In our second book, Buying, Selling, and Valuing Financial Practices (the M&A Guide), we introduced the term of a “predatory buyer” to our readers. If you are thinking about selling your practice one day, you need to understand how certain buyers will approach you, how to protect yourself, and what, or who, to watch out for. In this article, we will answer these important questions for potential sellers:
- What exactly is a predatory buyer?
- Where do I look to find a qualified and capable buyer, AND realize the full value of what I’ve built?
- What is the difference between selling value and realized value?
Predatory buyers don’t actually announce themselves. Still, there are telltale signs and, unfortunately, it’s often the outcome of negotiations that signals it was a “predatory” deal. In this case, the term applies to a group of well-funded and capable acquirers who buy everything and anything within a single independent broker-dealer (IBD) or custodian but do so with complete disregard for market value or professional deal terms. Such buyers typically acquire smaller books at the rate of one or two per year. These buyers are skilled at getting what they want. Indicators include proposing pure split revenue buyout offers, using rules of thumb based on multiples of revenue or earnings, discouraging a valuation of the practice (“it’s really just not necessary”), and creating deal terms that create a “heads I win, tails you lose” sale.
The unfortunate aspect here is that these buyers often have the IBD’s or custodian’s blessing because their approach can keep clients and assets in the network. Regardless of the monetary loss to an exiting or retiring advisor, a managing network rep has the overriding primary goal to maintain and build assets in the network. A smaller book owner is most at risk because on the surface it appears that there are fewer options for him/her. However, this is only because the owner doesn’t know the full range of options available. A third-party valuation or arms-length advice seems unnecessary when the underlying IBD/Custodian can opine on all these. And that is the problem.
As a seller, you should understand that when it comes to selling, retiring, and realizing value built, your interests may no longer match up with your BD or Custodian – no matter the strength of your relationship up to this point. What might look like a fortuitous introduction to a potential buyer may in fact be the opener to a predatory sale.
Locating a qualified and capable buyer requires understanding the selling venues. As we’ve said, a book owner will often believe there are limited options and be drawn to a buyer inquiry that at first seems simple and straightforward. However, this is often due to unfamiliarilty with where to search for a qualified buyer. Understanding that your selling venue may affect value and payment terms is the first step in crafting the best environment for a sale. The best suited venue will yield a higher number of qualified buyers.
To begin with, understand that your regulatory structure will likely shape the acquisition process as well as the marketplace. In other words, a fee-only seller will likely start a buyer search within their current custodial network, even though RIA’s/IAR’s can work with more than one custodian. A fee-based, FINRA-regulated seller with an independent broker-dealer might tend to look for a buyer within the same IBD network. Being independent means having lots of choices and flexibility, at least theoretically. As a matter of practicality, however, these choices usually center on one of the following four selling venues.
An open market sale has the greatest flexibility. It is defined as an unrestricted sale of a book or practice, at the owner’s discretion, either within the same IBD/custodian or outside of the seller’s broker-dealer/custodial network. This venue provides a very competitive marketing opportunity for you to find the best strategic or economic buyer offering best value on the best terms. It is effectively a nationwide search for the best-qualified buyer. The current buyer-to-seller ratio for an open market listing is 50:1, and while specific ratios vary, higher ratios allow the greatest opportunity for a well-structured sale. An open market search is typically your best strategy to avoid falling prey to a predatory buyer.
A closed market sale is one in which a book, practice, or business is offered only to certain buyers because of some limitation imposed by a third-party, such as a contractual agreement with a broker-dealer, or simply because that is the seller’s preference. Typically, all the potential buyers are with the same IBD or custodian which ultimately means less competition and, at least conceptually, an easier and faster transition in terms of buyer selection, documentation, and client/asset transfers. However, understand that this venue can also result in a lower price on less favorable terms when compared to the competitive open market process; it really depends on how well the negotiations are run and who is running it.
Handled professionally, there is nothing wrong about selling within a closed market venue. The problem is, not all closed-market venues are handled professionally or have sufficient scale to do the job right. The reality of many closed market and bulletin board systems is that this is where a predatory buyer can originate.
