From the November 2013 issue of Investment Advisor • Subscribe!

The Fatal Succession Planning Mistake

Consider this your warning: If you’re focusing too much on valuation, your internal succession plan is at risk

Illustration by Matthew Hollister Illustration by Matthew Hollister

I spent the beginning of my childhood living on a 10,000 acre ranch in the middle of nowhere-ville Kansas.

The “ranch house,” as we called it, sat on a long dirt road simply named North Kansas Road. The scenery on this road was beautiful—long green pastures with rolling hills bordering a state park. The road itself was pretty good, as dirt roads go, except for a blind left turn that swung straight west into the sunset in the afternoon. If you were going too fast or were blinded by the spectacular sunsets over the plains of Western Kansas or if it had recently rained, the car-eating potholes just around that curve made for a very dangerous situation where many people (and cars) got hurt. It was so bad that, as a child, I would fantasize about standing in the middle of the road, at that curve, holding a stop sign to warn drivers what was ahead.

Seems silly, but I’m reminded of that road nearly every day when I’m working on succession planning with my advisory clients. Succession planning is a lot like traveling that road for the first time. For many owners, transitioning their firm to the next generation can be a dramatic left turn into the sunset, blinding them to the dangers that lie ahead. Unfortunately, I have seen more than a few owners go into that turn way too fast and wreck their businesses. I have also seen them lose everything they spent years building because they focused on the wrong areas of the plan. I’ve consoled too many owners through their pain after hitting the potholes of an unrealistic plan and the drastic consequences that can follow.

The scope of the succession problem in the independent advisory industry is well-documented. We’ve known for years now that the baby boom generation of advisory firm owners are on the brink of retiring over the next 10 years or so, with some sources estimating that as many as 50,000 of their firms—and $4 trillion in client assets—will be changing hands or closing their doors. The vast majority of the owners of these firms would prefer to transition ownership to their junior partners in an internal succession. Yet very few have taken steps to make this happen, even at this late date. What’s scarier, many owners have failed to educate themselves and their juniors on how internal successions work.

A survey released last July by insurance giant John Hancock Financial Network’s renamed broker-dealer Signator Investors reveals three sad details about this situation. According to the survey, only 11% of independent advisors have a succession plan in place, and just 20% of advisors are certain about what they will do with their practice when they retire. At the same time, some 30% of firm owners have a successor advisor on staff, leaving 67% who plan to hire one in the future. Not surprisingly, advisors’ two primary succession concerns were training a younger advisor to succeed them (66%) and financing the transition (69%).

Yet the industry’s succession challenge isn’t limited to a lack of adequate planning, or even to finding and training appropriate successors. The fact is that succession planning for independent advisory firms has only been an issue for the past 10 years or so, starting when firms began to accumulate sufficient client assets under management to represent substantial, transferable value. Consequently, a consistently workable model for advisory firm succession hasn’t yet been developed. Many of today’s succession “experts” often use models designed for other industries, with templates that offer quick and easy solutions but ignore key issues. They repeatedly spend only a short time helping implement these plans and move on to the next job, with little or no involvement with the eventual outcomes—or the problems these models create.

In our experience working with independent firms on a long-term, ongoing basis, an internal succession presents numerous challenges that rarely have easy solutions—and virtually none of them is quick. Here are the often overlooked problem areas of internal succession, which every owner-advisor needs to understand and have a strategy for overcoming to manage a successful transition:

  • Lack of financing options. This is the major challenge for virtually all internal succession plans. Unless owner-advisors are willing to essentially give their firms away to their junior partners, there are only two viable options, which can be combined into a successful succession plan: finance the acquisition out of the growth of the firm or lengthen the time for the transition of ownership to occur.

  • The wrong incentives. Who’s going to drive that growth? If our experience has taught us anything, it’s that people tend to do what they are incentivized to do. Without significant motivation to grow the firm, junior partners may not get as much help as they need from a near-retirement senior advisor to meet the plan’s growth projections. If the compensation for junior partners increases too fast, too soon, it can have a dampening effect on their motivation, particularly in the early years of a plan when generating firm growth is most important.

