How To Run Your Business So You Can Justify A High Multiple When You Sell | FEE005 – Transcript
So now it’s time for some heavy lifting, we’re going to talk about how to run your business so that you can justify the highest possible multiple when you sell. Now a lot is going into this episode and you know if it gets too heavy then just bear with me because there is some great stuff here that at the end of the day it’s all – I’m talking about it today because this is the one thing ultimately that people want to get to when they’re running their fee based practices. They want to get to a point where their business is running efficiently, running profitably and there’s not a tremendous amount of stress involved, it just sort of runs like clockwork and at the end of the day when it does come time to exit yourself from the business you’re able to command the highest multiple possible.
So the real question or the starting question we’re going to go through is why are you running your own business, I mean you need to ask yourself what is it that got you into your own business in the first place, was it the fact that you wanted some independence, you wanted the freedom from sort of the nine to five work, you wanted to just make a lot of money, I mean you heard it was a great way to make money so you decided to do that. what is it that’s driving you, what is it that really got you to do this because you can go do exactly what you’re doing, get hired by another firm and if what you’re doing is what you love to do then that’s a great way of doing it and then you take away all the stress and stuff that goes along with it. But the reality is you’re doing it for yourself for a reason and it probably has something to do with making a lot of extra money, keeping control you know these types of things. So really you want to ask yourself what is it you’re doing, why are you running your own business.
Now the question I have for you next is how is that working for you, you know what’s it like. If your goal was listen I wanted some more independence well you know what the independence can get kind of lonely when you’re doing it yourself. Nine to five you wish, I mean mentally it’s now become 27/4, you never get away from it. You know you’re working more than you would have if you worked for someone else and you may be making more than if you may be if you were working for somebody else but the reality is that if you’re working many, many hours and you’re constantly thinking about it your hourly rate is pretty low. So you know if you’re still in the business where you’re kind of trading hours for dollars well we want to make sure you can get away from that. So this is where the idea of being an entrepreneur and working for yourself it allures so many people in and as Michael Gerber once said you know it’s someone having an entrepreneurial seizure and then when they get into it they realize that they truly aren’t an entrepreneur. So you know we want to ask ourselves why are we doing this and then really how’s it working for you and if it’s not working great well before you give up you know let’s have this conversation, let’s go through this episode.
So what’s your end game is really the next question. I want to know if you’ve ever thought about that. Why are you doing this, at the end of the day I’m mean you’re not doing this so you can have a job you’re doing this to create some freedom and to create some wealth for yourself and to add value and to contribute back to society, but what’s your end game. I mean what at the end of the day are you going to do with all of this. You have to have thought about that at least a little bit. It may be difficult to think about it because often times you don’t have an answer and it’s very difficult as business owners to continue thinking about something that you don’t have an answer to because that just simply increases our level of stress. But you know at the end of the day everybody you know if you asked the question, if you went into a conference and asked ten people what’s your end game and they pretty much all say well you know what I’m probably going to sell it, I’m probably going to sell my business at the end of the day. Well my next question would be then well I mean whose going to buy your business. Would you buy your business, if you were analyzing a business to buy would you buy your business, do you feel that there is value in your business. I mean this is a question that you do have to ask.
Now a lot of dealers are setting up programs within their dealership so that they can retain the assets because still the industry is built on I guess the assets under administration model or the life policy renewals and that sort f thing, it’s built on that. Now in my mind that’s still backwards. The industry has been built backwards and this is part of why I’m doing this is so we can try and help correct a lot of this but the reality is that a lot of the dealers are setting up programs within the organizations in order to retain the assets. So they’re saying listen we’re going to put together a program where if you are wanting to exit the business we’ll buy your book from you. We’ll have a preset multiple that we’re going to use, we’re going to buy that business, distribute it back to other agents or we’ll even help facilitate the transaction and we’ll finance the transaction or we’ll put some financing in place to help the transaction take place all so that they can keep those assets within their dealership because those assets in most dealerships are what allow those dealerships to run profitably and if they start losing business to people selling their books and selling their businesses to advisors that are within that dealership well then they’re starting to lose revenue as well. So succession planning programs are becoming more and more important to the dealers and so you’ll start to see that the dealers are really going to be emphasizing this and if your dealer doesn’t currently have a plan well believe me they’ve been talking about it and they’re probably going to put one in place.
