Before parties to an RIA transaction can close, they must first agree on a price. Narrowing that bid/ask spread is tricky, which is often why negotiations between prospective buyers and sellers fail. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. “Long-term client relationships” in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.
Unsurprisingly, these different perspectives on the same firm lead to varying opinions on value, and the gap can be substantial. Bridging that gap is key to getting a deal done. Below, we address five ways buyers and sellers can bridge a valuation gap.
1. Independent Opinion on Value
Obtaining an independent perspective on the value of your firm is a useful exercise to narrow the gap between a buyer or seller’s expectations and the current market pricing for RIAs. An independent valuation expert with experience in the industry brings a broader perspective on how the subject company’s business model, operations, profitability, and growth trajectory stack up to peers, as well as an independent point of view that considers both buyer and seller perspectives in developing a valuation for the business.
In the case of internal transactions, utilizing an independent valuation as the basis for transaction pricing is often the best way to reconcile the differing valuation perspectives of sellers (current management) and buyers (next-gen management). Such a process helps to create buy-in from both sides and facilitates a durable ownership model far better than formula pricing, which is fraught with pitfalls. In the case of an external transaction, setting realistic expectations of current market pricing for your RIA is a critical step in preparing to take your firm to market and evaluate offers from third-party buyers.
2. Quality of Earnings Analysis
Earnings are a crucial reference point in determining transaction prices negotiated by buyers and sellers of RIA firms. However, reported earnings, even when audited and presented in accordance with Generally Accepted Accounting Principles (GAAP), have limitations. GAAP earnings are backward-looking, reflecting how a business has performed under specific rules in the past. While these historical earnings have their uses, buyers in the RIA industry focus more on the future—what’s visible through the windshield, not the rearview mirror.
The objective of a Quality of Earnings (QofE) report is to translate historical financial information into a relevant picture of earnings and cash flows that is useful for developing future projections. This process can improve clarity around expectations for the business’s post-transaction earnings, which can help to narrow the bid/ask spread in a transaction or, at the very least, highlight some of the issues that may be driving the bid/ask spread.
3. Earnout
Earnouts are a common way to bridge a valuation gap. Through an earnout structure, the buyer pays one price at closing and makes additional payments over time contingent on achieving certain performance thresholds. If, for example, a seller thinks a firm is worth $100 and the buyer thinks the firm is worth $70, the deal might be structured such that $70 is paid at closing and an additional $30 is paid over time if certain growth targets are met.
Through an earnout structure, if the seller’s optimistic vision for the future of the firm materializes, the price ultimately paid reflects that. Likewise, if the downside scenario envisioned by the buyer materializes, the hurdles for the earnout payment will likely not be met, and the price will reflect that reality. Rather than hoping they get what they pay for, the buyer pays for what they get. Similarly, sellers are compensated for what the firm actually delivers.
4. Staged Transaction
If an RIA is being sold internally to next-generation management, then selling the firm in multiple stages is one way to help bridge valuation gaps. This is partly because it’s easier to come to an agreement on valuation when the stakes are smaller. But there are also many potentially value-enhancing benefits to internal sales that take time to realize. Through internal transactions, founders get to hand-pick their own successors and incentivize them to grow the firm through equity ownership. The buyers (next-generation management) have a pathway to advance their careers and increase the economic benefit they receive from their efforts.
However, if an internal transaction is done all at once, the owner does not have time to benefit from the growth incentives that management hoped the transaction would provide. By structuring the transaction over time, subsequent transactions will take place at higher valuations that reflect the growth resulting from the alignment of next-gen management’s incentives with existing ownership. As a result, sellers in internal transactions may be willing to come down on price for early transactions to incentivize employees to grow the business, while buyers may be willing to come up in price for the opportunity to become an equity partner in the business and participate in the upside.
Selling an interest over time also lessens the capital requirement for the buyer, which is often a barrier in internal transactions where the buyer may not have the financial resources to purchase a large block of the company at one time.
5. Deal Financing
Beyond the price, how the purchase price is paid can make a significant difference in the perceived economics of the deal. While external buyers generally pay cash or stock at closing (with possible future earnout payments as discussed above), internal transactions are often seller-financed.
We’ve seen a number of internal transactions where an otherwise attractive valuation was offset by payment terms that were extremely favorable to the buyer, such as seller notes with low interest rates and long repayment terms. Similar to earnouts, such favorable payment terms allow the seller to feel like they are getting full value for the business while making the higher purchase price more palatable for the buyer.
About Mercer Capital
We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.
