Like many financial planners, I've had reservations about the current conventional wisdom that practices need to get bigger to survive and prosper. It seems like every practice management guru is talking about the myriad economies of scale and efficiencies to be gained by adding partners, junior professionals, and staff. Yet most of the advisors I work with or talk to have a real antipathy to making a "business" out of delivering financial advice. Not that they're averse to making money or owning successful practices--it's just that they'd rather spend their time serving their clients than thinking about "building" a business. So when they hear calls for them to increase profit margins, add young professionals to leverage themselves, or even just to grow their firms, they have a tendency to tune out--or get very defensive.
After spending some time poring over the 2005 FPA Compensation and Staffing Study, I've come to realize the 'gurus' do have a valuable message for financial planners, but the message isn't getting to the majority of planning practice owners who desperately need it. In particular, smaller practices and their owners want to understand how to make their firms more efficient and profitable without losing control. Yet this seems contradictory to what industry research is telling them. Consequently, they have no clue how to apply what they read and this wisdom thus becomes useless to them. What's more, when they consistently hear the message that "bigger is better," these "loser" smaller firm owners feel inadequate and close their minds to the valuable messages written between the lines that could really help them.
I believe the real value of the FPA Studies is to show an advisor how to make decisions as an owner of a planning business without losing control, regardless of the firm's size. This will help them become more efficient (while improving the level of client service), be more profitable (reducing the need to worry about finances) and proactively manage the firm's development (otherwise known as growth).
Does size matter? Sure, it has advantages, but it's not impossible to reap large-firm benefits from better managing small firms. The key is simply doing the things the gurus recommend, but on a smaller scale, and without making big-time mistakes.
Bigger firms have a greater ability to do bigger things at a higher level, have more options, and can take greater risks with their resources (i.e., money) than smaller firms. There is a significant amount of knowledge to be gained from watching these larger firms go through this trial and error process as they get bigger. This is the kernel of the wisdom contained in the FPA Studies: It can help small firms grow into viable, more efficient and profitable businesses, too. If used correctly, this knowledge will result in smaller firms continuing to dominate the independent advisory industry, despite predictions to the contrary.
I've yet to work with or talk to one financial planner who says, "I want to build a large firm and be one of those top 50 firms that Mark Hurley predicts will evolve." The vast majority of planners reach a point where they are not only content but proud of what they built, happily taking home their low- to mid-six-figure paycheck. They no longer worry about marketing, finding the next client, and putting the next meal on the table for their family. Once they reach this point, they have a sufficiently organized firm to provide high-quality client service. They certainly don't worry about their profit margins, operating expenses, and client profitability ratios--whatever they are. They have control of their income and their practices. They have enough. They are experiencing pure joy.
Pure joy is the last of three common stages I believe every owner goes through over and over again during the business lifecycle. Pure joy is when you reach a milestone that many times you thought to be impossible. It's when a firm is at its best. What happens to planners is the same thing that happens to any other well-structured business: They reach the joyful stage, and clients recognize their joy in what they do and confidence in how they're doing it. That helps to attract more clients. Without any specific effort, they start to grow.
This growth, ironically, drops them back to the first stage of the ownership lifecycle, which is excitement. They get excited about the new opportunities for growth, about helping more people, and about the possibility of more income. As a result, they take on more clients, add more assets, and generate more revenues, without much proactive thought to how they are going to manage or reorganize their firms to accommodate the increased workload. Consequently, they reach disillusionment, the second and most painful stage in the cycle.
Disillusionment is a well-documented trend in the financial planning industry and has been quantified, using other words, in the FPA Studies. It is when you're working harder for less money because you've reactively added additional operating expenses and overhead to manage your own success. Disillusionment is painful because not only are you drowning in your own success, but you're also unhappy, overworked, and facing burnout. The 2004 FPA Financial Performance Study of Financial Advisory Practices quantifies disillusionment the best, calling it the "$1 Million Barrier."