So then the question is well you know what’s somebody going to pay you because if a dealer is setting up a plan that’s going to make it nice and easy well you know what they’re probably going to make sure that it is nice and easy so they’re probably not going to allow you to command the highest multiple that you otherwise possibly could if you did a good job in shopping your business around. So keep that in mind that the dealers although they’re making it nice and simple they may not be doing you the best favour because they may not be allowing you to command the highest multiple for your business.
So how are businesses valued then, how do we determine what the valuation to put on your business. I mean there’s a lot of industry jargon that goes out there and people say oh it’s two and a half times trail or you know it’s a multiple of two and a half times you know whatever the number may be, it could be three times, it could be four times, it could be one time it all depends who you speak to and this is one of those things. It’s like investments, nobody really talks about their losses, they always want to brag and talk and boast about their profits but nobody wants to talk about their losses. Well nobody wants to talk about a transaction that maybe is commanding a lower multiple, you know they just want everybody to think oh yeah I sold my business for a huge multiple or if you’re on the buying side you can say yeah I bought that for a song, it was so cheap you know it made a lot of sense and I really got a good deal for it. Well the reality is you know it’s somewhere in between.
So the question then is how are businesses valued. Well they’re valued based on one thing and one thing only and that is profits, pre-tax profits. How much is this business making on a profitability standpoint after all of your expenses, your payroll and all that sort of stuff is done how much are these businesses making from a profit standpoint. So if you’re not retaining profits in your business then really what you’ve done is you’ve created a job for yourself. A business is something that makes profits every year or tries to make profits every year and as they start to grow the business and as the business moves forward the profits start to increase and then efficiencies and then they may take some of those profits reinvest it back into the business for even higher profits. But everything is done at the end of the day for profits not for income.
So then what they’ll do is they’ll take the profits and they apply to that well what’s the discount rate and a discount rate is something that’s used – it’s basically if you look at it this way you say look if I was going to take a hundred thousand dollars and I was going to buy an investment what rate of return would I need to make on that to compensate me for the type of risk that I’m taking well that’s your discount rate. So if you know that you have a business that you’re looking at that’s got a consistent profit of a hundred thousand dollars a year then you can say well you know I’m going to discount that because I want to make on whatever I invest in that I want to make oh I don’t know it could be 15%, it could be 20%, I don’t know ten, fifteen, thirty, fifty who knows what it is, it’s whatever the return is that you feel is required to compensate you for the type of risk that you’re taking for buying the investment. That’s what’s called your discount rate.
So if you for this example if you have a business that’s spinning out a hundred thousand dollars in pre-tax profits every year and you come and say okay I’m going to put a 15% rate on that, I want to make 15% on my money, if I buy that business then I need to make at least 15% on my money for that to be a worthwhile investment. Okay so that’s your discount rate. So in the first year if next year is going to make a hundred thousand dollars then you’re saying well then I will invest $86,957 today for the right to receive that hundred thousand dollars at the end of the year. So you can see I’ve just simply done a discount calculation, $86,957 is basically a hundred thousand dollars discounted by one year by 15% that’s what it is. Well that’s the initial year so basically you’re buying one year of profit and you’re paying for it today for the right to receive that profit in the future. So you get all your money back plus your return there’s you 15%. But what about the next year? So the next year two years down the road it’s going to make a hundred thousand dollars so what am I willing to pay for that today. Well you can start to see that as you continue doing this you’re starting to build a valuation for that particular investment because if that investment or if that business is going to be spinning off a hundred thousand dollars every year then you can start to quantify what it is you’re willing to pay for the right to receive that level of income or that level of profit. So if you have a hundred thousand dollars in the second year then you would be willing to pay $75,614 today. So all I’ve done is I’ve discounted a hundred thousand dollars by 15% over two years.
