, that’s going to absorb my practice. Over a series of years I’m going to hand my practice off to them and I will be compensated for it. They’re called different things, but that’s essentially the sunset plan.
There are challenges though with a sunset plan compared to what you can do in the RIA space.
First, you are naturally going to get a lower valuation for your practice if the only potential buyers of your practice must be at your same firm. You have shrunk the pool of who could put a potential valuation on your practice. Whereas in the RIA space, you can go out to the entire marketplace.
I love using analogies. I’ll give you two as it relates to this.
First, imagine you own a home. You want to sell it, but you must rely on the HOA, which is the equivalent of the wirehouse firm, the HOA telling you what valuation you can get for your house and how that process is going to play out for you to sell your house. They get to decide that, they dictate it to you. You must play by their rules.
Second, imagine the HOA is not involved, but the only people that can bid on your house are people that live in your neighborhood. Now, yes, there might be some other good homeowners there that are looking to buy an additional house, buy a different house, buy a larger house, etc. But you’ve shrunk the pool.
That’s just economics 101. If you’re going to have a smaller pool of potential people to bid on your house, versus going out to the marketplace and whoever’s qualified, that is going to artificially constrict the price of your house.
Same thing if you’re at a wirehouse firm. You’re either forced to use a valuation from the firm, or at a minimum you’ve restricted the number of potential buyers you have. That’s going to artificially lower the price versus going out freely in the market, as-is the case in the RIA space.
Another thing you must consider is the taxation on the money that you will receive. Typically in the W-2 space, how that’s structured is you are paid over a number of years on a decreasing scale of the production of the practice, all while you are no longer working at that point. That income is typically taxed at W-2 rates, personal income tax rates.
Compare that to the RIA space where when you sell a practice, you can typically structure it so that most of that transaction will be taxed to you as the seller at capital gain rates. You typically can’t get all of it as capital gains, but most of it taxed at that rate, which is generally always lower than whatever personal income tax rate you might be in. So, taxes alone can make a big difference.
Even if the valuation assigned to your practice was the same at a wirehouse vs RIA, which is generally never the case, but even if it was, the taxation difference alone could dramatically move the needle. For some of you with a larger practice, taxation alone could essentially be hundreds of thousands of dollars in difference of what you ultimately will put in your pocket. It’s very important to consider.
And then one additional thought regarding sunset plans.
As the retiring advisor you may be less directly worried about this, but the receiving advisors, the recipients, this could impact them. W2 firms typically have formal sunset programs that must be used. It’s in writing via a document created by your firm.
Oftentimes, the language of those agreements will handcuff the recipient advisor for what they can do in the future. Some of the language can be restrictive even after the sunset program is completed and now impacts what they want to do with the practice going forward.
You’ve potentially put additional handcuffs on them that would make it harder for them to ever leave that firm, leave that model, if they ever desire to.
As the retiring advisor, that won’t impact you as directly because it’s not going to be your problem one day. It is fair to consider though what ramifications it could have on the receiving advisor as well. So, something to keep in mind.
Next, we’ll pivot to the independent broker-dealer model.
Here you have a little more flexibility, than the sunset programs. For the most part, you’re independent and can go and sell your practice. But there are two issues to consider.
Quick note, I should have said this at the top. Everything shouldn’t be solely about money. I don’t want this episode to come across as the only thing you should care about is how to get every penny out of your practice, and it’s all about making as much money as you can. I don’t want that to be the perceived message I’m trying to give.
However, the reality is, you’re doing this as a for-profit operation. You’re doing this to build a business, to build your life’s work, to then benefit from on the tail end for all your hard work. Your years and decades of hard work. You deserve to be paid for it.
But I do get where, we don’t necessarily need to do every last little path that squeezes every last little dollar. There are other considerations. How it might impact your clients, how it might impact your team members, etc.
So, I should have said that the top. I’m not naïve to the fact that there’s other variables involved. But the purpose of this episode is to talk about how to drive a higher valuation and how ultimately that’s one of the pieces that you would want to put into your consideration mix when you eventually exit the business.
