What’s Impacting the Value of Your Firm?
Key factors to consider when evaluating the value of your brokerages.
REAL Trends performed between 200 and 250 formal valuations in the past year—about equal to the year before that, and 50 percent more than in years before that. While some of these are for the sale or purchase of a brokerage firm, just as often they may be for the purchase or sale of interests in a brokerage, divorce within families, life insurance, estate gifting, and other general purposes.
We hear from brokerage leaders often on this topic and read other sources from time to time as to what factors, other than the actual financial results, are examined when doing a valuation. Here we review and few of the more critical factors that affect the ultimate value of a brokerage firm, regardless of the reason for the valuation assignment.
The valuation of residential brokerage firms (and related entities such as mortgage, title insurance, escrow, and property management) is often affected by the size of the market where the client is located. Larger markets generally bring higher valuation results. This is because there are likely more purchasers or investors both inside and outside of the market that would have an interest and because the upside opportunity to grow an acquired business is higher in a larger market than one that is smaller. Many acquirers are seeking to build a scalable firm, and that is far easier in larger markets.
There are, of course, exceptions. A large, market share leading brokerage, in a smaller market, may be valued as high as a sizeable non-market share leading firm in a larger market. Again, location comes into play as that large market share leading firm in a small market still needs to have some proximity to a larger market to attain an equivalent valuation.
The vast majority of brokerage firms (and related entities) are some form of a pass-through legal entity such as a partnership, an LLC, or an S corporation. A brokerage firm with this kind of structure generally will see no adjustments, positive or negative, in their valuation.
For those few that are organized as C corporations, the situation is different, and most of the time, it harms valuation. Why? Most buyers (in fact virtually all) desire to purchase the assets of a brokerage firm, and not it’s stock. This is for both liability and tax reasons, and it has been the case for the past 25 years at least.
However, a seller of assets in a C corporation generally faces ruinous double taxation on the proceeds from the sale of assets out of a C corporation as they first have to pay capital gains taxes on the internal gain, then pay personal taxes to extract monies from the C corporation as salary, bonus or dividends. Thus, purchasers do not want to buy shares in a brokerage, and sellers do not want to sell assets from a C corporation. The standoff results typically in the purchaser agreeing to purchase the shares of the seller (rather than the assets) but at a discount which leaves the purchaser no worse off from an after-tax point of view.
Compatible Cultures and Commission Plans
There is a multitude of types of residential brokerage firms today with far more diversity in commission plans and service delivery than in years past. This is neither good nor bad for the industry, but it does affect valuation.
In the past, the largest brokerage firms would be generally considered traditional, full-service with some form of graduated commission plans. The Gross Margins (Company Revenue) of these incumbents were usually within a specific range of each other. Competition generally kept a lid on a brokerage firm having a significantly higher Gross Margin than their chief competitors.
Today, many large firms have entirely different types of plans, many are lower cost, with less infrastructure, less managerial overhead, lower levels of office space, etc. The number and size of these kinds of firms have grown substantially over the years in many different markets.
The challenge for them is that there aren’t many in each market and the larger national and regional firms that are the major investors in residential brokerage firms can’t mix the plans they have in that market with such a firm. Nor are there yet large national firms with war chests to acquire such firms (although there are at least three we are aware of raising funds to do just that).
A firm with a flat monthly and transaction fee plan, with a Gross Margin of 11 percent is not going to be compatible with an acquirer with a Gross Margin of 20 percent. Our experience is that such an acquirer, although desirous of the market share that the lower Gross Margin firm may have, will look elsewhere for growth given the incompatibility between the firms.
Further, given the lack of capital (thus far) among the brokerage firms with lower Gross Margins, there is lower liquidity (and hence lower valuations) for these kinds of firms. As we comment, we do believe this is changing as several firms of this kind are raising capital to expand.
Likewise, a brokerage firm that has a measurably higher Gross Margin than the investors or purchasers in a particular market may have the same problem as the lower-cost brokerages. Where most of the purchasers in a given market have average Gross Margins of 20 percent and a seller is at 28 percent for example, the purchaser will be leery of trying to both pay for the higher Gross Margin firm and then figure out to how to keep it there when their other local operations are at 20 percent. Of course, this is not as much of a factor when the purchaser has no local operations. However, even in this case, purchasers are now wondering not only how the higher Gross Margin brokerage accomplished it, but how much longer it can be maintained in the market of 2019-2020.
In addition to compensation plan factors, other cultural factors that come into play. These include the level of support service differences between two firms, the history of support for core services, branding (national branding or local brand name), office structure, per person productivity and other such factors.
The Importance of Leaders
Among the most important cultural factors is that of the continuation of the leadership of a potential seller. Our experience has shown that this is the single most crucial factor. Most leading brokerage firms, regardless of type, location, or compensation plan, has a leader or leaders who built the company. Future success is highly predicated on the retention of these leaders. We won’t belabor this point here, but the ultimate value of a brokerage firm is highly affected by the continuation of the leadership in some form.
This is among the most misunderstood factors of all the non-financial factors affecting the valuation of residential brokerage firms.
Most franchise agreements restrict the ability of an affiliated firm from selling shares or a controlling interest to other parties without the permission of the franchiser. The history of the actions of franchisers is that they do not approve of such transfers or sales unless the franchised brokerage remains in the current franchise. This history goes back 35 plus years.
This limits the number of purchasers for such a firm. Logic instructs us on this point. A firm with five potential suitors versus one potential suitor is generally going to have a higher valuation.
It’s true that the franchise itself has contributed to the increase in the value of a brokerage firm. We are not arguing that point. It’s more likely true than not, otherwise, why would intelligent brokerage leaders agree to the franchise in the first place, absent some value they believed they were getting in the exchange?
Our experience indicates that regardless of a franchise brand, the value of a franchised brokerage does increase in most but not all cases as the franchise agreement near its end. That’s because that franchised brokerage is approaching the point where they may access a far broader market for their firm than that within its franchise brand.
Note that we say in most but not all cases because then the valuation has to take into account all of the other non-financial factors we list here together with the financial considerations.
The Housing Sales Market
On top of all these factors, there is the market place itself. The current market for most brokerage firms is certainly more bearish than the market two years ago at this time. When housing markets are stable to increasing, then values typically move upwards. When housing markets are headed down, as they have been doing since the first quarter of 2018, then brokerage valuations are going to either be flat or in decline.