Expert Video: Buying and Merging
FP Transitions is not affiliated with SEI or its subsidiaries.
Transcript: Hello everyone. I'm Gabe Garcia, head of RIA experience at SEI, and I'm joined today by Scott Leak, senior consultant at FP Transitions. FP Transitions provides valuation and consulting services for advisory firms looking to evolve through mergers, succession or other business transitions. Today we're going to touch on four key areas, how to prepare for an acquisition, sourcing and vetting sellers, negotiating the transaction and closing the sale. So we'll jump right into it and I'll pose this question to you, Scott.
The last several years have been very active in the market. There's literally weekly, if not daily headlines of transactions that are occurring. We're seeing record numbers year over year, and based on the demographics of the industry, the trends suggested that should continue for a period of time. However, being willing and able to buy an advisory firm isn't always enough. So what does a strong buyer profile entail for someone who's looking to make acquisitions? Yeah, it's funny, Gabe, we've got a saying here at FP, it's one thing to be able to afford a practice. It's another to be able to absorb a practice. So a strong buyer needs to have a really holistic view of their own business. So know what some of your key performance indicators can teach you, leveraging some benchmarking data. Some of the things that we provide for our clients at FP are things that are going to indicate what's your scale? What's your capability, your capacity to grow and absorb a practice? What's your profitability to be able to afford the practice? So look at some things like your profit per professional and revenue to expense ratios as an example.
Wonderful, wonderful. As you're entering this stage of a strategic growth for an organization, what are some of the non-negotiables that buyers should keep in mind so that they can maximize their time and effort and identify optimal opportunities versus suboptimal opportunities? Well, opportunities for a buyer aren't going to come by every day, and so when buyers do come across one, they tend to be a little overly eager when one arises. So buyers need to be very strategic and intentional about what it is they're wanting to buy and why. So know that certain things might be a good fit for you and other things may not. So know what's a good fit for you culturally and how an acquisition is going to be integrated into your current systems, your staff, and your own client base. So you want to choose assets and clients that resemble your own. A buyer's got a much better chance of protecting that value of their investment in this acquisition if they're buying a business that's going to be scalable and able to be easily integrated with their own. So if you, you're willing to put a round peg into a square hole simply to get an acquisition done, it's probably not worth it and you're going to struggle in the long run to make that cash flow. Yeah, success is critically important when investing the kind of capital and time and energy to grow an organization and bring another group of individuals and professionals and clients on board. Absolutely.
Once you think about some of those aspects and what your profile is, what's important to you and preparing yourself, and whether this is your first time entering the acquisition market or it's been a while since you've done an acquisition in today's environment, what is it that people should be thinking about and prepared for that they may not be aware of when it comes to doing mergers and acquisitions? Well, for a lot of advisors, I think they're going to think first a lot about funding and how are they going to be able to afford this. So if you're talking about an internal purchase, we're seeing advisors do a lot more bank financing, and that's certainly something that's being used with external transitions. So we're seeing some seller finance notes still being used, but you might want to go out and get pre-approved. If you're planning to be a buyer, you want to be pre-approved for lent just like you would if you're going to go out and buy a house. You want to be pre-approved for your mortgage before you go out putting offers out. And so firms that are looking to do that, be thinking about how is this going to affect you financially? I think you're looking at maybe a down payment of 40 to 50%, and then maybe you're looking at a three to five year note with bank financing to support the rest of it. There's all kinds of rules too as well around different types of lending. So whether you're doing an SBA loan or whether you're doing a conventional loan, it's really best to explore the pros and cons of each. So when we're talking about the financing aspect of a transaction, preparing for that, those are some of the key things to hone in on.