Conventional wisdom holds that to overcome the disillusionment stage, advisors should prevent their own growth or try to grow their way out of the problems. To help you better understand what disillusionment is, the 2004 Study coined the "$1 Million Barrier" term and showed that as a firm increases in size, its gross profit margin actually goes down until it generates over $1 million in annual revenues. At that point, firms reach economies of scale and start moving back into nearly optimal ranges for the overhead expense ratio.
However, the data in the 2005 FPA Study calls into question whether the $1 million barrier really exists. While the percentage of total overhead does increase and eventually falls due to economies of scale after crossing the $1 million line, it's not until you get closer to $5 million in revenues that this happens significantly. Furthermore, the gross profit margin decreases as firms grow but never fully recovers to that of the margin of smaller practices. As an example, the gross profit margins in the 2005 Study are the highest for firms producing under the $1 million barrier. For firms producing less than $250,000 in revenues, the gross profit margin was 67.3%; from $250K to $500K, 66.1%; and for firms with $500,000 to $1 million in revenues, the margin was 63.1%. However, even though the total overhead expense ratio is lower for all firms producing over $1 million in revenue, their gross profit margins are still decreasing compared to small practices, averaging 58.3%. It never fully recovers, so even in the largest firms producing over $5 million in gross annual revenue, the average gross profit margin stands at 54.9%.
I've yet to see concrete evidence that smaller firms couldn't potentially reap the same rewards as larger firms.
Lessons for Smaller Firms
What can smaller firms learn from their larger peers about creating more efficient practices? Evaluating profitability and overhead ratios aren't just crazy ideas. They help you take the pulse of your firm and provide insights into how it should be managed to prevent "growth" barriers from happening. When working with my clients, I try to change this thought process and make these suggestions:
Learn that growth is a gradual process. If your business is well structured, providing a high quality of service, then you can assume you will keep growing, attracting more people to it. Be proactive and anticipate this steady growth while having a strategic plan in place to implement prior to growth. To do this, you simply project it. In other words, figure your average growth rate for the last several years and assume you'll keep growing at that average. I run five-year cash flows for my clients to illustrate this point. We project revenues based on their firms' three-year average growth rate, as well as project operational and overhead expenses based on industry averages for their firm size. Then we run profitability and productivity ratios on those projections. It becomes very clear where the firm might encounter a growth barrier. As a result, we know exactly when to employ our strategy to prevent or move smoothly through a barrier.
Understand when to start the hiring process. Planners wait far too long to hire the help they need. This is the single biggest mistake small firms make. With the current shortage of talent, it can take six to nine months to recruit the right person for your firm. If you project your growth rate, you'll know six to nine months ahead of schedule when to start the hiring process.
Avoid impulsive technology purchases. The benefits from new technology can be tremendous but also costly. Make a technology budget, follow it, and be certain you know the benefits, the expected use, and the return on investment before purchasing. Some of the most profitable small practices I work with learn to get more usage out of what they already have. What's more, when they need something new, they have a technology escrow to use that doesn't kill their cash flow and ability to make investments in other areas to proactively manage growth.
Know when to say "No." There is a time to say, "Enough is enough for me." You should know your personal definition of success, which will indicate when you should stop. Make a plan to stop, know when you're going to do it, and get pleasure from the "pure joy" stage, while it lasts.
Good things can and do come in smaller packages. My generation of planners strongly believes in doing more with less. This is one of many reasons why the vast majority of next-generation planners turn down jobs in large brokerage firms to seek jobs in small independent practices with the potential to make meaningful contributions. In the future, I don't think large firms will dominate. It may take a while to get there, but when properly managed, small, nimble planning practices will allocate resources more effectively and adapt more quickly to the inevitably changing financial environment. At least to my way of thinking, smaller will indeed be better.
Angela Herbers is a virtual business manager and consultant for independent financial planning firms. She can be reached at firstname.lastname@example.org.