From the January 2014 issue of Investment Advisor • Subscribe!

Untangling Ownership: Succession Strategies for Firm Partners

Selling to a junior? Looking for a firm to acquire yours? Whatever your plan for succession, there’s one thing you can’t compromise on: your partnership

To prepare a valuable succession plan that will take their firm into the future, advisors have to begin at the beginning and build a business instead of a practice, according to Charles Farrell and Fred Taylor of Northstar Investment Advisors. Regardless of an advisor’s exit strategy, it won’t work if he can’t detach himself from the firm.

“In order to build any kind of enterprise value, to be worthy of receiving some sort of buyout when you retire, you have to build a business not a practice,” Farrell, CEO for Northstar, told Investment Advisor. “Saying you have a practice that’s unique to you, the clients are tied to you, the philosophy’s tied to you; there’s really no way for anyone to buy you out because there’s no way to tell how many of those clients will stay, what sort of revenue you’ll generate, not a year or two out, but really 10 years out.”

One of the hurdles to building a business with enterprise value is getting past individuals’ personalities. “Everyone who’s started these firms, they’re Type A,” Farrell said. “They don’t like to listen to other people. They don’t play well in groups. It’s very hard to find partners where you have Type A personalities—because you have to have them to build your business—but when they get in the office, they can check that Type A personality at the door and figure out how you can each work to blend your talents into a business that is scalable and can be run eventually without you.”

He added, “If you’re the sole owner and the firm’s named after you, that’s going to be tough.”

Taylor, president and co-founder of Northstar, agreed.

“That’s why we didn’t name our firm after the partners 18 years ago,” he said. “Prior to Charlie joining Northstar in 2007, we all had four different practices. Then when Charlie came in, he had this idea of this model portfolio. All new business was under the new model, which is way more efficient because now everybody is managing money the same way. It’s not like, ‘I work with Charlie’ or ‘I work with Fred.’ It’s, ‘I work with Northstar.’ It’s a better model. We’ve doubled our business since Charlie’s been working with us.”

Another obstacle advisors encounter when trying to establish a business instead of a practice is finding strong partners they can trust.

“In the end, it’s your partnership and relationships that are the most important,” Farrell said. “It’s hard to find people in finance that you can trust and work really well with. I personally feel very fortunate that I have Bob and Fred as partners because you can’t get to the point of building a business if you can’t 100% trust your partners.”

Lack of trust is what causes advisors to “pull in and build a practice instead of a business because they think they’re going to get hosed at some point,” Farrell continued. “If you don’t have that trust there’s no way you can turn over the client base to the business. Every person thinks about, ‘If I had to leave, what would I take?’ That’s what guys think about in our industry, and you have to be able to get over that and say, ‘No, I’m fully, 100% committed to building a business with my partners.’”

Farrell and Taylor described their own buyout structure, which has evolved over the years.

“The first person who retired, there really was no buyout for it,” Farrell began. “There was no theory or formula; the clients that were there were turned back over to the firm.” The next partner to retire was offered a buyout based on the clients that person brought to the firm. The buyout for the following retirement was based on firm profitability as well as the clients that had been brought in.

“Now there’s no connection to clients,” Farrell said. “It’s based on what we think the enterprise value of the business is and is designed so that there’s no windfall if you leave—there’s an incentive to stay. If you were to retire, there’s a fair payout to you that’s based on the value of the business, but there’s also potential for adjustments if the business profitability changes. You have to be sure that when you’ve left, you’ve left it in really good shape or you can’t get your buyout.”

Taylor added that when advisors are still invested in the firm, it’s better for all the partners.

“You still have skin in the game to make sure your clients stay with Northstar,” he said of their buyout structure. “We manage 95% of assets, so if one of us leaves, it really hurts the other partners. There has to be a way we can go out and hire someone else to replace one of the partners and maybe hire two more people. You can’t just write whoever retires a massive check and be done with it. A lot of firms have done that and lived to regret it.”

When it comes to hiring new advisors, what is Northstar looking for?

“They have to be able to bring in the business. That is the key,” Taylor said. One of the drawbacks of selling to a junior advisor is how they’ll pay the outgoing partners. “You can sell it within, but you’re probably not going to be able to sell it for that much. You’re going to have to be willing to take less of a price in order to keep the business going.”

Farrell hinted at another drawback. Younger advisors have grown up in a different environment from the one veteran advisors experienced. “You have to have second-generation skills, and that’s hard to find. We all did it because it was the difference between losing your house and making your business work. Other people who come up through this system where it’s more protected, it’s harder to find people who are driven to build the business as opposed to being a caretaker. If the business doesn’t grow, it’s not going to be around for 10 or 15 years for them to buy you out.”

“You need the right partners, and then you need to hire the right people,” Taylor said. He described one of Northstar’s recent new hires.

“We brought in a guy who’s 40, from Seattle. Ten years’ experience, MBA, CFA, really smart. More on the research side. We’re educating him on how hard it is to bring in new business; in some cases it takes years. It’s relationship based.”

Ultimately, what the firm wants is someone sales-oriented who can do business development, Farrell said. “With all these advisor groups, as clients age, there’s a lot of money that goes out the door every year. There’s a 4% to 5% drag. So let’s say your portfolio’s net after fees 6% or 7%—the market’s low. The only way you can grow is new business.”

Taylor agreed. “Say you have a 91-year-old client and their portfolio has $3 million. They have five kids. You don’t know the kids; they’ve never been introduced to you. You’ve done a great job with that person, but when they die, the portfolio gets chopped up, and [the kids] probably have their own [advisor]. You always have to be adding new business. With what the new numbers are, you really have to manage half a billion to survive now.”

The Merger Option? And the Problem With Banks

Some advisors may feel an “urge to merge,” as Farrell put it, but there’s a problem there too.

“It doesn’t make you any more profitable,” Taylor explained. “Then you pick up everyone else’s headaches and everybody else’s egos.”

What lasting success comes down to is the relationship between the partners, according to Farrell. “I think it’s hard to find many rollup firm models in other industries that have worked. Go look at insurance; there are all kinds of examples of these things. You’ve got owners who are used to being on their own. You roll them up, and everyone wants their payday, gets out, and what you’re left with is a gutted entity with no business value. It’s not good for the clients either.”

He added, “Your best investment is your own firm. The best bet is to build, just like we talk to clients about, sustainable, long-term cash flows—that’s your business. Focusing on that instead of a big payday is probably way more effective.”

Focusing on growing your own firm instead of rolling up two firms helps avoid the tricky problem of rolling up two different cultures. “Combining different cultures of people with that level of drive is really, really hard,” Farrell said. “If you have something that works, you should build it organically and figure out how you can make that really long term and sustainable. In our industry, I don’t know what it’ll look like in 20 years. It really is going through a big transformation. I think there will be a lot more of these national firms rolling up. If you don’t want to do that, then you have to figure out a way to be big enough on your own.”

Selling a firm to a bank has its own limitations, Taylor said. “You get, maybe, a nice payday, two or three times revenues, but then you’ve got to pay taxes on it. Now you’re working for someone else and you were used to making more money than you are presently. That doesn’t work very well so there’s this constant tension. The bank model doesn’t work.”

“The No. 1 thing is the partnership relationship,” Farrell concluded. “We spent a lot of years having really honest conversations about how to get into our roles and what it all meant and what it meant economically for the firm. Those were hard conversations to have, but they were the best thing we ever did because now we’re all rowing in the right direction.”

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