No matter what stage of development your practice is in, its critical to know the true value of your business. A valuation is essential for securing loans, evaluating the health of your business, and determining equity for succession events. Unlike traditional businesses with equipment, inventory, and other assets, a financial practice’s value is largely based on the goodwill of the firm’s clients.

Essentially, you own a relationship, which can be tricky to quantify, especially if one is not experienced in valuing relationship-based businesses. Valuations Experts that serve the financial services market have proven methods that they rely on for arriving at a number that represents the true economic value of a practice. Specifically, there are two approaches an experienced valuation expert will take: the market approach and the income approach.

In the market approach, the value of the firm is based primarily on client groups. The key factors they look at include:

• Quality of Revenue: How much is recurring versus transactional
• Average Client Age: Clients over age 70 have depleting assets that impact value
• Asset Velocity: Are assets growing or shrinking and at what rate?
• Comps: How the practice compares to key benchmark firms

Essentially, this approach is the one that truly assigns a number to the goodwill value of a firm.

On the other hand, the income approach determines value based on business operations. This approach looks at:

• The Team: Quantity and composition of the staff and their compensation
• Systems: Technology and other key systems that run the business
• Profit & Loss: The overall economic efficiency of the firm (revenue versus expenses)
• Risk: The discount rate based on a number of risk factors such as ratio of staff to high- value clients, future earnings, liabilities and expenses, etc.

The goal of the income approach is to see how wisely funds are being acquired and spent, and the general profitability of a practice.

To arrive at a true conclusion of value, the totals from the Market and Income approach are averaged. The resulting number is the final assignment of value. This sets a median price that the market would be willing to pay based on all applicable factors that influence value.

Too often, firms try to DIY many aspects of their business, including placing a value on the firm for investment or succession purposes. Often, advisors are not experienced at developing valuations and so they rely on industry averages and other rudimentary approaches for creating a valuation number. The problem with relying on industry averages and “rules of thumb” is that it doesn’t take into account your unique practice and the significant variations that can occur across the whole range.

If your firm lies on the upper end of the spectrum, an average valuation can cheat you out of hundreds of thousands of dollars in equity return, especially if you are relying on that number to set a sales price. On the buyer’s side, an average can have you overpaying by hundreds of thousands of dollars for a firm that isn’t as operationally efficient or secure as the average firm. Either way, there is a significant cost to this approach, and it fails to paint a clear and accurate picture of your practice’s value.

Again, a valuation is a critical tool for understanding the value of your firm and for making critical business decisions, including whether to buy or sell. It is in your best interest to leverage an experienced valuations expert who can generate a full report and explain all of the factors that influence your firm’s value and how. Your firm’s value is too important to DIY or to guess at. It’s much better to invest in a formal evaluation then to cobble together a rough estimate and hope for the best.