From the April 2005 issue of Investment Advisor • Subscribe!

Partner Track

First decide if you want partners. What to do with them comes later

Some years ago, I was working with an advisor who had reached a crossroads: Should he keep the practice small, and under his complete control, or should he add other advisors who could eventually become owners?

He finally made a decision to add a partner. "I've found the right person," he told me. "He'll bring the capital and I'll bring the experience." I asked him what tipped him in this direction. He replied, "In three years, I'll have the capital and he'll have the experience."

The decision to add partners does not come lightly. In fact, there are legitimate reasons for fearing it. Partners can question what you're doing. They'll be drinking from the same profit trough as you. You have to share decision making. You have to navigate through conflicts instead of powering through them. You may add somebody whose values, philosophy, and approach to business are different from yours.

Despite the potential pitfalls, adding a partner can be great for your practice. Individuals who can fuel your growth, add leadership, and boost your income will eventually want a stake in the business they are helping to build. Partners also provide you with an internal succession option, depth and continuity in the business, and a discipline that comes with having to be accountable to somebody else.

In weighing a decision to add a partner, it's important to consider both the upside and the downside. Begin by determining the problem you are trying to solve. Advisors who add partners out of loyalty, a sense of obligation, as a potential bonus should you sell out, or as an incentive may be solving the wrong problem.

A partnership should be reserved for those who are contributing in a meaningful way to the firm's financial success. They could be lead advisors, rainmakers, or effective managers of an important area in your practice.

If you have a desire to share a stake in your business with those who don't fit this profile, then consider alternatives like phantom stock, stock appreciation rights, or participation in an ESOP, each of which provide a long-term incentive and an opportunity for a big gain should you sell. But these vehicles do not put the individuals on the same footing as those who have a significant impact on the future of the firm.

When evaluating whether to make a person a partner, consider defining in writing these four steps: The firm thresholds; the individual thresholds; the rights and benefits of ownership; and the transaction itself. (To view a sample partner policy statement, visit www.investmentadvisor.com).

Firm Threshold. Before admitting a new partner, the current owner of a practice needs to make sure he can afford it. Dilution of ownership is one consideration; but dilution of income is even more important. You should add a partner to gain net income, not the opposite. To understand what the breakpoints are in firm revenue that allow you to add a partner without diluting your own income, ask three questions:

  1. What is the desired average income per owner?
  2. How much revenue does the firm need to generate in order to achieve that income?
  3. How much more revenue does the firm need to generate to maintain a reasonable level of profitability after fair compensation to the owners?

To be economically viable, a typical advisory firm needs to generate between $400,000 and $750,000 of revenue per partner. To add a new partner, then, a firm should already have excess revenues to cover the new partner, or reasonably expect revenues to increase by that amount. The "best managed firms" in our studies for Schwab Institutional generate between $700,000 and $1,000,000 per partner. The implication is that if you currently have two partners and would like to add a third, your business should be generating at least $2.1 million of annual revenue ($700,000 x 3 partners).

Individual Thresholds. It's tempting to promote employees to partner out of loyalty, instead of evaluating their contributions to the firm. As a general philosophy, if the person does not contribute meaningfully to growth, it probably is not a good idea to admit them as a partner. There are other ways in which to reward loyal staff who are not growth drivers in the firm, ways that may be more in line with their expectations and risk tolerance. Remember that partnership is a special role that entitles the partners to substantial income opportunities commensurate with the risks they are taking as owners.

In our 2003 FPA Compensation & Staffing Survey, we found that most firms add partners as a result of some evaluation process. In digging deeper, we discovered that most of this process revolves around revenue contribution or gut instinct, but there are other factors that advisors should consider including, such as:

  • Responsibility. What else do they do to impact the success of the business?
  • Staff Development. What are they doing to help grow the next generation of advisors?
  • Performance Evaluation. How well have they performed according to your annual or semi-annual evaluations, and have they responded well to counseling?

