From the June 2010 issue of Investment Advisor • Subscribe!

June 1, 2010

Formulas for Success: New Challenges for Achieving Critical Mass

Being too big and too small makes it hard to create the optimal result

These days, when so many advisors feel they dodged a bullet in terms of business survival, it may seem insensitive to bring up the idea of business fulfillment. But the best leaders are those who keep their eye on the goal even in the midst of calamity. Recent changes in fortunes may have given advisors reason to pause--but only for a water break. After a quick rest, it's time to return to work.

Advisors can't sit back and wait for the market to get them back to whole. In the new business environment, clients are more demanding, competitors are more aggressive, and the best employees are being poached by growth-oriented firms seeking talent. No, the sky is not falling. But there are very few times in the lifecycle of a business when the pieces have shifted and we see the potential for a new world order. Advisory firms must look ahead and position themselves for faster growth, improved profitability, and enhanced productivity--or they will be looking back with regret five years from now. The goal in operating terms should be how to get to critical mass, a destination not even on the radar screen for the vast majority of advisory firms.

First, let's define what we mean by critical mass: It is that sweet point at which the business starts to achieve an optimal level of productivity, profitability, and growth. It is the holy grail of any service business, that elusive, coveted target. You know you've arrived at critical mass when the departure of an employee or significant client doesn't send the business into a tailspin. The business just continues on its course, growing revenues, generating profits, and providing opportunities for others to make an impact.

Most independent advisory firms with at least 20 people in varying roles from advisory to administration to management can handle staff turnover and increased client growth while consistently producing a reasonable level of profitability. This generally means that a firm with $5 million of revenue has reached critical mass. But because fixed costs are rising for most advisors, that number is creeping up as well.

Getting Back to Your Target

Every business is unique in terms of its clients, its people, and the way in which it does business. Individual advisors are also unique in how they view success. But there is one immutable truth about all businesses--profitability is critical because it funds your future.

A well-managed advisory firm will consistently generate a gross profit margin in the 55% to 60% range, and an operating profit margin in the 20% to 25% range. Exact margins depend on the business model. Over the past five years, compensation and overhead costs as a percentage of revenue have gone up. This pattern accelerated during the market cataclysm when revenues dropped precipitously. So the question for advisors is this: what changes in pricing, client mix, service mix, expense control, or revenue generation will have to occur in order to get the business back on target?

Productivity is critical to enhanced profitability. Productivity manifests itself in ratios like clients per staff, revenue per staff, error rates, responsiveness, and other leading indicators. Productivity is also impacted by a high turnover of associates (see sidebar, next page).

How can your firm achieve critical mass? How much will you need to grow? Many advisory firms have a passive approach to business development, adding a comfortable six to 12 new relationships a year. But what if this pace is not sufficient to address the problems exposed through your analysis? What if you have to accelerate your rate of growth? How many new clients paced over what period of time can you absorb? How will the new marketing initiative impact your costs, thereby pushing your break-even point even higher? How will your staff respond to the intensified on-boarding of new clients? How will your existing clients be impacted?

Positioning for Growth

Most advisory firms have different types of clients, and many firms are opportunistic about which new clients they add. Advisors may believe a prospect has got to be good for business if that prospect brings in assets on which the advisor can get paid a reasonable (or substantial) fee. Being purely reactive to the marketplace is settling for mediocrity, however. Long-term growth must be thoughtfully planned for and carefully executed.

Advisory firms that are positioned for growth have purposefully determined which business to invest in. This clarity informs how they hire and compensate people, their technology and product platforms, their employee reward structure, and their sales and marketing efforts. If advisors had infinite resources, they could spread their investments over multiple strategies but, lo, most are not blessed with such abundance. So in the real world, just as you do with your client portfolios, your firm must develop a strategy that is guided by a clear philosophy and deploys assets in order to produce the optimal return.

While the 80/20 rule may exist in your business today (80% of your income is generated by 20% of your clients), is that a judicious way to build your business going forward? In a study we performed when I was at Moss Adams (2006 Moss Adams Financial Performance Study of Advisory Firms), we found that those advisors who reversed this relationship--including 80% of their clients in their target--grew three times faster than the average firm. The logic is obvious; they committed their business development and client service time to serving the optimal relationship instead of wasting resources on a few prospects and clients who would disrupt their business process.

Structuring for Growth

"Form follows function" is a concept rooted in modern architecture, the idea that a structure's design should be based on its intended purpose.

In an advisory firm, designing your business for success depends on your purpose. Are you growing a firm focused on the 401(k) market, or high-net-worth individuals? Are you creating a family office, or a money management firm? It doesn't really matter which business you commit resources to as long as you are clear about what it will take to support your strategy.

To build a business structure in which people, processes, and technology are aligned, advisory firms must develop a process map. A process map allows you to separate each function, such as account opening or rebalancing, and identify the steps, how much time they take, and the tools needed to complete them. When the current process is outlined, improvements are easier to identify and implement.

With the process and tools more clearly defined, it also becomes easier to see whether you have the right people matched to the right jobs. A poor fit can result from a lack of aptitude, interest, or motivation. Knowing the nature of the work makes it easier to define the ideal worker. If it is a repetitive function, for example, individuals who enjoy organization and order will focus on the role better than multi-taskers. Individuals properly matched to their jobs also tend to be more fulfilled and loyal, thus minimizing turnover.

Advisory firms that are clear about who they are serving can lower their break-even point, making it easier to get to profitability. Critical mass--that optimal level of productivity and growth--requires more still: adding capacity and redundancy, generating enough momentum to stimulate individual career growth, and building a sound structure that can withstand addition or subtraction of clients and staff. Be the architect of your firm's future in the new world.

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