When companies talk about their growth strategy, they tend to focus on either M&A or organic growth.
Those focused on organic growth often say they’ll consider M&A on an opportunistic basis but, in reality, many lack the skillset and desire to do a transaction.
Those focused on M&A understand its potential to catapult their business to the next level but few are prepared and equipped to do the hard yakka required to extract maximum value from a deal.
While a standalone organic growth strategy can be highly effective, the long-term success of any M&A deal is tied up in organic growth too.
Post-sale, buyers must consistently achieve net client growth (new clients minus clients lost) given the average advice business loses clients at an annual rate of 5 per cent, based on our research.
For a practice with 200 clients at an average fee of $3,500 that means 45 lost clients over a five-year period and $157,500 in lost annualised revenue.
In a relatively short period of time, it is too easy for a business to go from $700,000 in annual revenue to just $545,500 if they are not adding clients year-on-year.
Assuming a loss rate of 5 per cent per annum, basic maths suggests that advisers need to win clients at a rate of 5-6 per cent per annum at the same fee to stand still. This equates to at least one new client per month.
On top of that, if they can add two clients per annum (14 clients in total), over a five year period they will have 210 clients and $735,500 in revenue.
It’s not rocket science yet so many practices struggle to attain sustainable growth
Any M&A transaction – be that a book buy, tuck-in or large acquisition – must produce new client and referral opportunities in order for the financials to stack up.
In financial services, the industry’s historical reliance on passive income streams enabled businesses to get fat and lazy. They didn’t need to be fit around client acquisition and retention to make money.
They could get revenue growth by acquiring large client books.
Ironically, today those are the types of transactions that should be avoided at all costs. Businesses that survive on passive income are dinosaurs and potential buyers would be attaching a decaying margin to their home-base.
At AZ NGA, we affectionately call this area the Death Zone. Here, clients are not active or engaged, providing little scope for client acquisition opportunities. At best, buyers are getting a marketing database and the price they pay should reflect that.
The smart money is chasing deals that expand their capability and capacity to derive organic growth. Discerning buyers are seeking healthy businesses with a compelling value proposition that can attract and retain clients.
A quick way to determine business health is annual net client growth.
In nature, if a tree is not growing and producing fruit, it’s dying. Similarly, the absence of steady, consistent client growth is an indication of ailing business.
There are two elements to net client growth: attracting clients and holding onto to them.
Post-acquisition client loss is almost always higher than expected, which is problematic because the price paid for a business is usually based on a certain amount of revenue attached to a certain number of clients.
However, as illustrated in the example above, $1 of revenue can very quickly become $0.98, meaning buyers rarely end up getting what they paid for.
To combat client leakage, advisers first need to determine their annual client loss rate. Based on our research, client loss typically ranges from circa 7.5 per cent to 15 per cent per annum and best practice is 2 per cent to 6 per cent per annum.
With certain types of transactions, the leakage is higher. For example, the client loss associated with a book buy where there is no adviser attached is typically greater than a book buy with an adviser(s). Over a ten year period, the client loss rate can be as high as 20 per cent per annum.
Organic growth is the best antidote to counter leakage and, as part of any M&A strategy businesses should have a client retention plan.
Overall, businesses don’t fail because of leakage and natural attrition. They fail because they get lazy about maintaining and winning business.
Read more of Paul Barrett’s articles in Professional Planner.