Wonderful, wonderful. So let's transition to sourcing and vetting. Certainly we hear that there's a lot of opportunity in the marketplace, and I touched on a little bit of the demographics of the industry, which lean into more opportunities being available as people look to transition out of the industry. How are buyers finding the right fit sellers today? It's usually a multi-pronged approach. So first I would tell advisors, go out and network. Go to your local industry meetings. If you've got an FBA chapter locally, you can go to any industry association conferences and share with your centers of influence, your relationship manager at SEI, whoever it is that is a source of contact with other advisors. Let them know that this is something you're interested in and help them be your eyes and ears as well. So your broker dealer, your custodian, your tamp, your technology providers, anyone that is talking to other advisors on a regular basis, you never know who's going to be the first person to hear about someone looking to sell. One hidden secret that I'll share that we do with a lot of our clients here at FP is that we'll provide a service for them where if they find someone that maybe isn't ready to sell, but they need a continuity plan. And so what we can do is draft a continuity plan with someone that says, Hey, we're not talking about selling, but just in the event that I get hit by that proverbial bus in the event of my death or disability, this person is going to take over and buy the business. So that's kind of a good way to build up a pipeline of future acquisition targets by just agreeing to be their continuity plan. So I think for a lot of advisors, go out and target people who don't have a continuity plan, maybe a solo owner and just say, Hey, I'll provide that for you. Make sure that your clients are taken care of, your state's taken care of, and that builds up that pipeline. Yeah, great advice, and I couldn't agree with you more on your initial comment. I find that more often than not, marriages get consummated by two degrees of separation. Someone knows somebody who makes that introduction. Obviously there's consultants and recruiters and bankers that are in the market facilitating these transactions, but in many cases, that initial contact is two degrees of separation. So I agree with you, spread the word and contact those and let them know that you're interested. And those investment bankers and m and a consultants, places that have marketplaces, those are great, but they're highly competitive and they're not going to be probably as effective as those one or two degrees of separation.
Yeah, absolutely. So you found a couple of optimal opportunities. Let's talk a little bit about the vetting process. How should acquirers be thinking about that dating process, not just from a cultural and personal perspective, but also from a business and regulatory legal perspective? What does that entail? Well, first and foremost, I have to say don't share anything until both parties assigned an NDA. So that's usually step one that's often quickly overlooked and people get excited and start going down the path. Get an NDA signed first and foremost. So that's step one. Then start with some of the easy things. Thoroughly review the other person's website, understand what their value proposition is to their clients, how are they setting up client experience and how they are setting up client expectations, and then how are they delivering a client experience? Check out their A DV or go to brokerage check, depending on their situation. Look for filing status, look for disciplinary history. There's a lot of things that are kind of low hanging fruit you want to look at. That could be instant deal killers if you find 'em. Then after a while, particularly after that NDA sign, you're starting to share some information, then you might want to look into the financial. So look at revenue sources, try to find ways to verify that revenue. One way could be to get a report of all of the billings that they've done to their clients. It's pretty hard to fudge those numbers. So look at ways to verify that information, look at revenue, look at earnings, look at information about clients and employees as well. Start to get client demographics and tenure, and then look at employment agreements with the employees as well and see what kind of restrictive covenants might or might not be in place.
Great advice, great advice. You've seen hundreds of transactions or potential transactions. What are some things you've seen that are red flags that pop up that identified earlier could be overcome, but sometimes late in the process may derail a transaction that our audience should be aware of? Certainly there's obvious things like those disciplinary actions that you might find if you're finding incomplete data on the finances. If that's troublesome for you, then that's probably a good enough red flag to really be worried about it. But some of the less obvious things like a seller who's leading with price, you got to be worried about their motivation and how well are they taking care of clients if their price is their top priority, and if they're not forthright with you, even after signing an NDA, if they're kind of withholding about some things, I'd consider that to be a red flag. But there's certain metrics to be looking at too that can tell some stories. So look at their fee structure. We've seen deals that didn't work out because there's such a gap between the fees that two firms charge. If you're charging a hundred basis points and you're buying someone who's charging 60, you might have a hard time getting those clients to adapt to your structure or making a cashflow for you. Look at those households, average account size, how much money did this firm spend on technology, on marketing, on their service deliverables? And those are things that if there could be indications that they have weak client relationships, and if so, then you're more likely to have high client attrition, and so you might not be getting what you're paying for.