Sorry for the sidebar there, but I thought that was important to address.
Now, back to the independent broker-dealer space.
The largest buyers in the marketplace are RIAs that are buying practices. If you are still in an independent broker-dealer space, one of two things are going to potentially hold your valuation down.
First, the easiest transaction for you might be to find a buyer at your (independent broker-dealer) firm because that buyer is already there, that buyer is already used to the systems at that firm. The firm will help facilitate it, your clients are aware of the story of who this firm is, etc.
If you’re at a large broker-dealer, there could be thousands of advisors. So, a fairly large pool. But, again, you are still limiting that pool versus the entire marketplace of who could be a buyer, who could drive that higher valuation.
And even if your broker-dealer has thousands of advisors, they’re not all in your local area and/or able to accommodate buying a practice in your area. Whereas there are large buyers out there that can come in and build the infrastructure needed at a local basis to be a buyer. So, even in the independent broker-dealer space, you are going to limit your amount of buyers either way.
And then if you say…..“well, I’m independent and I can sell my practice to whoever I want.” That is correct. You might even say, “I’ll even sell it to one of those RIA buyers.”
But if you are in the independent broker-dealer model when you go to do that, that buyer now has two variables they must factor.
First, they must extract you from that firm. They want you under their RIA and the assets at one of the traditional custodians they are already using. That’s more work for them. That’s more uncertainty for them. They are not going to give you as high of a valuation as opposed to if you had already done that work yourself and you’re already with one of the custodians.
Next, there is also the uncertainty of how much of your assets will follow-you out during that extraction. That’s relevant with any sort of transition. What assets do you have now? What are your relationships like with your clients? Let’s try to estimate how much those assets will move with you.
For most transitioning advisors, most client assets follow them. But there’s always some that don’t. Whether the advisor chooses to leave them behind, some clients chose on their own to not make the move, maybe you have some smaller clients that you just as well leave behind.
And so, a buyer has some uncertainty of how much is going to move. They are going to give you a lower valuation because they must factor the practice might not be as valuable as they think it is.
Whereas if you had already extracted yourself out of there, gone into the RIA model, there wouldn’t be that certainty. They would know exactly what they’re buying.
You’re better in the independent broker-dealer space than you are in the captive W-2 space from a valuation standpoint. But there are still constraints.
It’s important to think about how this differs in the RIA space. Whether you are your own RIA, or you join the right kind of RIA (that says, at the end of the day, this is your book of business, this is your practice for you to monetize.)
Because at that point you’re already with a custodian(s). Even though a buyer might extract you out of that RIA, they’re not having to move the assets. That’s a completely different situation and opportunity for a potential buyer.
In the RIA space you’re just going to have significantly more flexibility of who you could sell to, what that sort of transaction looks like.
Related, another thing to consider, particularly those of you that are in some sort of path that would involve a sunset plan, those firms typically require a very specific process for the sunsetting.
In year one, this is the payout split. In year two, this is what it’s going to be. And now year three, advisor, you must leave at this point. And the payout goes to this in years four through five.
Whatever the case is, it’s a prescribed process that the firm puts in place and you have to sign off and follow it.
Now, you might like whatever they’ve put in place, and they’ve attempted to come up with something that they think advisors will like. They’re not out to make things difficult. But it is what it is, it’s their process.
In the RIA space, even if you put the valuation aside, you have complete flexibility on the terms that you want to exit under. You must find a dance partner, you must find a buyer that agrees with those terms, but there’s no prescribed way you must do it.
That impacts a couple things.
First, how the actual transaction occurs. Is there some amount of money paid upfront? Is some amount deferred? Over what intervals is it paid out? How long does it take from start to finish for you to receive that entire valuation? You have complete flexibility to negotiate that.
Now, there are some industry standards you might consider. But you don’t have to just say, here’s the sunset rule book. That’s all you get. You can negotiate to come up with something that works for both you and the buyer.
