Ryan Grau, CVA, CBA, is the valuations director and a
principal for FP Transitions. He is an authority on the topics of value,
valuation, and business continuity planning across multiple industries.
What is my practice worth?
This is a question that every independent financial adviser should ask, or has
asked, at one time or another. Given that the value of a fee-based advisory
practice is often the largest asset that most advisers own, it is a good
question in need of good answers.
Countless valuation services and tools are offered up to
help answer this question—some good, some bad. Very few business owners
understand the valuation process, myriad decisions, and judgment calls necessary
to arrive at a value. When it is time for you to determine the value of your
life’s work, you need to understand certain value, and valuation, fundamentals
so that you can get the right answer from the right expert every time.
The starting place for most advisers who need a formal
valuation is this simple mantra: purpose, standard, approach, and method. These
are the key starting points in every valuation engagement. Any time a business
appraisal is needed, the standard of value, approach, and method(s) used for
estimating value should be tied directly to the purpose or reason that the
valuation is being conducted. When you decide to sell your vehicle, for example,
standards of value include both trade-in and private-party values, among others.
Given the specific purpose (you want to sell your car), both values are correct
even though it is the same vehicle. Still, only one standard is applicable based
on the party you plan to sell to. This same concept applies to business
Value is a function of purpose, and the answer is not
universally applicable to every situation. Why have your practice valued? The
most common reasons include:
Non-tax valuation: general knowledge, reporting to
an owner, buyer, investor, or judicial authority in cases of:
- Sale or merge with a third-party
- Internal sale
- Dissolution, either marital or corporate
- Damages and other disputed matters
Tax valuation: reporting
value to a tax authority in cases of:
- Charitable contributions
- Transfers to related parties
- Estate tax
- Grants and options
You need to articulate the answer to your chosen appraiser
in order to determine the standard of value to be used, the approach (or
approaches) to take, and the methods to be used. Incorrect assumptions regarding
your purpose will yield an incorrect valuation result.
Any time you plan on making a business decision relating to
the value of one of your largest assets, you should seek the assistance of a
professional business appraiser (see the sidebar on page 27 for tips on doing
so). When selecting an appraiser, ensure they have a thorough understanding of
the financial services industry and that they have access to industry-specific,
private-party transaction data. Most important, the appraiser needs to have a
thorough understanding of your purpose and who will be on the receiving end of
any value results.
The most common reason to value a practice is for mergers
and acquisitions. The next most common reasons are divorces, internal sale of
stock, and gifting/transfers to related parties. Depending on which purpose is
applicable to your specific needs, the resulting value may vary significantly.
The reason for the differences in value results from:
The type of property being valued. Is
it assets or stock?
The standard of value. Value to whom
and under what assumptions?
Is the valued interest a controlling
share or not?
What is the level of marketability of
the subject interest? Is it liquid?
For example, the most probable selling price of a 100
percent controlling interest of the assets of a practice being valued for the
purpose of selling to a third-party in an arm’s length transaction, where the
majority of the purchase price is financed over five or more years, will be
valued higher than the fair market value of a 10 percent minority,
non-controlling, non-marketable interest in the equity of the same practice on a
cash or cash equivalent basis for the purpose of gifting stock. The delta
between these values is much greater than a pro rata portion of the 100 percent
interest. To clarify why, let’s explore how standards of value affect the value
of your practice.
Although many standards of value are applicable to the
appraisal of a business interest, the two most common standards in the financial
services industry are fair market value and most probable selling price.
Fair market value. Fair
market value is required when valuing shares and equity of a closely held
practice for IRS/tax-related matters. The IRS wants to know what the cash value
of the shares or units are worth. Often, financial advisers assume that a 10
percent interest in their company’s equity on a cash basis is worth a pro rata
portion of what they could sell their practice for in the open market. Rarely is
this the case. (Fair market value is also applicable when opining on the equity
value of a business interest for a divorce, but this varies per
The term “fair market value” is one of the most commonly
misunderstood and inaccurately used valuation terms. Of the last 5,000 practices
we have appraised, valued, or offered opinions on, fair market value has almost
never been an applicable standard of value for the purpose of valuing a practice
when selling to a third-party in an arm’s length transaction; especially when
the seller is providing post-closing consulting, an agreement to not compete,
and is willing to finance the majority of the purchase price.
