From the June 2012 issue of Investment Advisor • Subscribe!

Smaller Pieces Make a Bigger Pie

Wider equity distribution leads to better succession options and growth for the whole firm

Illustration by <a href="http://www.shawnielsen.com/">Shaw Nielsen</a>. Illustration by Shaw Nielsen.

Across all stages of development, better-performing advisory firms distribute equity more broadly among their team members. While firm owners often view transferring shares as a way to “cash out,” distributing shares is as much about creating value as it is about realizing value. Sharing equity with team members can serve as a powerful incentive for attracting and retaining key talent. Broader equity distribution also improves succession options by reducing the amount of shares that owners need to liquidate prior to their exit while concurrently creating a pool of acquirers for any future equity transition.

Our study data provides strong proof that the benefits associated with distributed ownership have a meaningful impact on the performance and, ultimately, the value of an advisory firm. In “The 2011 FA Insight Study of Advisory Firms: People and Pay,” as with our previous studies, we designate the best-performing firms as “Standouts.” Standout firms represent the top 25% of firms at each stage of development in terms of two key performance indicators: revenue growth and owner income as a percentage of revenue. A clear correlation exists between Standout firms and broader distribution of ownership (see Figure 1, below).

Primary Owners As a Share of FTEs

At every firm stage, primary owners with a 5% or more equity stake account for a greater share of total full-time employees (FTEs) within Standout firms compared with others. The implication is clear: Cutting the pie into smaller pieces creates a bigger pie as the superior performance associated with broader ownership translates into more valuable firm shares.

The role of ownership structure in the success of an advisory firm is one of several pressing human capital issues explored in “The 2011 FA Insight Study of Advisory Firms: People and Pay.” Our focus on the transition of equity for this article is the last for the 2011 “People and Pay” series and follows articles examining succession preparedness and the development of team members. (See “Sounding the Alarm,” Investment Advisor, January 2012 and “Building a Talent Hothouse,” Investment Advisor, April 2012.)

Transitioning equity is an important part of a departing owner’s succession plan. As addressed in the previous articles of this series, transferring shares joins the transition of client relationships and management authority as the three key elements that make up a succession solution. Additionally, without an ability and willingness to share equity, staff retention is put at risk and succession options are obviously limited. Developing and retaining key talent is vital for continuing the growth of a firm and upholding its value. Experienced employees are a valuable commodity on the job market and retaining them will typically be difficult unless there is an opportunity for equity.

Crisis Looms as Ownership Concentration Grows

Despite the benefits of wider distribution, advisory firm ownership is gradually becoming more concentrated. Over the last two years, just 13% of firms, about one in eight, added a primary owner. The addition of new owners, however, has not kept pace with the departure of existing owners. Growth in owners has not kept pace with growth in employees either, resulting in owners accounting for a shrinking share of firm personnel in recent years. In 2010, fewer than one in six advisory firm team members owned a 5% or more share in the firm.

As ownership grows in concentration, shares become more valuable, and finding creative ways to transition equity is increasingly critical. An inability to develop new advisors and future ownership prospects at a rate that keeps pace with the wave of owners that are soon heading for the exits threatens the sustainability and growth of the industry.

Owners as an Average Share of FTEsMost Important Criteria for Admitting a New OwnerAs illustrated in Figure 2 (left), ownership is especially concentrated for larger firms as fewer and fewer individuals hold increasingly valuable firm shares. Innovators have just one primary owner (those with an equity share of 5% or more) for every 10 staff members. The share of secondary owners (an equity share of less than 5%) does increase with firm size, however. Despite this, owners of any type continue to account for a smaller share of FTEs as firms grow.

Few, if any, owners can afford to ignore the implications of concentrated ownership. A lack of distributed equity restricts succession options and hampers firm value. Conversely, broadening ownership can serve as a recruitment and retention tool as well as sustain firm financial performance and enhance firm value. It is not likely a coincidence that at every development stage, the Standout firms in our study show a much wider distribution of ownership.

Setting the Standard for Ownership

Internally progressing a team member toward ownership is typically a firm’s preferred succession path. Over the past two years, firms were nearly three times as likely to progress an existing employee into an owner or partner role as opposed to admitting an outside owner. All things equal, an internal succession is lower risk and less disruptive for clients as well as employees. The challenge is in defining the expectations around ownership, identifying and developing an internal successor and structuring the buy-in to be affordable.

