From the January 2011 issue of Investment Advisor • Subscribe!

The Day You Call It A Day

Buy/sell agreements should provide clarity but are often poorly written documents

The majority of advisors who wish to retire in three years are no more prepared for their exit from the business than those who plan to retire in 10 years. At least that’s a statistical surprise from the recent Investment News/Moss Adams 2010 Study of Financial Performance of Financial Advisory Firms, sponsored by Pershing Advisory Solutions (for more information, visit www.pershing.com/advisorstudy). Only about 30% of advisors—at both three and 10 years from retirement—said they were ready.

This obviously means the majority are not.

It seems many advisors don’t even have a buy/sell agreement in place, or at least not one that gives much direction to the sellers, buyers, estates, heirs and businesses that will be affected.

Challenges in these agreements revolve around the terms of exit, the triggering events, how the ownership stake is valued, how the transfer of ownership is funded and whether both parties to the buy/sell agreements feel disposed toward honoring the contract. One reason that last issue even comes up is because many agreements do not declare the sale back to the remaining owner(s) as a put, but rather as a right of first refusal. Similarly for the buyers, the call provision is often absent or silent on what to do about price and terms in cases when an owner gets dismissed from the firm, as well as when they leave voluntarily.

This raises many questions like: What will happen to your business if something happens to you? What will happen to your long-standing relationship if your buy/sell agreement sows confusion instead of clarity? What will happen to your retirement plans if the buy-out blows up? What will happen to the business if a heavy repurchase obligation weighs it down or drives the buyers away from the deal?

Seeking Counsel
Seeking professional help to construct a useful buy/sell agreement seems obvious, but it is frightening how many advisors create their own documents on the cheap. Pulled off of websites or borrowed from others, poorly prepared agreements often lack consideration for the local tax implications, corporate law in the state where they reside, provisions for both voluntary and involuntary termination, and how to resolve disputes. The consequence of saving money in the beginning is a bigger bill in the end.

The time to seek professional help is before you become partners, or prior to the merger or acquisition. As with a prenuptial agreement before a marriage, it is easier to come to agreeable terms when you like each other than when you are attempting to resolve a problem.

Recently we have received several calls for help from advisors who failed to negotiate the terms of a buy/sell agreement as part of their original merger transaction. I’m thinking of one particular case in which a merger was conceived as the first step in the older partner’s succession plan. His departure was meant to be the conclusion of the transaction. Why didn’t they establish the foundation for price and terms before consummating the merger? Alas, that was not part of the deal.

Unfortunately, when facing the end of a career—as with a marriage—decisions tend to be emotional and filled with conflict. An agreement would not necessarily have ameliorated the emotional distress, but it would have allowed both parties to traverse a fact-based path that was developed when both were coherent, relatively objective and working in harmony.

Now the challenge is how to manage through the exit with minimal disruption, if not complete happiness on both sides. When both parties passionately disagree on the price and terms, it is important to unbundle the issues. If they can come within a reasonable range on the assumptions, there is a chance that the emotional challenges will be resolved.

Developing the Assumptions
When buy/sell agreements are unclear, most disputes focus on the price to be paid and the timing of the payments. Inevitably, the seller wants to get the highest possible multiple paid immediately, while the buyer wants a price that is cash-flow affordable and a payment schedule stretched over time. The other issues that arise are usually less complicated to resolve.

The most expedient way to settle the valuation question would be to engage an outside firm to establish the price and craft a binding agreement that this opinion of value prevails. But oftentimes heated negotiations leave one side holding a grudge until the end of time. So before going to binding arbitration, it is usually helpful to begin businesslike discussions with each other over the key elements that drive both price and terms. In other words, develop a set of mutually agreed upon assumptions that could be put into a model.

Since the buyer wants a reasonable price paid as quickly as possible, and the seller wants a reasonable price and payments staged so he can manage his cash flow, here are the issues to negotiate, using facts and a respectful tone:

• What are the demographics of your clients and what is the expectation of growth in organic assets over the next five years, accounting for withdrawals and infusions? Be as specific as possible based on what you know about each client, and try to avoid being speculative.

• What is a reasonable expectation for growth in revenue for the next five years based on your current clients, your pattern of new business development and your physical capacity to take on more clients?

• Based on the current investment mix of your clients, what is a reasonable rate of growth in the value of those assets and how will that translate into fees for the practice?

• What overhead expenses are likely to continue for this period, and how are they likely to go up or down? What is the likely rate of increase?

• Will the seller have a continuing role and what will be his compensation during this period?

• Will the buyer need to hire additional professional, technical or administrative staff to manage the business based on its current and projected client base? What will this cost?

• Using any of the compensation studies available in the market, what would be fair market compensation to replace the seller based on his job description, experience, credentials and role—both as an advisor and as a business manager? In other words, hypothetically, if he had to be replaced, what would it cost to replace him? (This is a useful exercise to apply to the buyer as well in order to demonstrate the on-going economics).

• What will likely happen to the client base should one of the principals leave? Are there any loyalty concerns? Or clients at risk? Be specific.

• From an objective investment standpoint, what is a reasonable rate of return for an investor in a small, closely held advisory business dependent on a few people, when compared to long term bonds, large cap equities, small cap equities or any other liquid investment that you would be inclined to invest in? Is your business more risky or less risky than any of these choices? (Clue: if one party says “less risky” and therefore the required rate of return is lower, the chance of coming to a reasonable agreement is remote because you are not dealing with a rational person).

Much more goes into determining the valuation and deal structure, but these questions are the essence of the process. If both parties can’t objectively and systematically address these issues and make appropriate compromises within reason, then binding arbitration or litigation may be the inevitable conclusion. This conversation should occur before becoming co-owners of a business to avoid such a conflict. Unfortunately, hundreds of buy/sell agreements in place today will produce a bitter end to a once beautiful relationship.

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