The definition of fair market value according to the International Glossary of Business Valuation Terms
is: “The price, expressed in terms of cash equivalents, at which property would
change hands between a hypothetical willing and able buyer and a hypothetical
willing and able seller, acting at arm’s length in an open and unrestricted
market, when neither is under compulsion to buy or sell and when both have
reasonable knowledge of the relevant facts.” This definition is nearly identical
to the one found in IRS Revenue Ruling 59-60.
The often overlooked, but key issue is that fair market
value is considered “value in exchange” on a cash or cash equivalent basis. In
other words, transferable property is sold in exchange for something of value,
namely cash. This is logically inconsistent with how a typical financial
advisory practice is bought and sold: less than 5 percent of all sales are
completed on a cash basis, and the industry standard pricing multiples assign a
value attributable to non-transferable property such as (1) the seller’s
agreement to provide post-closing consulting to help transfer the assets (a
consulting agreement); and (2) an agreement to not compete or solicit the
clients subject to the purchase agreement. These are services that only the
seller can perform; they are not “transferable property.” By ignoring these
facts, a statement of fair market value could be inaccurate by as much as 15 to
25 percent which—as you can imagine—is an issue when the opinion of value is
used for tax, divorce-related, or disputed matters.
It is worth noting that this standard of value is more of an
academic standard than the reality of what an adviser could expect if he or she
actually sold their practice to a third party. Most buyers and sellers who
participate in an open marketplace are under some level of compulsion to buy or
sell. If compulsion were not present, it stands to reason that a seller would
never accept anything less than absolutely favorable deal terms at the highest
value from his or her point of view. The inverse of this argument is applicable
to buyers as well.
Most probable selling
price. This standard of value best describes the value that a seller
could expect to receive if he or she sold their practice to a third party in the
financial services industry. It is defined by the International Business Brokers
Association (IBBA.org) as: “The price for the assets intended for sale which
represents the total consideration most likely to be established between a buyer
and seller considering compulsion on the part of either buyer or seller, and
potential financial, strategic, or non-financial benefits to the seller and
The most probable selling price reflects the reality of the
marketplace. For the sale of financial service practices, this standard of value
assumes the sale, transfer, or acquisition is accomplished using a standard tax
allocation strategy for the sale of capital and personal assets, resulting in
the majority of the value ultimately being realized at long-term capital gains
tax rates (presuming an adequate holding period for the capital assets). This
value further assumes a 100 percent transfer of ownership interest in the
customer list and files, personal and enterprise goodwill, consulting agreements
with the seller(s), and a non-competition and/or non-solicitation agreement(s)
from the seller(s). The majority of the purchase price is expected to be seller
financed over a four- to six-year period at interest rates that are
substantially lower than what third-party lenders would require.
Both fair market value and the most probable selling price
can be determined using either the income or market approach (see below), and a
professional business appraiser should be able to produce similar estimates of
value using either. The key to successfully determining value from each approach
is understanding the standard of value inherently produced by each approach and
the necessary adjustments required based on the standard of value for the given
An income approach, for example, is going to produce a value
consistent with fair market value. If this approach is used for the purpose of
valuing a practice that is going to be sold to a third party in an arm’s length
transaction—especially when seller financing is involved— adjustments need to be
included to account for the cost of seller financing and any additional services
or agreements a seller is willing to provide post-closing, such as a consulting
agreement, a non-compete/non-solicitation agreement, etc.
A market approach, relying on the use of private company
transactions in the financial services industry, will most often produce a value
consistent with the most probable selling price (depending on the source of the
data). Using this approach for an opinion of fair market value requires an
analysis of the deal structure of the transactions.
The appraisal discipline has three generally accepted
approaches to value: asset, income, and market approaches. These approaches are
broad categories for various ways to value a business. Under each of these
approaches are commonly used and accepted methods of valuation. Without an
understanding of the purpose for the valuation or the appropriate standard of
value, the correct application of these approaches is limited to a best
Of the three valuation approaches, the easiest to understand
and the most commonly used is the market approach. The asset approach is rarely
used in our industry due to the lack of physical capital assets needed to
produce revenue. The income approach is the most complex approach to value a
closely held practice.