You can’t just ask for anything and necessarily expect to get it, but you have a lot more control over what’s going to work for you with the economics. Then on the non-monetary part, how you plan to exit, when you plan to step away, how long you want to stay on after the transaction, etc.
If you’ve found the right buyer, they typically will want you to stay on for some period to help with the transition, to help with the client handoffs, to help make sure the clients are comfortable with the new arrangement, the new team, whatever the case is. They will want you to stay on.
But, again, when you’re in the flexibility of the RIA space, you can negotiate that. I’ve seen some advisors that say, “I’m at the end of my career. I get you need me to stay around, let’s pack it into six months, I’ll do everything we need to do in that six months and then I’m stepping away.”
Others say, “I’m ready to get the certainty of the transaction done, but I still feel good and I could do this another two, three years. We’re going to have to figure out how I’m going to be paid over those two, three years, but I would like to stay on that long.”
Again, you must get the buyer to agree, but you have that flexibility. That’s dramatically different than being forced to use a prescribed rulebook that your firm has set for you.
So just know, it’s not just better economics selling in the RIA model, there’s much more flexibility of how you exit the business as well, which for some of you is very important.
I’ve seen advisors that are done. They’re ready to move on. They don’t want a two, three, four, five-year runway. They know they need to stick around a bit, but it might only be six months.
Then there are other advisors that do want to stay on for a long time. But I’ve also seen some buyers who say, “we don’t want an advisor staying on for five years. We want to absorb the new practice and integrate it into our team and at some point it is right for the advisor to then step away.”
So, again, you must get both sides to agree to it. But as I keep saying, much more flexibility to negotiate both the economics and the terms of how you do it.
This has not been an exhaustive list of every element that goes into the valuation of a practice under both a captive environment versus the RIA space. But at a high level, I hope this has helped you understand why, generally, in every circumstance, you’re going to have higher valuation and generally more flexibility with your practice when you go to sell it, you go for that liquidity event, at the end of your career.
I get money is not everything. Perhaps you’ve been nurturing an internal junior advisor for some time and you’re at a firm now and you are even willing to accept a lower valuation and accept less flexibility because this is an alignment that you’ve had going for years and you’ve committed to this person that you are going to sunset with them.
Even for less money you might be willing to do that. That’s a personal decision. That’s for you to decide. I get where that situation does happen. I know people that are on both ends of that where that happens. But it is also hard when there are valuations that are oftentimes significantly higher that you could achieve in a different direction.
That’s for you to decide, but it is important to understand why it is different in the RIA space than maybe where you’re at now. Understand it fully and then decide if that’s for you.
This hopefully helps you understand another reason why you should maybe be considering, if you’re not already in the RIA model, going down that path. Whether you have 5 years, 10 years, 15, 20 years left in your career, one of the variables that you will achieve by going into the RIA space is the better scenario for that enterprise value at the end of your practice. Even if you have a long runway ahead of you, at some point, you’ll want to take a look at the RIA model.
With that, like I said at the top, my name is Brad Wales with Transition To RIA. This is the sort of thing I help advisors with. Is the RIA model even right for me? Does my practice profile fit it? And if I were to make a move into it, what am I going to gain from doing so?
That comes back to the flexibility bucket, the economics bucket. Part of that economics bucket is the enterprise value we’re talking about today. I’m happy to have that conversation with you to help you learn more about how this would apply to your specific practice.
First things first, head to TransitionToRIA.com. You’ll find all the resources I make available to help you better understand the RIA model. This entire series in video format, podcast format. I have articles, I have whitepapers.
At the top of every page is a Contact link. Click on that and you can instantly and easily schedule time to have a one-on-one conversation with me, whether you want to talk about today’s topic or anything else RIA related. I’m happy to have that conversation with you.
Again, TransitionToRIA.com.
With that, I hope you found value in today’s episode, and I’ll see you on the next one.
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