From the July 2012 issue of Investment Advisor • Subscribe!

The Financial Upside of Succession Planning

This is an extended version of an article that appeared in the July issue of Investment Advisor.

As a smart financial advisor, you want to maximize the value of your most valuable asset—your practice. Merger and acquisition professionals suggest beginning succession planning at least 10 years ahead of transitioning a practice, but only 6% of advisors are doing so, according to a recent research study commissioned by NFP Advisor Services Group and produced by leading independent research firm Aite Group. An even scarier statistic: A whopping 42% of advisors who are within two years of transitioning their practice to a successor lack a succession plan. The same study shows that advisors aren't realistic about the factors that impact practice valuation.

The Efficient Frontier of Succession: Maximizing Practice Value” is based on interviews with M&A consultants and leading buyers of advisor practices, as well as on a national survey of practice owners, quantifies the current state of succession planning by financial advisors and suggests solutions.

Succession isn't a concern only for near-retirement practice owners. The next generation of advisors who take over practices will benefit from the legacy of savvy succession planning. So too will clients, who can feel torn by the transition to new advisors. You should also consider the possibility of unexpectedly becoming disabled. The sooner you start planning, the better you, the new owners and your clients will fare.

Practice owners who view succession as a long-term process, rather than simply an event, can minimize the pain and maximize the gain they achieve when they finally leave the business they've built up over the years. This issue has industry-wide implications, as 39% of advisors surveyed said they plan to transition their practice to a successor within the next 10 years. The quality of the upcoming large-scale transition will affect how positively—or negatively—individuals view the financial advisory business.

Advisors Are Waiting Too Long

Advisors know the value of aiming for the efficient frontier in their clients' investments, balancing risk and reward over a long time horizon. But they're failing to apply the same methodical approach to their practices. As a result, they're shortchanging themselves.

Advisors have unrealistic expectations about how long it takes to implement a succession plan. Almost 70% of survey respondents said it takes five years or less. This figure includes 26% who responded that it would take two years or less. Only 11% of advisors believed succession would take six years or more. As mentioned above, many advisors are approaching transitions without any plan.

However, in the experience of M&A consultants who deal with financial advisory practices, it takes 10 years to plan for a successful transition. There are many things that can go wrong or take longer than expected. This is especially true if—like most advisors—you'd like an internal candidate to take over your firm. For example, your first candidate may not pan out. "Finding a successor who is a good fit" was the No. 1 succession planning challenge identified by practice owners in the survey. You may also need to address other weaknesses of your firm.

Advisors Underestimate Practice Valuations Drivers

Reliable earnings and client retention, along with allowing adequate time for the succession planning process, are key determinants of practice valuation. However, the survey shows that advisors mistakenly think that assets under management (AUM) is the most important factor in valuation, followed by revenue. Assets and revenue count, but normalized earnings are more important, as the valuation table below shows.

Three Levers Advisors Control

Advisors can boost the value of their practices by paying attention to three critical factors: time, client retention and earnings before interest, tax, and amortization (EBITA).

Time. The more time you have before you leave your firm, the more influence you can have over its valuation. Many risks can be avoided if you start planning early enough. Planning should start at least 10 years ahead of a transition, with deciding on internal or external succession and creating a detailed plan for the succession process. This lets you identify your firm's weaknesses and risks, and then create a plan to address them.

Client retention. Among the greatest risks is client retention. It’s the biggest stumbling block for advisors who acquire practices. One in three acquirers in the survey experienced client retention of less than 50%—well below the ideal target rate of 90%. If you don't position your practice for a high client retention rate, you'll face buyer demands to cut your price. While 90% client retention may sound aggressive, it's doable if you start planning early.

Here's a tip for your negotiations with buyers: Don't agree to lower client retention assumptions, as buyers sometimes request. Instead, agree to reduce the practice valuation if the actual client retention rate falls below a benchmark, for example, 90%. Also, ask for an upward revaluation if the transition boosts revenues. This is a win-win scenario because both parties achieve downside protection.

EBITDA. There are several factors that enhance your firm's earnings as represented by EBITDA. It’s no secret that you can improve your bottom line of earnings by generating more revenue and reducing firm expenses. However, fewer advisors recognize that they can help both revenue and expenses by increasing their firms' technology efficiency, a topic which Aite Group and NFP Advisor Services Group addressed in an earlier white paper, “RIA Technology Integration: The True Opportunity Cost of Inefficiency.” If your time horizon is less than three years, focus on reducing risks with projects such as technology integration or putting contracts in place to help you retain key employees.

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