Market approach methods.
The market approach has three common methods: (1) Guideline Public Company
Method (GPCM); (2) the Public Company Transaction Method (PCTM); and (3) the
Guideline Private Company Transaction Method (GPCTM).
GPCM and PCTM are often used to value financial service
practices by appraisers who do not have access to comparable private company
transaction data. These methods compare the practice being valued to the
enterprise value of public companies in the same industry, but with market
capitalization rates 20 to 40 times the size of the typical practice. In other
words, these methods rely on the possibility that closely held financial service
practices will sell for a price similar to that of a publicly traded
Alternatively, GPCTM develops a value based on a group of
five or more transactions of closely held practices that sold in a free and open
market. The results from this method are grounded to previous transactions of
similar companies and arguably provide the most reliable estimates of value for
most practices in the industry. Unfortunately, the usefulness and accuracy of
the GPCTM approach is limited to the number of transactions and quality of the
information available to the appraiser.
Transaction data on financial service practices is often not
readily available through industry databases such as the Institute of Business
Appraisers, Bizcomps, Pratt’s Stats, and PeerComps. Moreover, available
information is typically limited to one year of financial statements that may be
much older than the actual transaction date. The best source of data when using
the GPCTM for valuing a financial services practice can be firms that provide
certified valuations, business brokerage, and consulting services.
Income approach methods.
The income approach is a suitable approach for allowing the appraiser to
forecast income and expenses, and project the future economic benefits that will
flow to the owner(s). The two methods that fall under the income approach are
stylistically similar, but contain underlying assumptions that make them
The first method, capitalization of earnings method, makes
the assumption that growth of the practice or business will be uniform into
perpetuity. This assumption manifests itself through one long-term sustainable
growth rate that is used to capitalize a benefit stream, typically net cash flow
to invested capital.
The second method, the discounted cash flow method, is based
on the concept that the growth of the company will vary for a determined
forecast period, typically five to 10 years. When performed correctly, this
method forecasts the practice’s revenues, expenses, capital expenditures, and
working capital requirement of the business until it reaches maturity. These
forecasts are then discounted to their present value.
It is important to understand that the value produced using
either method from the income approach will produce a cash or cash equivalent
value consistent with the definition of fair market value. This can be observed
by analyzing the sources from which the discount rates are developed—publicly
traded C-Corporations. When was the last time you saw a market cap rate quoted
at a price other than cash? When was the last time you purchased stock of a
publicly traded company and the quote included anything about how you might
finance the purchase?
If the source of the discount rate is derived from
transactions of minority shares in a freely traded marketplace, then the value
calculated from this apporach will represent a marketable, liquid interest. The
very nature of a closely held company is a marketable, illiquid interest, and,
therefore, is less valuable than a marketable liquid interest. As such, an
additional discount to reflect the decreased liquidity of a closely held company
should be applied when an income approach is used. This is common practice among
business appraisers who are familiar with the use of the income approach.
However, it is often skipped in models developed by those who do not specialize
in the appraisal profession. Omitting this step means value may be overstated by
as much as 25 percent. Appraisal pundits Shannon Pratt, Gary Trugman, Jeffrey
Jones, and Rand Curtiss, all accredited by the American Society of Appraisers
and the Institute of Business Appraisers, reached this conclusion in a
conference sponsored by Business Valuation Resources.1
No single valuation approach and method works every time in
every situation. If you’re told otherwise, it is usually by someone selling the
one approach that they understand and that can be sold profitably. For this
reason and others shared in this article, it is highly recommended that advisers
wishing to sell their practices seek the professional assistance of a business
appraiser or certified valuator who can employ the appropriate approaches and
methods that tie value directly to the adviser’s purpose. This step is where the
appraiser can help the adviser save money by accurately identifying the
necessary scope of work to provide a defensible value.
Opining on the value of a financial services practice is
contingent on the appraiser and on the adviser seeking to understand how the
concepts of purpose, standard, approach, and method fit together to provide an
accurate view of their practice’s value for a specific situation.
Finding an Appraiser