  • Unrealistic assumptions. Transition plans that are based on too low a growth rate over too short a time period usually prove to be unworkable. When it comes to succession planning, firm owners need to start early, providing time for firm growth to underwrite the buyout and tying junior partners to the firm—and eliminating turnover, which can be disastrous to any plan.

While each of these challenges presents its own set of issues, in our experience, the hardest challenge to overcome is focusing too much on valuation. While the buyout value of the firm is certainly a factor in a succession, it’s not nearly as important as many buyers, sellers and experts in this industry seem to think. Much of what is written and talked about regarding internal succession is valuation. This over-focus can lead to unfavorable deal terms, divisions between buyers and sellers, and a lack of options to get the deal done.

For example, we recently had an owner-advisor contact us to solve a big problem he had. He wanted to internally finance the transition of his 30-year-old firm to his three junior partners (one of whom is the owner’s daughter). So the owner first got a valuation as suggested by the expert and put a plan together in which the buyers didn’t have to come up with any of their own cash, and the growth of the firm would buy out the owner over the next 10 years.

Unfortunately, the junior partners were not happy. Instead, they focused solely on the selling price of the firm. They countered by getting a consultant to do their own valuation based on different assumptions, resulting in a price that was half of the original valuation. Then they negotiated to buy the firm immediately at the lower valuation, with a 10-year note that allowed them to defer any annual payments that couldn’t be covered out of profits into a “balloon payment” at the end of the term. If they defaulted, the unpaid equity would revert to the owner—and the owner was out from day one.

The owner took the deal (family was involved). That was two years ago: The firm, which had been growing at 15% per year prior to the succession, hasn’t shown a profit yet, and the new owners have made no payments on their note and don’t seem to be planning any. The owner understandably feels taken advantage of, and he and his daughter aren’t speaking.

As illustrated above, the real key to virtually every successful internally financed succession is firm growth. It provides the capital to finance the buyout and controls the time it will take, as well. Consequently, firm growth creates an incentive for the owner to keep working hard and for the junior advisors to maximize their contributions to the success of the firm. By focusing on valuation rather than the far more important deal terms and incentives to grow the firm, both owners and junior advisors can cost themselves millions of dollars, years to make the transition of ownership, and even jeopardize the succession itself.

We’ve found that the master key to reducing the emphasis on valuation and increasing the chances for a successful transition is education about firm growth, finances and the deal structures of succession. We outlined those principles in our recently released white paper, “Take Two: The New Direction of Succession.” Unrealistic expectations and false assumptions by the buying advisors can undermine the best of intentions of the owner-advisor. The first step is for the junior partners to understand that it’s an internal succession not an acquisition and the difference between the two. They need to realize that because they can’t get external financing, the firm owner is willing to share the growth of his or her firm to finance the deal and will probably receive less than the market value of the firm. They need to see the other options that the owner has: selling to another advisor, an institution or a roll-up firm—or simply banking the increased revenues for the next decade or so and then closing the doors.

What’s more, junior advisors need to understand that it is an internal succession based on internal (read: owner) financing. It’s not a negotiation like buying a house or a car. It’s a plan for a team effort to turn the owner’s firm over to them, usually at some cost to the owner. Firm owners need to understand the firm growth that will finance a succession is largely dependent on the junior advisors: Consequently, they deserve to share in that increased revenue and firm value.

Because there’s so much information—and more misinformation—about succession, junior partners need to understand the various models that they might hear about, and the pros and cons of each. They need to see the various valuation methods currently in use and then, through the use of sample deal projections, see that valuation isn’t nearly as important to a succession as the deal structure and the growth of the firm.

Once the junior partners have been brought up to speed on what it takes to create a successful internal succession, the present and future firm owners can work together to structure a deal that works for everyone. In this process, the owner needs to be open to suggestions by the junior partners and to a minor amount of negotiating

Most negotiating should revolve around the assumptions upon which the succession plan will be based: the time frame, the firm growth rate, the profit margin and the role that the selling owner will play in the firm, now and in the future. We use multiple spreadsheets so that the junior partners can clearly see how each assumption affects the time line and the payouts to each party. It’s also important to create motivation for the buyers and the seller to complete the transition of ownership sooner than planned by leaving room for a higher growth rate than the one used as a baseline.

