When we value an asset management firm, we do so in cash equivalent terms, as if someone were to pay that amount, on a given date, for a given firm or interest therein. On many occasions, clients have asked us how our estimate of value compares with an offer they received for the same firm or an interest in the same firm. It isn’t unusual for the offer to be ostensibly higher than our valuation, but it is unusual for the offer to be made in cash equivalent terms. As a consequence, we often have to look beyond the face value of the offer to determine what the economic value of the offer is, which may be much less than the headline number.
In this final blogpost on evaluating unsolicited offers for your RIA, we take on this issue of valuing an offer. Valuing the offer for your RIA can be more difficult than valuing the firm itself.
Similar Assets, Priced Differently
Sometimes, things which look similar are actually worth very different amounts of money – so one has to be careful making comparisons. The headliner offering at RM Sotheby’s latest auto auction in New York was a 1959 Ferrari 250GT California Spider built in full racing spec for Bob Grossman. The car is, of course, beautiful, but the story behind it is even better. The apogee of sports car racing was the 1950s and early 1960s, when well-healed amateurs could enter major races against established professional teams and often do very well. Bob Grossman was a successful sports car dealer and amateur racer in New York. He ordered the Ferrari pictured above and had it delivered straight to the track to race in the highly competitive 24 hours of Le Mans in 1959. The car had an aluminum alloy body (one of only eight made that way by Ferrari) and a race tuned V-12 with external plugs. Grossman had never driven at Le Mans before, was unfamiliar with the car, and had a co-pilot for the race whom he’d never met and who didn’t speak English. Grossman entered with the 250GT anyway and took third in his class.
The car went on to perform very well in subsequent competitions before Grossman sold it. It doesn’t have leather seats or a radio, but still sold for $18 million. A similar 1961 Ferrari 250GT convertible, freshly restored but lacking racing heritage, was available at the same auction. Despite a pre-auction estimate of less than one-tenth the sale price of the Grossman Ferrari, the ’61 failed to sell. Two very similar cars offered at the same time in the same market; two wildly different valuations.
Comparing Offers for Your RIA
If all RIA offers were all cash, this wouldn’t make much of a blogpost. RIAs rarely sell on simple terms in all cash transactions, however, so converting offer pricing and terms to cash equivalents is critical to determining whether an offer is reasonable or not. Because investment management is often a relationship intensive business, transacting an RIA often involves performance based payments like earn-outs, compensation arrangements tied to client transition, non-compete agreements, and other terms which effect the value of the transaction to the seller. Oftentimes cash consideration may only constitute two-thirds or so of total consideration offered.
A selling client of ours a few years ago was counseled by a friend to assume that the cash he was paid up front would be the only consideration he ever got for his company, and not to take the deal if that wasn’t enough for him. That’s a little extreme, but the maxim that “cash is cash and nothing else is cash” does establish a hierarchy to think about the value of other forms of consideration.
Trading Your Stock…for Stock
Taking stock in another asset management firm in exchange for some of all of your shares isn’t necessarily a bad idea, but it does double the complexity of the transaction. In addition to having to determine an appropriate value for your firm, you have to think about what the buyer’s stock is worth. Sellers can take this issue for granted, but it has a huge impact on the value transacted.
Think, for example, about the relative merits of two shares of stock. If the selling firm’s stock is valued at 8x earnings, and the acquirer values their own stock at 10x earnings, then essentially for every dollar of earnings being given up by the seller, it now has a claim on 80 cents. There may be reasons why the acquiring firm’s stock is worth more – higher quality earnings, lower risk profile, better growth opportunities, etc. The trouble for most sellers, though, is that they understand the potential upsides and downsides of their own company, while having much less visibility into the relative merits of the acquirer’s stock.
Does a stock for stock transaction involve giving up control of the selling company and taking an illiquid, minority position in the acquiring company? What is the dividend policy of the buyer versus that of the seller? Is the acquiring company a C corporation and how does that affect shareholder returns if the seller is a tax pass through entity like an S corporation or an LLC?
Rolling your interest into the stock of your acquirer may be a good way to stay in the game. The question becomes: whose game is it?
Is Selling Your Firm Just an Advance on Your Salary?
One thing that is very likely to change when you sell your investment management firm is your compensation package. This is probably something you want to happen – within limits. If you’re currently taking out, say, $1 million per year in total compensation and you could be replaced (at least in theory) for half of that, then your earnings are understated by $500 thousand. At a multiple of 8x, that’s a difference in value of $4 million. You would probably rather pay capital gains tax rates on $4 million today than receive an extra $500 thousand per year, taxed at ordinary income rates, for several years.
That said, if there is no clear correlation between compensation give-ups and the value being received from the transaction, it may start to feel like the buyer is paying you for your stock with your money. In some cases, that may even be true. If post-transaction compensation is set too low, you and your partners may have little incentive to perform after the ink dries on the purchase agreement, which doesn’t lead to good outcomes for anyone.
We usually counsel acquirers to agree to normal compensation levels with their seller as part of transaction negotiations. If you do that, you’re much more likely to have a common understanding of the profitability of your RIA, and, thus, the negotiation is really about the multiple being paid.
Performance Compensation as Risk Sharing
Many larger and more sophisticated acquirers use bonus compensation as a way to manage their risk. The typical arrangement we’ve seen is for acquirers to take something equivalent to a preferred stake in an RIA – taking their pro rata piece of the upside and little, if any, of the downside, or holding a stake in which management gets more benefit from increases in earnings and more detriment from declines in earnings. RIA consolidators seem particularly fond of this arrangement, and while it’s difficult to “value” the offloading of risk from buyer to seller (or continuing minority partner), it isn’t difficult to see who’s getting the better side of the deal.
Earn-out Consideration is Never a Given
Earlier this year we had a whole series of blogposts about earn-out consideration, so I won’t rehash that here (Why Earns-outs Matter, Five Considerations in Structuring Earn-outs, and An Example of Structuring Earn-outs). Suffice it to say that earn-outs are common in RIA transactions and often are necessary to ensure that the value of client relationships and investment products are effectively transferred from seller to buyer. But an earn-out is only worth as much as it is likely to be earned, and this has to do with the target performance and terms associated with the earn-out. The time value of money must also be considered, particularly in earn-out arrangements of three years or more.
One thing to keep in mind, as a seller, is how likely you are to reach the targets set by the earn-out. If the minimum growth target is, say, 15%, and your historical growth is less than that, consider how far markets have run to date and how you expect them to perform over the term of the earn-out. Modest earn-out requirements after a lull in the equity markets are one thing, but robust expectations after a long bull run are quite another. This issue is particularly poignant given where markets stand today.
Don’t Forget to Value the Terms
Non-compete agreements, office buildings, life insurance policies, working capital, contingent liabilities – there are a few dozen other issues that can change the economics of your offer. We can’t cover everything in a blogpost, but I will end with a simple piece of advice that many of these issues should be isolated and dealt with on their own merits – as opposed to being interactive with the operating value of the company. Even if the buyer wants to treat the transaction as an “all-in” or prix fixe price, you should know the breakdown of the offer on an a la carte basis.
It isn’t always easy to determine whether an offer is too good to pass up, or too good to be true. If you’re considering a proposal to buy your investment management firm – especially one that came in over the transom – let us take a look at it. Whether you need a sounding board or an advocate, we can help.