From the March 2006 issue of Investment Advisor • Subscribe!

March 1, 2006

Preparing for the Fall

In the autumn of your career, are you prepared for the inevitable?

Are you succeeding at succession? This question increasingly comes up as advisors see each month flip away, and each year change a digit. Recently, an advisor reminded me that we started talking about her succession plans in 2001 with a goal of retiring in 2006, but now she says, "Every year, I tell myself five more years. Five years have passed since the first time I said that and I still haven't done anything."

Procrastination is an affliction suffered by many of us. It seems when we contemplate the inevitable, we fight it even more. Like wrinkles, weight, and whiskers, we can see the effects of life's transition but are often late in managing it. Over the past five years, we have observed that advisors are pushing out their retirement more and more. While the average age of the advisors in the survey has held steady, the percentage of advisors who say they expect to retire in more than 10 years has gone from 69% of our Financial Planning Association survey participants to 76%, while advisors who expect to call it quits in six to 10 years shrunk from 23% to 18%. In an analysis of their advisor client base last year, Schwab Institutional found that 50% of its advisor population is over the age of 50. Other organizations have also voiced concern over the graying of the advisor population and the shortage of talent to replace them.

Delaying the Inevitable

When we asked these same survey participants whether they have considered selling or are entertaining offers for their practices, the statistics are also surprising. Eighty percent emphatically stated that selling is not in the cards. So even though the average age is increasing, it doesn't appear that there will be as big a flood of advisor sales as many had been predicting--at least not as long as so many advisors plan to die in the saddle.

We have found in the course of working with hundreds of advisors that most would prefer to transition their businesses to other advisors internally or to their children rather than selling to an outside buyer. They believe that this transition strategy will enable them to better control their destiny and how their clients are treated once they leave the business. Of course, there's this nasty little thing called economics that gets in the way of these plans. Common issues that arise include: Can my internal successors afford to buy me out? Will they be capable of serving my clients at the level they've come to expect?

For solo practitioners, an internal transition obviously is not an option unless they decide to bring in another advisor. While that's a viable alternative, often it's like the 55-year-old bachelor who gets married for the first time--will he really be able to share the bathroom with another person? Old habits make it difficult to tolerate "intrusions" by others into one's life and practice.

Each of these challenges is solvable, but the longer one waits to begin implementation of a succession plan, the less likely that the transition will go smoothly. The closer you get to the end, the more the transition will look like a fire sale where the options for picking the best buyer get slim (and often unappealing). Unfort-unately, most people sell because of boredom, burnout, advanced age, or declining health; these are not conditions conducive to an optimal transition.

For financial advisory practices, there are three components to an effective succession plan:

1. Client transition--the orderly transfer of relationships;

2. Management transition--preparing your understudy to manage the details of your business;

3. Ownership transition--creating transferability of the enterprise itself in a way that will help the seller achieve his liquidity and income goals

Client Transition

The goal of a client transition plan is to build an organization that can serve your clients with continuity. The first test is to determine what would happen to your clients if something were to happen to you. It is not uncommon for advisors to enter into buy/sell arrangements with other experienced advisors as a way to ensure their clients are tended to. One of the great flaws in these arrangements is that often each advisor is already busy and lacks the capacity to service a slew of new clients without sacrificing service to his own clientele.

As an exercise, it will be helpful if you evaluated your client management honestly along these lines: Are they appealing and transferable to somebody else? Which clients are at risk? How could this impact the price I get paid? How would my clients react to being introduced to my successor? How should I prepare my clients for the inevitable? When should I tell them?

You will often find buyers interested in acquiring just a book of business or a client list and not all the other things typically associated with your business like people, systems, or infrastructure. They may view this as a simple financial transaction and they are betting on the probability that a certain number of clients will stick after the sale. Typically, buyers in this circumstance will pay the seller on an earn-out basis wherein they pay a percentage of the future gross revenue for a defined period of time. When there is no clear connection between the clients and the acquiring advisor, the potential for attrition is very high and, therefore, the ultimate purchase price paid could be diminished.

This is one reason why many advisors will consider an internal transition as more appealing than a sale to an outside buyer. With an internal transition, the seller often has had the time to train his successor(s) in the processes that made the practice so successful and will have had the opportunity to introduce clients to the internal successor without the trauma of an outright sale.

Management Transition

Obviously, if you plan to sell your book of business, preparing for how the practice will be managed is not important. A compelling reason to contemplate this question, though, is the risk that you could become disabled and unable to manage your enterprise. What is your contingency plan? Are you comfortable that you have the people and processes in place to ensure continuity of your business?

As practices get bigger, the quality of management can enhance value. Strategic buyers often want to acquire more than just the clients, and that includes competent advisors as well as an effective management team.We often hear owners say they lack confidence in the people in their firms to manage elements of the practice and that is why they have to control everything. If you hear yourself saying this, it would be prudent to ask if you have surrounded yourself with the right people, and whether you are doing what's necessary to prepare them for expanded roles in your practice. To maintain an incompetence gap in a practice is not responsible behavior and does little to help you build a valuable practice (even if the cost of acquiring this "talent" later is low).

One advantage of building an internal team of competent individuals is that it also gives you the option of an internal transfer. If you hire and develop the right people, you can prepare for a transition that allows you to have a degree of control as to how the business will operate after you've gone. Significantly, by attracting and developing the right people, you can usually build a practice of higher transferable value.

As a general guideline, if your desire is to sell inside, you will probably want to have at least two qualified people for every existing shareholder to make this work. One reason is that the value of your practice may be too much for one person to digest; the other is that having multiple internal buyers gives you several options in case one of them flakes out.

If your practice is of sufficient size, it is often helpful to begin the transition early by admitting qualified individuals as partners (shareholders or members) in the firm. To do this, first you must define what are the firm financial thresholds that allow you to afford another partner without causing dilution to you as the primary owner. Second, you must define what individual thresholds must be crossed before a person can be considered for partnership. Such thresholds might include financial contribution, responsibility and leadership, staff development, client service, and general attitude and behavior.

Ownership Transition

When planning for the ultimate disposition of your practice, an important question to resolve is whether you want to optimize value. I pose this question because in practice transactions, the seller often imposes a set of restrictions or deal killers that make it difficult for a buyer to pay top price. So part of your planning process should be to define how you would like the transfer of the business to occur.

But planning is not about "the deal" alone. If you begin your succession planning early enough in your career cycle, you can also focus on the things that will build value. If you're already at the deal phase, you will have to accept the cards you're dealt. Areas to work on in building value and transferability include:

- Reducing dependency on the owner of the practice

- Building a clientele with growth potential (check demographics and other factors)

- Creating efficient processes for serving the clients effectively

- Managing to consistent profitability

- Structuring a practice with capable individuals who will want to continue with the practice

An effective ownership transition plan leads you to focus on how you can enhance cash flow, minimize risk, and structure a practice for sustained growth. Ultimately, the best practices are those that are built to last, not built for sale. When you do the former, the latter becomes much easier, and more valuable.

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