Now do this for ten years and then add up each year’s what’s called the net present value. So that $75,614 is the net present value of the profits that are expected to be generated in two years. So if you do that for say ten years and add it all up then in this example the value of that business is five hundred thousand dollars or you can say it’s a five times multiple with a 15% discount rate on that hundred thousand dollar profit. So that just gives you an idea of how we’re quantifying it so that you can almost reverse engineer, if somebody offers you a certain price you can kind of reverse engineer it and say okay well wait a minute what kind of multiple are they looking for and just simply say well if they’re going to be paying me this, take a ten year number and use a discount and just start playing with the multiple and say well how did they come up with that valuation and that will give you an idea of what level of risk they see as associated with your business because they’re making an investment they need to make a certain rate of return to compensate them for the risk that they’re taking for the right to receive those profits in the future.
Now if you had a 50% rate of return on that same example then your multiple actually is only two times because if you discount 50%, you want to make 50% on your money every single year well then you’ve got to discount that well that brings it down to about two hundred thousand dollars. So that just gives you again a little bit of an understanding about how the number is being calculated so you can reverse engineer it so that if anybody ever makes an offer to purchase your business and they say the dollar I’m going to pay is you know five hundred thousand dollars and you know that your business is generating a profit, a pre-tax profit of a hundred thousand dollars a year then you can say you know what I run a rough calculation that says they’re paying me a five times multiple or they’re looking for a 15% return on their money every year and that’s how it’s done. So that gives us sort of the building blocks to start from.
Now the one thing we also know is that that hundred thousand dollars is probably going to grow so the profits every year are going to grow so what you want to do is take a look at your own business and ask yourself well how have my profits been – what’s the rate at which they’ve been increasing each year. So go back as far as you can and take a look and say okay well you know the profits were a hundred thousand dollars last year, this year they’re a hundred and twenty thousand dollars okay so that means there’s a 20% growth and if you can average that out over the course of you know maybe five or as many years as you can then you can start to see what your growth rate is every year on those profits till you can start to see okay well I can then justify commanding a higher multiple or a higher price for my business because it’s not just a hundred thousand a year it’s going to be a hundred thousand plus some profits because maybe there’s market appreciation, there’s a lot of things that will increase the value that you’re capitalizing on that are allowing your profitability to grow every year.
So if that’s the case then you can then simply work that in. Well if you do that same calculation and you’ve got a 20% growth rate every year, if you’re using a 15% discount rate but you have a 20% growth rate then the value of that business changes from five hundred thousand dollars to $1.2 million. That growth rate is powerful so you need to be able to then justify what it is about your business that you are able to say look this business is going to keep on growing and here’s why and this is why you’re not offering enough because there’s a pretty predicable growth rate we can factor in. And so part of the process of going through and selling your business is educating the buyer on exactly what it is that they’re buying. They may not know your business as well as you do so you want to make sure you’re educating them on that. So you want to have this information sort of in your back pocket in advance so that you know exactly how to sell your business.
Now not all revenue streams attract the same discount rate and the discount rate is all a factor of risk. So what do I mean by that. Well in our businesses we have different types of revenue okay so we have things like deferred sales charge commissions so transaction commissions, anything that you receive on the transaction of we’ll use investments in this case so you have investments that are going to transact how do you purchase those investments, are you getting commission upfront, are you getting trailer fees where you’re basically buying no load investments or you’re not putting any loads on the investments and just getting a trailer fee, are you getting referral fees on the investments, you know are you generating insurance revenue or what are your insurance commissions and are they consistent, you know what’s your rationale for how you’re able to continue that level of production, then you’ve also got financial planning fees. So the financial planning fees these are the fees that you’re you know charging for the writing of your financial plans and the maintaining of the financial plans and the right for these clients to be part of your unique process and the unique financial planning model. So these are all the different types of revenues that come into our business. Now each one of those revenues needs to be assessed on the level of risk of whether or not that revenue stream is going to be easily replicable. So can you replicate that revenue stream without a lot of effort. If it takes a lot of effort and there’s a high level of effort then that means the risk on that is higher which means the multiple is probably going to be lower or the discount rate is going to higher. People if it’s a higher risk they’re going to command a higher rate of return on their investment on that.