A bulletin board – as the name implies - is an on-line meeting place that typically provides few, if any, other benefits aside from accessibility. They neither offer nor require a formal valuation (other than a free, on-line system using a proprietary formula with no supporting database), and they provide no documentation or qualified authority other than a list of third-party providers you can hire on your own. The goal here is to simply expose prospective sellers to prospective buyers, which is certainly important and relevant, but does not account for other pain-points of the process.
While many IBDs and custodians operate their own bulletin board systems, there are quite a few without affiliation. Bulletin boards tend to list everything and anything. Most allow both buyers and sellers to list or peruse for free without any screening, so neither side is guaranteed to be qualified, properly valued, or even serious. Prospective sellers are the bait and they tend to attract a lot of hopeful buyers who will pay for your contact information. For the most part thus far, no harm, no foul. But be aware that some bulletin-boards are run and organized by recruiters and predatory buyers themselves. Equally important, confidentiality in this selling venue tends to be a low priority.
An odd aspect of a closed market selling or bulletin board site is that many buyers here feel they are entitled to special, lower pricing because it appears that an advisor needs to sell and is therefore at the mercy of the market. The thinking is that the prospective buyer is doing the seller a favor by stepping in and helping out with a quick and easy sale – whatever the terms may be. Once the conversation gets started, it can be quite difficult for the selling advisor to exit, especially when engaged with a more experienced buyer.
A private transaction is the situation where a seller decides to sell to a consolidator (regional or national), a friend or an associate, or perhaps an experienced or interested buyer introduced by their IBD’s or custodian’s practice management team. It may also be the result of answering one of those acquisition-oriented letters many advisors receive in the mail a couple of times a year. At FP we often help orchestrate the paperwork and final negotiations for such transactions. However, it sometimes comes to light that the original negotiations were rather one-sided. In one way, a private transaction represents a hand-picked, ideal buyer. On the other hand, since the seller didn’t start with multiple buyers in order to select the best option, he/she is starting with a 1:1 buyer to seller ratio. The challenge here is for a first-time seller to realize full value on competitive terms without the benefit of multiple parties indicating interest.
In most cases where there is some manner of closed market or bulletin board style acquisition, the buyer or IBD rep will often have a short, easy agreement for the seller to sign. Be extremely vigilant in these cases. These agreements are often nothing more than a revenue sharing agreement and apply only to client revenue that transfers. Without delving into a tax seminar, this almost always translates to ordinary income to the seller. This is less than ideal for a seller. Instead, craft an agreement that allows the seller to enjoy capital gains treatment at a lower tax rate, and offers some kind of long-term protection on client retention.
Understand the difference between selling value and realized value. By the time you arrive at the negotiation stage, you have, in theory, sifted through at least a short list of prospective buyers. This allows you to determine whether the purchaser is a good match, or whether certain buyers are simply looking to cherry pick the best “A” clients and drop the others. Most importantly, you will know whether the buyer is willing to engage in a meaningful give-and-take during negotiations. As a seller, when you enter a deal with only a single buyer through a private transaction or closed market selling venue, you cede all these options. Instead, the sale becomes more about “getting it finished” than it does about “is this the best avenue for me?” By the time contracts (or short forms) are dotted and signed, the final value can be significantly less than the opening offer. At FP, our data indicates that the final realized value delivered on limited venue sales, using the current selling and payment methods, is very low (.60 to .70).
Selling advisors tend to choose just one selling venue until they are successful, or until the possibilities have been exhausted. The problem isn’t that prospective sellers in this industry need more than one venue to achieve success. The problem is that too many sellers accept an overture from someone in the industry without the proper framework to craft a fair sale. Speed, efficiency, and confidentiality are all important issues; however, sellers should also ask whether a selling venue can deliver on these issues without an agenda of their own.
In short, be cautious when approached by a buyer in some of these circumstances. That buyer might just be one who is trying for any deal he or she can sniff out in hopes of landing an advantageous sale …. at your expense.