My family and I had just finished having lunch with friends in a small town in France when an older, distinguished looking Italian pulled up to the valet in his perfect Porsche 356 convertible. Our friends’ six year old son, Tom, who has been a precocious car guy since he could make the sound vroom, yelled over to the man: “I love your car!”
“And I love you!” replied the Italian, with a cinematic accent. “Would you like to sit in my car?” Tom clambered into the driver’s seat, studying the dash like he was considering an offer price. The Italian continued: “Put your hands on the steering wheel. Do you have a girlfriend?”
“Yes,” replied Tom. “Zoe.”
The Italian looked at Tom approvingly. “Imagine that you are driving this car with Zoe, and you are in love…” A giant grin opened across Tom’s face. It was a good day.
Your Firm Planned Ahead, But Then Plans Changed
When you’re young, the future looks bright and comprehensible. Once time brings reality into the equation, it’s easy to look back at youthful myopia and want to trade a little experience for the “good old days.” Wisdom never comes cheap.
The future looks similarly straightforward to partners in young firms as well. Sometimes the agreements partners enter into at the genesis of their firm don’t serve them well as the firm matures. We have found this to be the case, repeatedly, with buy-sell agreements, and believe that the Tax Cuts and Jobs Act (TCJA) has rendered most shareholder agreements obsolete.
You probably don’t remember signing it, much less reading it, but your buy-sell agreement is there, ostensibly, to protect your investment management firm, you, and your partners from disagreements over how to transact as owners inevitably come and go (voluntarily or not). Shareholder agreements are a big issue for most closely held businesses, but particularly for RIAs, because 1) investment management firms are often very valuable and 2) their ownership is usually made up of individuals who are otherwise unrelated (not family businesses). The topic is so significant for asset managers that we made it the subject of a whitepaper.
The problem for most RIAs is that shareholder agreements do not have a perpetual shelf life. Firms grow, ownership structures become more complex, and needs change. Sometimes the basic economics of the firm change as a consequence of outside forces. Outdated buy-sell agreements are toxic, and – because of the recent tax bill – there are more outdated agreements today than there were a few months ago.
The Only Two Certainties in Life…
Death and taxes may be inevitable, but we can neither predict the timing of the former, nor the magnitude of the latter. The TCJA has really shaken up the underlying economics of investment management firms and, with that, the value of those firms. As a consequence, many owners of RIAs have inaccurate ideas of what their firms are worth, and, worse than that, they have outmoded shareholder agreements suggesting the willingness to transact at inaccurate valuations.
We aren’t aware of any formal surveys of the matter, but suspect most shareholder agreements rely on some type of formula to derive buy-sell values (i.e. RIA partners agree to transact at X% of AUM or Y times revenue or Z times EBITDA). The beauty of formula agreements is simplicity: base the agreement on a simple performance metric and it’s difficult to dispute the result. The drawbacks to formula agreements are legion, however. If partners agree to transact at 2% of assets under management, it’s probably because they had some expectation of how profitable the business would be, such that 2% of AUM was reasonable. Reality usually doesn’t match expectations, however, and a transaction at 2% of AUM that is fair with profit margins at 25% isn’t fair when profit margins are twice that (or half).
Most buy-sell agreement formulas are based on so-called rules of thumb, which are inherently problematic under the best of circumstances. Given the TCJA, many RIA rules of thumb will need revision, because most are based on pre-tax performance metrics, which are now subject to lower taxes. Prior to the TCJA, a 30% EBITDA margin might equate to, say, a 15% after-tax margin for a C corporation in a high tax state like New York or California. Post-TCJA, that same EBITDA margin could yield a 20% after-tax margin. If the firm is worth 10x net income, the tax structure that equated to a multiple of 5x EBITDA before the tax act would equate to about 7x EBITDA afterword. This isn’t to say any particular percentage increase in value is appropriate in all circumstances, but more after-tax cash flow will usually drive more value.
Rules of thumb have always had severe limitations, but with the change in tax rates, the advent of the Qualified Business Income deduction for smaller firms, a change in the market multiples for public companies, and the potential impact on sector M&A, relying on anachronistic shorthand valuation metrics has become even more risky.
Instead of Revising Your Buy-Sell Formula, Discard It
The advent of the tax bill highlights the major fallacy of relying on formula prices to value investment management firms: what’s true about value today will remain true forever. Your formula agreement is probably out of date; the question is: what do you do about it?
We have advocated process buy-sell agreements for years at Mercer Capital. A process agreement is simply a set of expectations for a qualified, independent valuation professional to conduct a regular analysis of the firm to set the value for purposes of the buy-sell agreement. Most of our investment management firm clients who do this have us perform the analysis annually, although the frequency of analysis can vary depending on the needs of the firm.
The downside to process agreements includes the cost of conducting the valuation analysis, both in dollars and time. The offsetting reason to commit to a regular valuation procedure is developing realistic expectations about the value of your firm, and having a thoughtful analysis that is understood, reasonable, and reliable. If having partners with an informed understanding of the value of your RIA sounds valuable to you, then you can see why firms commit to process agreements for their buy-sell.
Don’t Be Afraid to Look
If you were putting off reviewing your aging buy-sell agreement before the TCJA, you can’t excuse waiting to review it now. If you have a process agreement, then your valuation may have a few new wrinkles this year that you’ll want to study and understand. If you have a formula agreement, you probably don’t know what your firm is really worth, and you need to find out.
So pull your shareholder agreement out and think about whether or not it still works for your firm today. No matter how straightforward you thought the future would be, life isn’t all girlfriends and convertibles. Fortunately, some of it is.