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Research Assignment: When buying or selling an advisory firm, due diligence may be the most important thing you do before signin

September 17th, 2008

Research Assignment: When buying or selling an advisory firm, due diligence may be the most important thing you do before signing on the dotted line.

Due diligence is the process of acquiring objective and reliable information prior to an acquisition or sale. It is about finding those "red flags" that exist in every practice. It's the name we give to the function of kicking the tires and looking under the hood.

The purpose of due diligence is to help a buyer determine the benefits and liabilities of a practice by inquiring into all relevant aspects of the past, present, and predictable future of the business. Careful due diligence will help a buyer and seller decide whether they want to go forward with the transaction or else renegotiate the price and terms of the deal based on the results of the review.

First, let's correct a few misconceptions about the process. Due diligence is not about finding a reason to abandon an acquisition or a sale. People are often afraid that finding problems will kill the deal. That's wrong. Finding problems is normal-every practice has its own challenges. During the review process, a buyer's job is to find the problems and deal with them either by planning ahead or by adjusting the terms to offset the perceived risk.

In addition, most people incorrectly think that due diligence is the process a buyer conducts on a seller before an acquisition. When deals involve financial advisory practices below $150 million in assets under management (or a sale price of less than $3 million), sellers tend to provide a significant part of the financing (bank financing at this level is still hard to come by). As a result, sellers also need to conduct due diligence on buyers, to whom they will be "lending" money until the practices are paid for.

Due diligence begins from the first contact between buyer and seller-the first handshake, the first phone call, the first typo, the first slip of the tongue. It all counts. Due diligence involves not only checking files, facts, and figures, but also listening to and observing the other party during the process. It starts before you realize it, and it can be over that quickly if you're not prepared.

The first step is to sign a confidentiality agreement. Any problems with the honesty of buyers in the due diligence process are rare, but it only takes one. In most cases, the buyer signs a seller's confidentiality agreement, but the process should be reciprocal.

Due diligence typically takes place both before and after a letter of intent is signed by a buyer and accepted by the seller. About 10% to 20% of the due diligence process is completed before the written offer is made; this can involve as many as five or six potential buyers.

But the number of buyers plummets immediately after an offer and a backup offer are accepted. Most offers-or letters of intent-require an earnest money deposit, the refundability of which is tied to a limited due diligence period of 15 to 30 days. Only one or two buyers at a time, those with an accepted offer and earnest money deposit, should be given the go-ahead to conduct any on-site due diligence in the seller's office.

Once due diligence begins, it continues to the moment of closing. As a buyer or a seller, be aware that you are always auditioning-every word, every action, every letter, every single e-mail matters until the transaction is completed.

Many buyers are rejected because they didn't take the time to spell-check their letters or e-mails. Sellers always ask themselves, "If buyers present themselves this way to me, then what will my clients think when they do it later on?" With all of today's technology, there is no excuse for sloppiness or spelling mistakes, and with 30 or more buyers to pick from, sellers move on quickly.

A seller's clients are typically never contacted by the buyer during due diligence. The one exception is when the seller has a large concentration of assets with one client or one group of clients. In that case, the buyer may be allowed to meet this special client as a final step in the process. Alternatively, some sellers prefer to build a contingency into the purchase agreement rather than to introduce an important client to more than one prospective suitor before the transaction is completed.

In a practice that sells for $200,000 or less, most buyers spend approximately one or two full days in the seller's office reviewing materials in advance. In purchases of $1 million or more, a buyer or team of buyers may spend five to seven days in the seller's office. Buyers who are not familiar with the practice they're reviewing obviously require more time. If you are paying a large down payment or taking more risk than you are comfortable with, continue the review process until you are fully satisfied.

Solid preparation and organization by the seller can greatly reduce the amount of on-site review, as well as enhance a favorable perspective of the seller's practice. Both sides should start with a good checklist. Sellers should prepare three or four sets of all due diligence materials to be furnished to a prospective buyer. Preparation also can shorten the amount of time a buyer spends on due diligence if it improves the buyer's comfort level and confidence that the seller is on top of things.

The amount of time that's spent on the review process also depends in large part on what is being bought-stock or assets. Most advisory practices involve the sale of assets, not liabilities, and at terms of approximately 30% down with the balance contingent on success. If you're a buyer in the process of acquiring a practice similar to your own, you are likely to perceive this as a lower risk situation, and the due diligence process can be fairly forgiving.