Wonderful. So you've taken a look at yourself, you've sourced, you've done some discovery, some vetting of a potential opportunity, and you transitioned into the negotiation phase. The marketplace certainly has changed over the last several years from what many thought was a typical standard approach in acquiring firms. What are typical terms, how should acquirers be thinking about structure, retention, earnouts equity versus cash, cash upfront? You touched on a little bit at the outset. Talk to us a little bit about that. Deal structures vary quite a bit. If we're looking at the overall averages of what we've seen the last couple years, you're looking at probably around 40% down payment, 60% on a three to five year note. And then you're going to see probably a one year lookback provision that's going to say, Hey, if client attrition varies by X, we're going to adjust the price by Y. And usually that's something like 90% is around the threshold that we see people put in of, if I'm going to have 88% client retention, then we're going to reduce the value of the agreement by 12%. If it's 90% or higher, then it's usually the full 100% payout. And generally speaking, we're seeing these transactions come in around 97% retention. So that's not usually too much of an issue, but that is something that should be written into a contract for both parties. And then one of the other things that might vary with this is what's the end goal for this advisor? Is this a sell and walkaway transaction or is this a sell and stay transaction? If it's a sell and stay, then there's usually an employment agreement that's going to go along with it, and that's going to also be something negotiated as part of the deal too. So a lot of different variables to consider.
Yeah, so a stickier topic sometimes is fair compensation for owners of a firm that's being acquired. And in our industry, in many cases, owners simply take a draw and then take what's left over at the end of the year. So how should an acquiring firm be thinking about owner's compensation, particularly in a sell and stay? So in a sell and walkaway, I'll answer that part first. In a sell and walkaway, there's usually like a one year consulting agreement, and that is going to cover that 12 month period up until the lookback where you want to give that seller the opportunity to help with the transition. And so they'll have something written into the agreement that says, this is what I'm going to be paid for that consulting period. Usually you're done in probably three to six months, and then you can just hang out at the beach and you're on call at that point. But with a sell and stay, now you're getting compensation as an employee. And for some advisors, this is kind of a breath of fresh air. It's like they get to go back to being just a wealth manager for their clients again, and they don't have to deal with the minutia of running a business anymore. So they do need to understand there might be a little bit of a drop in income on a yearly basis, but you do have less responsibilities. And so there is a trade off there. This does vary a lot based on the size of the firm and how structured how pay and comp was structured for that owner when they left their prior firm. But for the most part, they're just structuring a fair base salary for their years of experience and the type of work they're doing and an incentive comp plan to hopefully get them to continue to want to increase revenue.
What about non-owner advisors and staff compensation? How do you work through that? Well, I'll tell you right now, we're seeing a lot of advisors who are really interested in the talent that comes along with an acquisition, not just the revenue stream. So there's been a lot of speculation of like, oh, our valuations coming down, and the answer is not really. No, because there's so much talent to be acquired, and this is one of the easiest ways to get talent. We've got a significant shortage in the industry in this. So I would say with a few exceptions, no acquisitions should start with a pay cut to the retained employees. These people could be as influential, if not even more so in some cases than the owner in client retention. So you want to make sure that they're well cared for and you want to look at all in comp. You might have some apples and oranges comparison. Maybe they got paid a higher salary at the smaller firm that they were with before, but now they're joining a larger organization that has more benefits, better benefits, 401k matching. Maybe they've got a path to ownership in the new organization. So you do want to be able to present to them the entire comp package, not just what they're going to see in their weekly paycheck.