Frequently, firms defer equity decisions because of uncertainty as to what to look for in a potential successor. Questions arise concerning the importance of client relationship skills, technical expertise, business development ability, management skill and personal qualities when evaluating ownership candidates.

According to study results, personal qualities are most often deemed the important criteria in owner selection. Leading the results was “character and values,” cited by half of firms as most important for an owner (see Figure 3, right). Unlike most other potential ownership criteria, character and values cannot be learned or acquired. Leadership and management ability, another attribute not readily taught, followed in importance, although its desirability will likely vary depending upon the presence of existing management in the firm.

A Question of Control

A reluctance to share control is another common hurdle preventing owners from more broadly sharing equity. Often, current owners, particularly founders, may be hesitant to let others influence the direction of the firm. Some firms (16%) sidestep this concern by not granting voting rights to certain ownership share classes. For these firms, voting rights are typically restricted to founders.

Assignment of Voting Rights Among Firms

Primary Form of Payment for Ownership

Passing on ownership without full rights is only a partial transition, however. A complete succession solution requires transitioning full voting rights with ownership at least in proportion to ownership share. When voting rights do exist for all owners, these rights will typically vary in accordance with the percentage of shares held. A significant minority of firms, however, grant every owner equal voting rights regardless of shares held. As shown in Figure 4 (right), slightly more than half of firms (53%) grant rights in accordance with shares owned, while just more than one-third (35%) grant fixed rights.

The practice of maintaining different tiers of ownership may suggest that those owners with lesser rights cannot yet be fully trusted to have input on significant firm decisions. If this is the case, then the firm’s original owners have inadequately vetted new owner candidates. A proper evaluation and admission process, including a focus on character, values, leadership and management ability, should give original owners the confidence to award new owners, at minimum, voting weight that is proportionate to their ownership share.

Funding an Equity Transition

As equity concentration and value increases with firm size, distributing meaningful shares to the next generation of owners becomes a growing challenge from the standpoint of affordability. Despite the need for creative solutions, most new owners (33%) are paying for shares with cash up front (see Figure 5, right). Cash through long-term financing is another important form of payment.

The remaining 38% of transactions do not involve cash and include contributing a book of business, earning shares as part of an incentive plan or simply being granted shares. These methods are not without drawbacks. Contributing a book is not applicable for an internal candidate. Granting shares without payment may create a sense of entitlement toward ownership among employees and will fail to communicate the full value of ownership. Distributing shares through a carefully structured incentive plan can be effective, but a longer period of transition may be required depending upon the size of the incentives.

For most cash-based transitions, the new owner is responsible for securing funding. The personal cash reserves or personal debt of the incoming owner was the primary source of funding for 56% of transitions. If current owners are truly serious about creating succession solutions, they need to explore creative ways to facilitate funding an acquisition that will support the succession plan. Some options that selling owners may wish to consider include the following:

• Extend the buy-in period over several years

• Designate multiple new owners per each selling owner

• Finance out of profits or cash flow in combination with a loan from selling owner

• Seek financing through the firm’s custodian or broker-dealer

• Work with a local bank where the firm already has client relationships

Plan to Succeed

Several reasons exist as to why firm ownership is increasingly held by proportionately fewer owners. Many owners fail to sense the urgency, and others are stymied by the practical challenges. The issues associated with transitioning ownership can be overcome, however, providing an owner takes the time to plan. An effective plan for qualifying and transitioning candidates for equity will include the following:

• Measurable criteria that define what the firm expects in a new owner, enabling the firm to consistently evaluate new successor candidates.

• A thorough due diligence process for vetting candidates that assures existing owners that the new owner can be trusted to participate in important firm decisions.

• A process for funding the buy-in of a meaningful proportion of shares.

With these pieces in place, firm owners will be better positioned to realize existing value and build greater future value in their firms.

Further Guidance

For additional guidance on human capital-related challenges that are fundamental for growing a firm, building value and preparing for succession, including detailed compensation and financial benchmarking data, readers are encouraged to order the complete “2011 FA Insight Study of Advisory Firms: People and Pay” at www.fainsight.com. For firms seeking advanced support on human capital-related challenges, please contact FA Insight directly.

In the months ahead, Investment Advisor readers can look forward to a new series of articles relating to “The 2012 FA Insight Study of Advisory Firms: Growth by Design.” Future articles will probe best practices as they relate to the pursuit of growth. Topics will include recommendations for structuring firm marketing and operations functions and how to best realize efficiencies of scale.           

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