Listen & Subscribe On Your Favorite Podcast App
Why Building A Bigger Firm Drives Economic Value
Have you ever wondered whether a larger firm equates to larger profits and value? In some cases, larger firms end up creating more hassle for the business owner. However, if a firm owner can focus on three key ways to scale efficiently, they’ll be able to increase revenue and the value they’re able to provide for their clients. These three key points are:
- Cash flow
- Succession planning
Ready? Let’s dive in.
Specialization, also called division of labor, is one of the key economic innovations in human history. What I mean by that is each person does whatever he or she is best at, and then provides that good or service to other people who do whatever it is that they are best at for the good of the community.
Being a jack of all trades but a master of none is stressful for a business owner. You want to do right by your clients, but without specialized services, you’re always going to come up short. Unfortunately, in order to truly specialize and serve your clients well, you’d have to be a superhuman.
Being pulled in ten different directions when it comes to estate planning, tax efficiency in retirement, investing, and all of the other ways you serve your financial planning clients is exhausting. No one person can be an expert in everything their client needs. To some extent, outsourcing or having strategic partners can help solve this problem. However, eventually these solutions also come up short.
You want to be able to serve your clients well and keep revenue in-house. The only way to do this is to scale to a larger firm where multiple employees can have unique specializations and all serve the same sets of clients. Eventually, even having people who duplicate key areas of specialization is critical to growth.
That way, if someone is out sick or on vacation, you’re not left wondering how to perform an action for a client because they are the only one who can help. Additionally, as your employees continue to become more specialized, they’re able to truly shine. They aren’t getting distracted with non-specialized tasks, and can focus on what they’re best at.
The more your firm scales and is able to serve clients in a specialized way, the more organic growth you’ll see as a business. You’ll start gaining new referrals, new work from existing clients, and your specialists will draw in new leads of their own solely because they have a specialized need that only your firm can solve. This can also lead to increased client retention, and optimal client satisfaction.
The Power of Expansion for Cash Flow
The second thing that business owners need to focus on in order to add economic value is the power of multiple expansion. Many advisors have heard various rules of thumb about how much a financial planning practice is worth. These generalizations are often right – around 2x recurring revenue, and 1x non-recurring revenue. Those formulas may be out of date for a couple of reasons, but the most important reason is that a business’s value is a function of its profit, not it’s revenue.
Let’s look at an example:
Pretend your business generates $500,000 per year in revenue. Unfortunately, you don’t have your spending under control, and only $50,000 per year of that is profit. The firm down the street also has $500,000 in annual revenue. However, they’re only spending $250,000 per year to support their business, and are therefore worth much more than your business.
This method of evaluating your business’s worth is critical. Looking at revenue alone is a vanity metric – it doesn’t actually show how well your business is doing, or what your business worth might be. Profit, or cash flow, is what ultimately pushes investors to back their investments. That’s because profit pays back their investment over time – and then some.
Larger firms are a less risky investment because they often have better processes and systems in place to generate more profit for their business. Additionally, large firms who have multiple people to fill each role are a less risky investment because there’s less risk of personnel turnover.
In a small firm with a small profit, if one key employee leaves the entire operation may grind to a halt while a new key player is hired and trained. Investors are, ultimately, looking for low-risk business investments.
They want high-profit, low risk organizations that will almost guarantee them a return. In most cases, larger firms will produce the most consistent client experiences, have lower personnel risk due to turnover, and generate higher profits. This economic factor of building profitable (and high-value) firms is pushing advisors to join together to create larger, ensemble groups.
By taking a small business and plugging it into a larger firm, the value of the small business immediately jumps up. When you join forces with a larger firm, your net worth could jump 60-80% nearly overnight. You’re essentially risk-proofing your life’s work, and that’s an incredibly powerful thing.
Market Shares and Succession Planning
The third and final factor that I wanted to address in terms of how building a bigger firm drives economic value for the owners is the concept of having a market for your shares. A third way that larger firms drive value is by creating an internal market for your equity interest.
The vast majority of wealth management firms are owned by just one or two people, and if the single partner or larger partner is ready to leave the business or wants to monetize their equity value, they generally need to find an external buyer. That requires a certain amount of effort, due diligence, kissing frogs – whatever you want to call it. Finally, there’s a negotiating process that might be unpleasant as both parties try to reconcile potentially big differences in the value that they perceive for the business.
Bigger firms, on the other hand, don’t have to worry about that. They have multiple owners and they already have everything penciled out. Everybody knows exactly how the succession plan works. There’s enough people involved that there’s no shortage of buyers, and banks love to lend money to large firms with a stable cash flow.
So, selling your stock to an internal market means no negotiating about price. Everybody agrees to use the most recent valuation price. It’s just a win-win when it comes to working in a leveraged ensemble with multiple owners. Having an internal succession plan in place can be a game-changer for firm owners who want to ensure that their work building their business will, eventually, translate to their personal net worth and retirement plan.
Economic Value of Larger Firms
The truth is that small firms, while valuable, often can’t compete with the economic value and security a larger firm can provide both their clients, investors, and partners. If you want to learn more about how you can plug into a larger firm, visit cxinstitutional.com today.