So I basically categorize things into three categories, high risk, medium risk or low risk. Now high risk is where there’s a lot of sales efforts required so you need to have a certain skill set, you need to actually put a lot of energy into continuing that revenue stream. So examples of those would be insurance commissions or investment commissions, those commissions will only happen if you show up every day and you make those sales. You need to have production that’s going to generate those sales. So basically there’s a higher level of risk on that because it’s kind of you know this is where your relationship with your prospects and clients come in. If you’re buying somebody else’s relationship and they’re the one that’s been doing the sales all the time well it may be more difficult for you to do it. So the risk is a little bit higher so you may command a higher return on that to compensate you for the risk that you’re taking which means you’d be paying less for that particular block of the business.
Now other things which would be medium risk, so this is where you may have a pretty reliable ability to be able to generate that revenue but there are external factors that may cause havoc with that and this one can sort of increase or decrease your multiple and what that is is market risks. So if you’re basing let’s say most of your revenue comes from referral fees as a percentage of the investments or trailer fees which are also a percentage of the investments well in a market decline then the risk on that has gone up because now you have a smaller asset base that you’re drawing from and a percentage of a smaller number is a smaller number. However if you’re going through a period or a market cycle where things are really, really trending upwards and things are appreciating, the markets are moving forward then you can then say you know what realistically next year things are looking good you’re going to just make natural appreciation on this asset because of market appreciation. So you can have that one work for you or work against you and so just keep that in mind.
And the next one is the low risk and this is what your goal is. You want to try and move everything you possibly can in your business into the low risk category because this is where it doesn’t require a lot of effort on your part, really all you have to do is show up and make sure the business keeps on running and the renewal fees and that sort of thing are going to come through and an example of that are the financial planning fees. So with the financial planning fees however I have broken them into two different types. There is a high risk associated with financial planning fees and a low risk associated with them. Now it’s because there’s two different types of fees. With the financial planning fees you’ve got your initial year’s fee so that’s the fee that you generate from new clients coming on but then you’ve got your auto renewal fees and those are from your existing clients and it’s basically their payment to you to keep their plan up to date. So we set things up so it’s an auto renew type situation where really a client of ours and every year we just charge their credit card or however you want to do it but the stream of revenue is quite predictable and that will command a much higher multiple because you say look you know it’s pretty easy to make that money so it’s going to be just easy money in the bank. So you’re going to command a higher multiple or you’re going to require a lower discount rate on that because it is a lower risk investment in that particular component.
So that’s how you want to be looking at the different types of revenue coming into your business, you want to categorize them as high risk, medium risk and low risk so that you can actually dissect that and sort of extract the revenue stream that you’ve got and find out a little bit more and get a little bit more educated on the multiples that you’re looking for in each one. So you can really put together a bit of a spreadsheet on this and say okay well of my revenue you know we know that if 50% came from high risk and 25% was from medium risk and 25% was from low risk then you can say on that hundred thousand, if it was a hundred thousand dollars in profit, fifty thousand would be high risk and so you understand there’s probably a higher multiple but then you can start to command a lower discount rate on the other components for that purpose. So you can give yourself a bit of an idea of how to blend your ideal I guess revenue discount rate which is sort of a weighted average of the profits coming in and the level of risk associated with each component of those profits.
So that’s you know one of the things you also want to look at is making sure you really know your numbers so that when you go through and if you are involved and you really want to sell your business you’re much more educated on your business so you can start to really sell what it is people are buying and when they start to understand that you really know your numbers then they’ll start to take you a little more seriously and you know what it looks better, the optics of that are so much better where they say you know this guy really knows his business, the reality is it’s probably going to work the way he is and if he’s got strong reasons for why this revenue stream is really low risk that it’s going to be consistent and continue because he’s got a historical track record of all that then it just allows you to justify a higher fee for your business.
