When Matthew Scholten began working as an adviser in 1996 with Godfrey Pembroke Doncaster, he had a desk but no clients. He spent the next six years building his client base and assisting the then practice principal, Neil McKissock, with paraplanning. By October 2002, the pair had built up such a close relationship that they were regarded as a team. But McKissock was in succession planning mode. He shrugged off several external offers to take over the business, allowing Scholten to buy his client base. In essence, it was a merging of the two businesses.
"Since that time the combined business has more than doubled in size," says Scholten, 40, "and Neil who is 63 still works four days a week. "I am on to the next stage in the succession plan and am about to sell 25 per cent to another adviser, Trent Collins, who is 31, and has been with us for four years. Trent purchased 5 per cent a while ago and is purchasing another 25 per cent so he will have 30 per cent and I will have 70 per cent." Scholten paid McKissock up front in a deal - financed 100 per cent through National Australia Bank - that valued the business as a multiple of recurring income. He paid a multiple in excess of three times the recurring income. "I paid a fair price. If you looked at it on an EBIT [earnings before interest and taxation] basis, it was reasonably attractive from my perspective," he says.
"Trent and I are doing our transaction based on an EBIT multiple." With 54 the average age of advisers in the industry and business owners closer to 60, Stephen Prendeville, director of Kenyon Prendeville, says succession planning is probably the biggest issue facing the industry. He reels off Business Health figures suggesting one in two business owners will seek to realise their business in the next three to five years. With 5500 practices in Australia, that means 2750 could suddenly come to market. Of that 2750, up to 50 per cent are likely to want to succeed their business, but, he adds, few have a succession plan in place.
"Proprietors expect current staff to want to buy the business, but the reality can be different," Prendeville says. "I have seen few succession success stories in our industry for a number of reasons.'' "First, the average price of a financial planning business is $1.2 million. Often the successor has small kids and a large mortgage and doesn't want to put their house in play to secure finance.''
"Second, securing finance is problematic. Banks will cash-flow lend up to 2.5 times the recurring revenue of the business, so if the business is valued at 3.3 to 3.5 times recurring revenue, the average recurring revenue of an Australian financial planning business is about $400,000. If you take it as 3.3 times recurring revenue, the value of the business is $1.32 million. You either put times factor to recurring revenue or times profit. There is a gap. If the bank only lends 2.5 times recurring revenue and the business is valued at 3.3 times then that gap requires other assets, which is normally the house." The third reason is the actual valuation. Recurring revenue is used for a trade sale, but EBIT, the normal valuation mechanism, is six to eight times the recurring revenue, director Alan Kenyon says.
"As a partner, you are focused on your dividend so that is why the profit methodology of EBIT is used," Kenyon says. "But because the average financial planning business operates at 20 per cent EBIT to gross revenue that can represent a substantial discount to recurring revenue for a trade sale." For Kenyon Prendeville, less than 10 per cent of its sales are based on EBIT while most are trade sales based on recurring revenue. Prendeville recommends that when advisers are looking at a succession strategy they prepare a five-year cash flow. "You have to look at how you will grow the business and that can mean investment into additional resources," he says. Kenyon says many people give employees a shareholding now as part of retention. But that can be fraught with danger. He cites a case in Brisbane where 10 per cent of the business was gifted to a senior adviser. Three years later, the senior adviser went to the United Kingdom with his wife and the business owner had to buy back the 10 per cent at $400,000. "Life has a way of really ruining plans and this is why you have to have multiple plans and well-thought-out strategies," Kenyon says. "As a retention strategy, giving people a share doesn't always work out. Equity is an intangible asset to many and not valued or sought after. It depends on the financial strength of the business.
"What we are saying is if they wish to sell or succeed their business, they should be operating their EBIT level at 35 per cent or more to gross revenue to provide themselves with multiple options. They need to be running their business as if they're selling it next year. It is normally the biggest asset anyone has, greater than their property, and they should be investing in that business to ensure it is continually growing. Too many people get into a happy comfort zone while the top and bottom line is flatlining or going along with market average growth." Prendeville says with trade sale, you can still look after staff and the senior adviser can still buy in 10 per cent or 20 per cent. True succession is when someone fresh comes into the business, bringing a new level of expertise and making the business more valuable, according to Strategic Consulting and Training principal Jim Stackpool.
