This week’s post is co-authored by Kevin Condon, an associate of JHA. Please see his bio below.
When one buys or sells a firm, there are a number of key questions to consider. The “science” relies on clear cut questions with quantifiable, or at least unambiguous, answers. The “art” relies on fundamental relational skills like building trust, discernment and cultural sensitivity. Will my practice be better if I add to or join this specific practice with these demographics, this “feel,” this style?
The Covey adage “begin with the end in mind” is especially important when considering a partnership. If one can handle the need for closure, one can handle anything! Partnerships are like marriages [see last week’s related post here] with a major exception. Marriages are designed to carry us through death. But, unlike marriages, partnerships need to have a clearly defined way to end before death! Michael Kitces’ recent blog highlights some key questions that the buyer and seller need to examine: https://www.kitces.com/blog/advisor-succession-challenges-issues-to-negotiate-and-when-to-walk-away/#more-7515.
1. Is There a Clear and Current Buy/Sell Agreement in Place? Is it Funded?
A current buy-sell agreement should be in place before buying into the business. It should spell out how the firm is valued and how ownership changes are managed.
Changes happen in the event of the death, disability, departure or retirement of an owner.
If a partner dies, the surviving partner will not want to be in the situation where he’s not only managing the business–having lost the founder’s work capacity–but also having to pay off the founder’s spouse or heirs without the liquidity to handle it. Terms and funding to buy back the partner’s equity need to be spelled out.
If a partner is aged or disabled, funding for that partner’s salary and contingency planning to cover his workload are needed.
If a partner departs, departure terms under which partners can leave should also be spelled out. If your purchase into the business is dependent upon certain revenues and profits, a strong non-compete needs to be in place. To develop into the strongest firm possible, clients should experience that they are clients of the firm, not of an individual.
The case of retirement is similar with an important difference. While outside the scope of a buy/sell agreement, the retiring partner should have a clear exit plan that includes reduction in hours, duties and pay while ramping up a clear post-business life.
2. How Profitable is the Firm, Really?
When I (Jon) worked in B2B sales forecasting and operations at HP (Tandem), I learned that not every dollar is a dollar. At the end of my first quarter I worked long hours to ensure we could recognize “revenue shipped.” I didn’t realize what assumptions went into that dollar.
After the quarter closed, I visited the manufacturing plant in Fremont, CA. The manager giving the tour showed me the chain-linked, paddocked area where “shipped” computer systems were moved. Then I understood the meaning of that term on a report. If the systems were over the yellow and black striped line and in that cage by midnight of the last day of the quarter, it could be recognized as revenue for that quarter. If the system was not over the line and it was 12:01 a.m. it was not counted in the quarter.
In the same way, profitability of a firm needs to be clearly defined. Assumptions matter. Therefore, when you are defining profitability of the firm, consider questions like
- What’s counted in profit? (e.g. How do you count extraordinary, sporadic “bluebird” deals?)
- Are there any “questionable” expenses being run through the business?
- Are there family members on the payroll?
- Are there lease-backs of property/equipment at higher (or lower) than market rates?
- Do owners take “reasonable salaries” and distributions? Or, is profit weighted toward distributions?
- How much depreciation is there?
- Will future cash flows be dependable and will they carry the same margins that past cash flows did?
Many firms built their “book” either on a specific product or on an opportunity presented by a new or changed tax law change. Closing sales at that level again is not probable. This argues for risk adjusting (discounting) future sales and cash flows. Conservative valuations are not merely a reasonable multiple of past sales but include a close look at the factors that created past success.
Reality: 74% of closely held businesses have no written succession plan (2015 Voya Services Company). If you don’t have a succession plan either get started or get help starting!
How well do you understand your firm’s profitability? Call me for my trusted partners who can help you accurately determine that: 303-871-9550.
This week’s co-author, Kevin Condon, began his career in 1984, starting from technical due diligence and developing a full service financial planning practice through partnership, practice merger, acquisition, and diligent sales and marketing. He sold his mature Washington, DC-based practice in 2002 to return to Denver where he developed a first-ever commercial portal for financial advice provision online.
Active in leadership positions through the years as a CFP Practitioner, NAPFA Member and blogger, he provides a uniquely helpful perspective to new and mature business owners to buy, sell or enhance a professional practice. His thirty years of experience and honorably acquired scar tissue can help your firm think through and meet today’s challenges.