These three criteria are obviously subjective. As your business grows, you should also develop more formal processes for evaluating these areas. The performance evaluation may become the most important, which is one reason we encourage advisors to use upstream evaluations in which staff evaluates practice leaders, as well as downstream in which the leaders evaluate staff. These can be very insightful when you create a culture of candid feedback without recrimination.

One of the other benefits of using these subjective measures is that it allows you to build a culture you enjoy. While many advisory firms prefer to evaluate performance purely in financial terms, you run the risk of not balancing revenue growth with desired behavior such as respect, integrity, teamwork, and other concepts pulled directly from the Boy Scout manual.

This is not to minimize the importance of financial criteria. Obviously, if someone is not contributing to the growth of the business, it is hard to rationalize sharing profits with them. Further, if the individual is not growth oriented, this could undermine your succession plan if you are expecting them to eventually take over your practice by buying you out. You always need to ask yourself whether they have the ability to acquire your ownership over time when you retire, because it's rare you would get cash on the barrelhead for your ownership in this case.

Rights and Benefits of Ownership. Partnership in an advisory firm is a special position. It entitles one to profit distributions, a say in the direction of the enterprise, and, usually, a higher level of income than non-owners. But with these benefits come certain risks and responsibilities:

  • You are on the hook for any financial obligations of the firm
  • You are stewards of the business and must act in its best interest
  • Your actions should contribute to the continuity of the enterprise
  • You must create an environment in which other motivated people can flourish.

Generally, we recommend looking at partners as key employees first. In this regard, their compensation should be a combination of salary plus incentive. The base should be tied to reasonable market rates for the job they are expected to perform, e.g., senior advisor, portfolio manager, or CEO; and their incentive should be tied to exceeding the expectations of that job.

As practices become larger, it becomes easier to make this distinction and create a process for setting both base and incentives. There is a growing body of data on fair compensation for relevant positions, including the FPA Survey which Moss Adams conducts every other year.

In addition to base and incentives, owners are entitled to a profit distribution. While usually based on the partner's pro rata ownership interest, we have seen some clever compensation programs in which partners are awarded "income units" instead of equity units. The number of units may fluctuate each year depending on a variety of factors related to their individual contribution. The simplest form, however, remains treating the distribution as a dividend.

Define the Transaction. There are many ways advisory firms structure the transfer of ownership to new partners. Most establish a purchase price and may use a formula that sets both the buy-in and the buy-out of partners. Then, in many cases, they grant the stock in lieu of cash, which is a practice I'm not too keen on. In some cases, the current owners require that new partners borrow or liquidate investments to pay cash for their ownership. A more practical approach, and one more commonly deployed, is when the business itself funds the transaction.

As an example, the new owner might be paid a base salary plus incentive. When the incentive is paid, the firm garnishes enough of it to pay down the purchase price, leaving a sufficient amount to the new partner to cover her taxes and perhaps have a little left over. In this case, they don't touch the new partner's base because that's likely what the individual is living on. By creating an incentive plan with good upside, they also give the new partner the opportunity to pay down her obligation quickly. Typically, an interest rate is imputed in these terms.

In this circumstance, new partners typically vest in three to seven years. Sellers should be careful not to make the buy-in too onerous, yet set the threshold high enough that the new partner feels as if she has skin in the game. Any distributions of profits may be tied to the vesting so that they don't get the full financial benefit of ownership until they are fully capitalized. Some firms also have incentive plans that allow partners to purchase a larger stake in the business, and often will have a provision in a buy/sell agreement that gives this individual the right of first refusal to buy older partners' ownership when they die or retire.

As the practice grows and you clarify the career path for key individuals, it will become important to clearly articulate your partner admission policy so that prospective partners have a framework for how to get there. Knowing that you are adding partners who can carry on the practice after you have retired gives you a strong option in your succession planning.

Mark Tibergien is a nationally recognized specialist in practice management for financial services firms, and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S. You can reach him at mark.tibergien@mossadams.com.

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