However, people are calling succession a client base sale and purchase. "That is a different piece," Stackpool says. "Does the seller have a horizon longer than five years? Generally, they don't. They are making great money at the moment. In fact, they are overpaid at the moment. They see the writing on the wall in the future. They are thinking how long can we keep earning these trails? So they want out." He believes in future there will be less one or two-person operations that just do super and risk as practices will not be earning today's margins. They will have to diversify to earn similar profits. "We have just had the absolute best of times the past four or five years in this industry," Stackpool says.
"They are drunk with success. But they don't see the changes coming. They are flat out and tired working on the activity they have at the moment. They are looking for better incremental improvements, such as improved software, but are not looking at significant change." Business Health research reveals nine out of 10 financial planning businesses in Australia have no effective succession planning in place. "This is an amazing statistic that hasn't changed for years," Business Health principal Terry Bell says. Bell says those who have an effective succession plan, that is, written, up to date, covers all contingencies with the riqht successor identified and funding arrangements in place, is less than 5 per cent. About 70 per cent have nothing in place. For the 5 per cent who have a plan, the average profit for each principal is $447,197. For the 70 per cent who don't, the average profit is $123,367. "Those who are thinking about it and doing something and putting in better processes in place are reaping rewards immediately," Bell says. Ipac head of adviser solutions John Saint says many don't have a plan in place because they haven't thought it through, they have put it off, they believe they will find a buyer when the time comes or they may be 45 and believe it is too early to worry about it. In building a succession plan, you have to look after the clients and staff also need to be considered. "A financial planning relationship is a 20-year relationship," Saint says.
"Someone who comes in at age 45 or 50 will live to age 70 or more and the financial adviser who is likely to be older is not going to be there and deliver through to the end of the journey for that client. It is remiss of them to be making promises unconsciously or consciously that they are not going to be able to fulfil, so they need to put in a succession plan. "Staff need to know they will be looked after as well and shareholders want to get the best price. But it is not always about price; it is about who you deal with." At MLC, where eight staff are focused purely on succession, Bob Neill, MLC's succession and acquisition services manager, believes the ideal time frame for succession planning is five years out.
"You can become a deal-maker by constructing a deal to best suit your circumstances," Neill says. "As the time frame shortens, you become a deal-taker. According to Neill, the buyer has to understand the business and its value. "They need a funding solution in place, so there needs to be a fair bit of work done with those successors. In an ideal world, as the principal is easing down over time, their level of activity eases while the successor is stepping up so they get a smooth transaction," he says. "The first key position point is when they sell any equity at all, the dynamics change. The next critical point is when they move from the position of control to a minority holder or they exit."
Part of MLC's education ensures they are equipped financially and emotionally. It recommends in some instances that they move from control to exiting, or at least have that as an option as they may not be comfortable in a minority shareholder position. Axa has also launched several succession initiatives, including Grow, an integrated solution to help advice businesses acquire, merge or sell. Since its launch 18 months ago, 29 deals have been done, Grow national manager Steve Davison says. "Succession is a massive destruction for a practice and can take the principal's eye off the ball for between three and nine months. If they are trying to deal with it by themselves, it's a significant distraction and can hurt profitability. Grow is about putting appropriate resources behind the business to make sure it is successful," Davison says.
He suspects there are transactions that have paid above the odds, making it difficult for some acquirers to gain a return on their investment. On the other hand, he has witnessed good deals done to high multiples that will be sustainable because the buyer knows how to extract value out of the business. MLC believes that in the next three to five years there will be a significant shift to multiple ownership/shareholdings largely because as advice businesses continue to grow and achieve scale, they will embark on a corporatisation process where the value will reside in the business, not in the assets. Principals will also seek to continue the legacy of the business by maintaining the current model rather than folding it into someone else's model; equity will be used as a recruitment, motivation and retention tool for quality employees; and many potential acquirers of businesses or equity will have funding challenges that will require innovative solutions.
"One of the consequences of these changes is that the realisation of value in financial planning businesses will need to be achieved via a staged sell down over a period of time," Neill says. "Transferring tranches of equity to a number of parties at different periods of time and for different dollar amounts requires careful planning and sound strategies. "The old rules of multiples of revenue will become less relevant as we move to equity level. It comes back to far more fundamental valuations: what is the return I am going to generate for the risk I take?"