At this point, a major stumbling block is often confusion on the part of the junior partners about the difference between their annual compensation and their profit sharing. Typically, they need help mentally separating their compensation for doing their jobs from the portion of firm profits they receive as owners. Clear spreadsheets can help illustrate that their compensation structure is not changing by separately showing the payments for their job, the payments for their ownership profit and what they are paying to the owner on their note for their equity shares.

Unless the selling owner will be scaling back his or her workload or leaving the firm, or the owner’s compensation is completely outside industry compensation benchmarks, his or her compensation should not be reduced. (Word of advice: Any time a succession plan requires the firm owner to significantly reduce owner’s compensation to make it work, you have the first indication of a bad internal plan.) We like to see at least modest increases over time as an incentive to help grow the firm. The last thing a junior partner should want is a reduction in the owner’s compensation structure because it reduces their motivation to help grow the firm under a deal structure that requires that growth to make it work.

As we pointed out earlier, part of the driving force for growth will be the owner-advisor and, increasingly over time, the new partners. So, we have to ask ourselves: What are their incentives to grow the firm? If the owner’s compensation will be reduced in the plan or he sells his firm for too much of a discount, sooner or later he’ll lose motivation, which can have a substantial and negative impact on the success of the plan.

Only after an agreement has been reached on the structure of the succession should the parties begin the discussion about the value of the firm. If you talk about valuation first, the junior partners will focus solely on a price, and there’s a very real chance that the deal will spiral out of control.

Here then, is our action plan for a successful internal succession:

#1 Establish trust. A successful transition depends on trust between the firm’s owner and its junior partners. To lay the groundwork for succession, we use firm-wide compensation structures that share a percentage of the firm’s revenue growth with all employees. At a minimum, this should be done with all advisors at the firm. Revenue bonuses also form a financial bond between firm owners and employees. If the firm succeeds, we all succeed; if the firm goes through rough times, we all share the burden. Most importantly, including revenue-based bonuses as part of employee compensation proves to all employees that they can trust the owner to share the firm’s success.

#2 Invest in education. As owners, you have to understand the finances and structures of succession so you can educate your future partners. This is the most important element of a succession plan. Because there’s so much bad information out there about succession, junior partners need to understand the various models that they might hear about, and the pros and cons of each. In order to educate them (and it’s your job) you need to invest in your own education and then the education of your junior partners.

#3 Create a deal that works for everyone. In all of my years consulting, the most successful internal successions are as unique to the firm as the firm itself. Your plan will be unique to your firm, and no template is going to perfectly solve your succession. There are key elements that include a sufficiently long time line combined with reasonable growth projections to pay the owner a reasonable value for the firm, while allowing the junior partners enough profit sharing to increase their total take home pay and pay for their new equity.

#4 Don’t focus on valuation. Only after an agreement has been reached on the structure of the succession should the parties begin the discussion about the value of the firm. To start discussions about valuation, we suggest the parties come to an agreement about which valuation method best suits their firm, then any additional assumptions to be used. Most assumptions will already be contained in the deal structure itself. Depending on the valuation method, additional factors might be needed such as the discount rate and relevant time period for future cash flows (in the case of a discounted cash flow method), or the attrition and spend-down rates of the client base, or market performance within AUM.

Warning: There are a lot of industry valuation companies out there that have strong beliefs about how your company should be valued. You have to educate yourself about their biases and ask them a lot of questions about how they determine value. Then, you and your team should agree on a valuation method before you ever go to an outside party for a valuation on paper. Otherwise, you are at a grave risk of having an outside expert determine the philosophies of your transition for you or getting into some serious negotiating with your buyers about which method is right or wrong.

#5 Start early. It’s never too early to start transferring ownership to a successor advisor, once the owner is sure who that successor is. The increased motivation will help drive firm growth, which is the key to internally funded succession plans.

We know through our experience and research in succession planning that if you take a step back by following these five principles, you can take two steps forward by avoiding the potholes on what can be a dangerous road. As a result, when you decide to make that turn into the sunset, your transition will be just as meaningful and rewarding as the road you traveled to get there.

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