So value your business, how do we do that. There’s really a four step process. So the first thing you want to do is you want to determine the average profit growth for the past handful of years. So again go back take a look at the growth pattern, what’s the average growth rate been on your business so just take the growth year over year and then average it out, what does that average number work out to. Then determine what your profit is for this year, break that profit into low, medium and high risk and put a multiple on each risk level. So that third step of breaking that profit into the different categories is really, really important because now this is all about building the rationale as to why you’re commanding a higher price for your business and then run a ten year analysis to determine your net present value of your business. So once you’ve done that it’s a spreadsheet and you’ve got this basic nice working document that you can key your numbers into, you can say well I know of these different types of revenue streams they’re low, medium, high risk, you plug them into the spreadsheet, you put a discount rate so you can just estimate it and kind of noodle it a little bit so that you know when somebody comes back to you with an offer and they say well I’m willing to pay X for your business you can actually look at that, reverse engineer it to determine what kind of multiples they’re paying on your business and what kind of discount rate they’re applying so you can then say does that make sense or not. It just allows you to make some better decisions when offers do come in.
Now how to justifiably increase the value of your business, that’s really the key to this whole thing is how do I design my business and grow my business and build my business so that I can command the highest multiple possible and really this is what being a business owner is all about. So the fee revenue is the most important part of your business for this purpose because the fee revenue carries with it the most value to a buyer. This is one of the reasons why getting involved and transitioning yourself and migrating yourself to a fee based financial planning practice is so important because at the end of the day it’s where you’re going to be able to command the highest multiple. So why do fee revenues carry a higher multiple or a lower discount rate than any other and well it’s because that’ revenue is very predictable, it’s recurring. So you’ve got the recurring revenue, the fees especially are not market dependent so fee revenue as I said before is considered low risk which simply means no matter what year over year you are going to get that revenue coming in, as long as you take care of your clients and as long as you service them properly that revenue is going to be fairly consistent. It’s not going to be affected if the markets go down or if the markets go up, it’s completely separate from all of that. So it’s a very, very low risk type of revenue and the main focus that you want to do in order to build the multiple for your business is to focus on how do I command the most renewable fees for my business. So number one fee revenue carries with it the most value to a buyer. So the goal is to simply build your business on fees, do everything you possibly can to make those fees not market dependent and just make them consistent.
So how do you do that, what’s the easiest way of doing that. Well first of all you’ve got to be able to charge fees. So if you’re not in an environment or you’re not in a structure where you can charge fees and I’m talking literally charging a credit card then you know you do need to take a look at what you need to do to get that in place. So turn your service, so the service you provide, your financial planning services, turn that service into a product and then sell that hell out of it as your product. this is what differentiates you, this is what allows you to scale your business, this is what allows so much, this is the essence of running a fee based financial planning practice, this is how we can justify the fees, this is how we show value for what it is that we’re doing. So how do you scale your business or why do you scale your business in this case. So when you’ve turned your service into a product now you can scale your business and the reason why you can do that is because number one it’s teachable so when you’ve got this process that you’ve created and you’ve taken your service and you said okay we do this, this is what’s unique to us, we’re going to turn it into a product now and this is the product we’re going to be selling now you can teach others how to do that. It’s also quite valuable so number two is scale your business because it’s valuable. Now you’ve got something you can charge whatever you want for because you’re the only one doing it so you can set your own price. And number three it’s repeatable, you know that because you’ve got a process in place the product is going to be repeatable this is what allows you to start to build tremendous value and efficiencies into your business so you can command those higher multiples.
Now the benefits of turning your service into a product or what’s also known as productizing are simply number one creating a unique process gives you what I said before price control. You can charge what you want, charge as much as possible. So when you’re the only one who’s allowed or licensed or whatever you want to call it to do your particular unique process you can charge whatever you want, you don’t have any competition. So charge as much as you can that justifies the value that a client is getting. If they’re getting a lot of value then you can command a much higher price so do everything you can in productizing your business, bring as much value to the table as possible.