So let's transition to closing the sale. How do you get to a successful close? Well, selfishly, I want to say with the help of an independent third party like FP Transitions, but you do want someone who's going to be responsible for keeping everyone on track, who's going to offer solutions that both parties might not know, particularly if neither one's ever done a transaction before, and then be able to show data to one side and the other to say why their objection or their holdout is valid or not valid. So some advisors falsely assume that adding a consultant to the process is going to be an unnecessary expense to the deal. Buyers in particular are tending to be a little bit cautious of hiring a consultant thinking this is going to just increase the price and I can do better negotiating on my own. But at the end, you're still going to need banks. You're still going to need an attorney, and they often have a reputation for complicating negotiations and accruing expensive fees charging by the hour, and so they don't necessarily have a incentive for this to get done quickly. Hiring a consultant can be a useful litmus test of either party's genuine commitment to the sale, and then once more, an impartial mediator can actually return value to both parties by enhancing alignment, providing guidance along the way to the contracts and reduce the need for endless revisions to it. Yeah. Yeah, I'll definitely make a plug for FP and your colleagues in the industry. I have found that in many instances, bringing professionals into the process helps remove some of the friction and smooth out some of the more sensitive conversations by having that intermediary engage in that dialogue, but also bring experience and market perspective to the conversation where you have real facts and experiences to rely on rather than just emotion. Right. Yeah, I mean, I myself, I've got my CFP designation, but I still have an advisor that I've hired because I recognize the value that an advisor brings by being someone who's doing this on a day-to-day basis and understand all these different scenarios that I'm not seeing, and they're going to bring insights to me that are going to be well worth my fee.
So let's talk a little bit about communication. When should you bring the team into the loop? This is really case by case, but other than the owners of the organization, I would say it's really not necessary to bring them in until the deal's signed. You're potentially just going to open up the opportunity for confusion. And so until a deal's done, it's probably best just to kind of keep it quiet unless you've got some really significant stakeholders in the organization that need to be involved.
What about clients? What are some best practices of communicating to clients and when? Yeah, so on the buy side, if you're the buyer, you absolutely need to let the seller go first in the communication. That's one of the worst things you can do is reach out to those clients before the seller has had a chance to explain to them what they're doing and why. So let the seller go first and be sure you understand all the ways that this transaction's going to impact the clients. So reach out to your RM at SEI talk to them about what changes are going to happen as we transfer ownership. Talk to your broker dealer or custodian. Talk to your tech providers of any client portals. Make sure that any questions that a client's possibly going to have of how is this going to affect me? You're prepared to answer every single one of those. And then explain the benefits. And hopefully if the buyer is, usually the buyer's, a larger and maybe more sophisticated organization, talk about the potential benefits and upgrades they might be getting. Just be sensitive. The fact the seller might be a little offended if you're like, oh, we're so much better than the person that you've been working with all these years. So find the tactful ways to communicate those together.
Lovely, lovely. What's one piece of advice as we wrap up here today that you want to leave potential acquirers with? So generally speaking, successful buyers have a really good overall growth strategy that integrates organic and inorganic growth. So I see too many firms come to us and say, Hey, we want to buy, and they're doing so because organic growth has plateaued, and they probably haven't realized that really what the problem is here is that this is not necessarily a way to grow in lieu of organic growth. You probably have a capacity issue, and that's why you've plateaued organically. So you need to address some of those things in your back office, if you will, and make sure that you're a well-run organization and you're not exacerbating the problem by adding in a bunch of clients when you're already having capacity issues. So be careful you're not misdiagnosing what the issue is, and then how to solve for it. For me, as a golfer, I might stand up at the T and I'm slicing all day long, and if I do the wrong thing to fix my slice, now I got to snap hook for the rest of the round. So you got to correctly diagnose what the problem was, or you end up fixing two things and they were both wrong. So make sure your acquisition goals are wholly integrated into your overall growth strategy and compliments and already strong organic growth process.
Well, Scott, thank you for sharing your experience and your advice. For those who are interested in acquiring advisory businesses today or into the future at SEI, our advice is stay focused on what your desired outcome is and focus on a win-win win situation, win for the seller, a win for the clients, a win for the staff, and of course, a win for your firm who's doing the acquisition. The need to be balanced and in harmony to create long-term success is critically important in all of these types of transitions. And as you begin or continue this journey, know that your team here at SEI is happy to support and serve you in any way we can and bring resources and insights as we did today via Scott to help you through the process. Thank you all.