Contrast this to an all-cash sale or to a stock acquisition. When you purchase stock-a relatively rare event in acquisitions with a sales price under $2 million-you are acquiring the history of the company that you're buying, including contracts and liabilities. This creates a situation where due diligence must be razor sharp and extra time invested.

Due diligence is typically performed by the participants in the transaction themselves-the buyer and the seller and sometimes their staff. For the most part, both registered reps and investment advisers are trained to evaluate risk and spot problems on the horizon. Just do what you do.

In most practice acquisitions, buyers acquire a client base and income stream similar to their own. One of the points of due diligence is to determine just how closely aligned the investment strategies and administrative functions really are. Buyers should see things they are familiar with and do every day.

Buyer due diligence. Here are some items you should review as a buyer:

* Tax returns going back at least three years;

* Detailed financial statements showing income and expenses;

* Regulatory history, including on-line databases;

* Third-party verification of cash flow (from a broker-dealer or custodian);

* Any liabilities you choose to acquire (office lease, for example);

* Sample client files and associated computer records;

* Client demographics;

* Advertising and marketing records and referral sources;

* Business bank statements; and

* Complaint file and closed accounts.

Seller due diligence. In contrast, sellers tend to focus on whether a buyer has the full set of skills, experience, motivation, and integrity it will take to succeed in transferring and retaining acquired clients. But keep one thing in mind. If you're in your sixties, don't expect your buyer to match up to you in terms of experience-it won't happen. Give full credit to a buyer's education and past success in business. If the buyer is close to you in size, the fact that he or she got there by a different path than you did doesn't have to be a deal killer.

Sellers should ask to speak to the buyer's clients, especially ones who have been with the buyer for more than five years. They can tell you from experience why their loyalty was earned. As a seller, you'll learn far more about the integrity of your buyer from clients than from the buyer's resume or designations.

Investigate, even if the buyer offers a full cash deal. Your clients deserve it.

Here are some of the basic items you should consider as a seller:

*Tax returns going back for at least three years;

* Detailed financial statements showing income and expenses;

* Regulatory history including online databases;

* Credit history;

* Bank statements for three months;

* References, especially clients in the age range of your own clients;

*Career resume; and

*Insurability in the event that seller financing is over $200,000.

If the buyer has a much larger practice than yours, your evaluation may be quick and easy. Such companies tend to offer high down payments and audited financial returns. While it's always flattering to sell to an up-and-coming financial planner whom you can mentor, set the ego aside and try to sell to someone who is bigger and better than you are. In these days of seller financing, following such a course of action will reduce your long-term risk.

Remember, avoiding risk isn't the goal; verifying representations, confirming cash flow, and finding problems is what due diligence is all about. Don't get caught up looking for any one big problem to break the deal. An accumulation of little things is more likely. Once the facts are known and you're comfortable with the other party, you can adjust the terms to take into account anything that's different than expected.

Due diligence should be a straight-forward exercise, since most practices have many similarities and buyers tend to be mirror images of sellers in personality, business model, and investment philosophy. Buying or selling an advisory practice is about what happens after the transaction is complete.

The point of due diligence is that both buyer and seller are betting on the future, in the hands of someone else. In effect, they are gambling that they are replaceable or can replace someone their senior, and often betting a small fortune. Comprehensive due diligence helps to bring the gamble closer to a certainty. It's simply a matter of knowing the rules and following them.

David Grau is president of Business Transitions in Portland, Ore., a leading facilitator of buying and selling advisory, accounting, and insurance practices on its Web sites: FPtransitions.com, RIAtransitions.com, CPAtransitions.com, NAPFAtransitions.com, and Insurancetransitions.com.

Where to Find Due Diligence Information

One of the few advantages of being a highly regulated industry is that a lot of public information is available. A good place to start is the National Association of Securities Dealers' Web site (www.nasd.com). Clicking on the "Investor Information" tab, you will find a wealth of information access points, including a column labeled "Investor Services." Once there, you can click on the link "Check Out Brokers and Advisers," where you can discover registration and other background information on investment professionals and firms.

The Investment Adviser Public Disclosure Web site, which can be accessed through the NASD's site, allows you to search for information about investment adviser firms regulated by and electronically registered with the Securities and Exchange Commission or state regulators. It's also a good idea to have a personal discussion with the state regulators where the individual or firm is based.-DG

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