This is the second post in our two part series exploring the economic considerations of an advisor contemplating starting an independent RIA firm. The pending implementation of the Department of Labor’s (DOL) new “fiduciary rule” is pushing many advisors to consider transitioning to a fee-only advisory business model. A fee-only model can more easily allow an advisor to utilize the “Level Fee Exemption” rather than needing to implement the more substantial “Best Interest Contract Exemption” often referred to as the “BICE.” In addition, moving to such a business model can also allow an advisor to greatly enhance the value of his or her business given that commission-focused advisor practices tend to sell for much lower valuation multiples than fee-based advisory businesses.
How Wealth Management Firms are Valued by Potential Buyers
How wealth management businesses are valued is no different than how small businesses in any industry are traditionally valued. Generally, a potential buyer is more willing to pay a premium to acquire a business when these characteristics are present:
- Contracted, recurring revenue rather than one-time, product-driven revenue
- Clients can easily be transitioned to the acquirer
- Low client concentration with no client being a significant percentage of revenue
- High profitability margins
- An expanding market with long-term revenue growth potential
Advisors in general, regardless of their current affiliation, are fortunate to benefit from attractive profit margins and a demand for investment advice that continues to grow. While transitioning to the independent RIA model is unlikely to have much impact on an advisor’s current client concentration, such a transition can allow an advisor to:
- Shift from a one-time, commission revenue model to a recurring, fee-based revenue model
- Establish a separate, registered entity that is much easier logistically for a potential buyer to acquire
Furthermore, by transitioning to a new business entity that is fully owned by the principal or group of principals, this may create an opportunity for the owners of the RIA to realize capital gains tax treatment rather than ordinary income tax treatment upon the future sale of the business. This opportunity alone can create significant after-tax value. As such, we strongly advise all advisors to always seek proper tax and accounting guidance when first establishing an independent RIA firm.
Value Creation When Transitioning to the Independent RIA Model
To quantify the value creation an advisor could experience when transitioning to an RIA, it is important to note that in general, the majority of RIA firms, or any other wealth management book of business, will traditionally be valued as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA serves as a benchmark for a business’s level of profitability. While revenue matters, two firms with $100 million of assets under management each generating $1 million in annual revenue may be worth vastly different values depending on the level of profitability.
Transitioning to the RIA model allows an advisor to fully manage his or her firm’s profit and loss statement and determine how to best optimize for growth and profitability. As depicted in the transition scenarios found in part one of our two part blog post, transitioning to an RIA model can allow an advisor to immediately improve profitability. Assuming a state-registered RIA firm with $100 million or less in AUM may be valued at around a four times (4x) EBITDA valuation multiple, a $75k increase in annual profitability as depicted in scenario 2 can lead to a $300k increase in total firm enterprise value. Thus, not only can an advisor generate increased profits whole operating the RIA firm, but the advisor can also receive a much higher valuation when looking to one day sell the firm.
Value Creation When Transitioning from Commission to Advisory Fee Revenue
The ultimate enterprise value creation opportunity for an advisor is to use the transition to the RIA model as an opportunity to fully transition his or her business from a commission to fee model. Commission-focused advisor practices tend to sell for much lower valuation multiples compared to fee-based advisory businesses. At times, commission-driven practices may only sell for two times (2x) EBITDA valuation multiples compared to 4x EBITDA multiples for fee-based practices. The reason for such a sharp valuation discount is that commissions are much more difficult to predict in the future due to their infrequency and lack of contracted, recurring revenue. In addition, the pending implementation of the DOL fiduciary rule is creating a regulatory overhang further reducing the value of commission-based revenue given the future uncertainty of the business model.
To quantify this a bit further, consider an advisor affiliated with an independent broker dealer today that does around $400k in annual production split evenly between commissions ($200k) and advisory fees ($200k). Today, the practice may be valued as such:
However, if the advisor was to transition the $200k of commission production to instead $200k of advisory fee revenue, the practice may instead be valued at a significant premium as depicted here:
Thus, an advisor with $400k of annual production split evenly between commissions and advisory fees that transitions to a 100% fee-based advisory practice may be able to generate $160k (or +33.3%) in increased enterprise value. Furthermore, if the advisor affiliated with an independent broker dealer transitions those fee-based advisory assets to his or her own independent RIA and further improves overall profitability levels, dramatic enhancements in after-tax enterprise value creation can be achieved. It’s also important to note that some larger fee-only RIA firms with $500 million or more in assets under management (AUM) can often sell for much higher EBITDA multiples ranging from 6 to 12x EBITDA.