It also allows you to hire sales people to sell it which solves in my mind – man this is the biggest problem we as financial planners have in this industry, the biggest problem is how do I scale my business, how do I grow my business without running the risk or increasing the risk of somebody bringing on a junior, bringing on another financial planner and then at the end of the day having them walk away with all your clients. I’ve seen it done before, I’ve seen it happen. I have colleagues that have had other planners in their office and those planners have you know built relationships with their clients and everything was going great and then one day they came in and they basically were notified that that particular planner decided that they were going to go and open up their own business and all the relationships were going with them. That is a very stressful position to be in. so when you’ve productized your business you can now hire sales people to sell the product not the actual relationship. So it means that you can go outside of the industry, you can go to other industries where people are just naturally good sales people and say look this is what we do, this is how we do it, this is the product we’ve created now go out there and sell it for me and because it’s got a fee associated with it, this is the price for the product people can sell products. It’s very, very difficult to sell services because services are kind of open ended, you know people are afraid to get involved with that because it’s just kind of open ended and so there’s some risk associated with that. but when you actually have a process that you’ve productized then the sales people can actually sell that and what that means is they’re out there selling but once they’ve sold that product to a client they’re not the one who’s actually implementing it. The client now becomes a client of the firm and the firm services and implements and builds the relationship with the client.
So we’ll talk about this more in future episodes but that is really a huge, huge benefit is that it allows you to hire sales people without the risk of those sales people walking away with your business. And the next step or the third point is your team will always know what to do. Your staff knows what to do at each stage of your process. So when you document your process and you have this great process that’s just adding so much value and people are saying wow man you’re the one who does that, I want that, this is exactly what I need. Well now you know that everybody goes through the same process. When you know that you can start to put together checklists and unique methods for how we do what we do so you can get the same result every single time. It’s the same process everybody goes through. So document your process and then outline who does what at the various stages of your process. So that’s how you can get your team to start taking over a lot of what you’re already doing. You see we as financial planners we kind of work on islands by ourselves, we do it all but the reality is if you want to grow your business to the next level and take it to the next level and you want to do it profitably without really killing yourself you need to hire people, you need to bring on support staff.
Well the question is well how are they going to do it, how are they going to know what to do, how do we design it so that they know what to do and when to do it and that it’s going to be done right and all that sort of stuff. Well it’s very simple, simply document what you do, put it into a screen capture or a screen cast video or write it down in a checklist format just like you would if you were a pilot doing your pre-flight checklist, you know put a checklist together for each stage of your process so that everybody knows okay when the client comes in for stage one this is what happens, this is how we set up for the meeting, this is what happens during the meeting and this is what happens after the meeting. So document all those processes. The great thing is you just have to do it once. Spend the time looking at the details, do it once and then you can start to hire people to do the components of your process for you.
So that is it. I think that if you follow these steps at the end of the day you will have built a business that is worth so much more to someone else because it’s got a process, because it’s profitably, it’s predicable, it’s reliable, it’s actually a fun business to run and the reality is at the end of the day you may not even want to sell, you may want to just continue doing it because you’re making so much money, you’re having so much fun, you’re adding so much value, contributing back to society what a great position to be in. So go to www.feebasedfinancialplanningmastery.com, click on episode five, there post any questions you’ve got, ask me anything, put some comments, let’s communicate a little bit about this, what are your thoughts about this, do you agree that this is a good process to go through, have you bought a business before, have you sold a business before. I’ve actually done both so I can speak on both sides of it, I know what works, I know what doesn’t so what are your thoughts, what are you r comments, what’s worked and what hasn’t for you. Let’s talk about it, let’s help everybody else out so we can build a better industry and also check out the toolbox and the recommended reading list to see a list of other resources I use to run my successful fee based financial planning practice. So get out there and build yourself a better business.
Copyright © Scott E. Plaskett 2012 All Rights Reserved. No part of this document may be reproduced without Scott E. Plaskett’s written permission.