Advisors we talk to say that for the most part, business is good, yet many express concern that they are not growing fast enough with the right clients. To remedy this situation, advisors may choose to create financial incentives for referrals among centers of influence or to rely on custodians to create business leads. In either case, there is a cost: not just in money, but in firm culture and identity.
When you abdicate control of your brand to others you have stopped building a self-sustaining business. You have also diminished the need for others inside your firm to learn how to build proper relationships with the marketplace. These personal relationships are the lifeblood of all service companies. Business growth under a referral scenario becomes a mere financial transaction. Your firm becomes a product manufacturing enterprise that sells investment advice, financial planning or wealth management via a distribution channel.
In spite of my righteous indignation on this topic, advisory firms commonly form strategic alliances with other professionals such as accountants, insurance agents and lawyers. It is commonplace for money to change hands in return for the opportunity to serve each other's clients. This approach may work, but only with clear expectations, measurable terms and aligned goals for the client experience.
Every party to a strategic alliance should understand that the relationship is meant to be short term. Either it works extraordinarily well and the parties create a more formal business structure, or it works poorly and the relationship dissolves. I have rarely seen anything between these two extremes result in long-term success. Even for the short term, each party should agree to certain conditions and answer certain questions:
What is the value of the referral to the advisor?
What should be paid to the source of the referral?
What are the profitability implications for the receiving advisor?
Should the referral source have performance expectations?
Should the arrangement be disclosed to the prospect or client?
Let's begin with the economic implications of this strategy. A number of referral arrangements dictate a fee split of 50/50 between the source of referral and the recipient of the lead. More commonly, the advisor who gets the referral pays a higher amount in the first year and a lower amount in subsequent years. This could start in the 20%-25% range on the first year's revenues and drop down to 5%-10% of revenues in subsequent years. Some arrangements require that amount to be paid for the life of the relationship, but in the best situations for the advisor, the payment will be limited to a defined term, somewhere between two to seven years.
Two things to keep in mind: First, whatever you pay for the opportunity to do business with a particular client is the same as putting a value on a book of business. Second, over time, the client relationship transfers to the advisor. The referral source is no longer connected to the economic value once the advisor has built a strong and trusting relationship with the client.
To test a referral arrangement, apply the total referral payout over the projected life of the relationship times the revenue the advisory firm receives from the client. If the value is more than two times annual revenue, then you will have paid too much. (And frankly, for most advisory practices, two times revenue is too high.) Imagine that the client stays with you for 20 years — at a 50% payment to the source of referral, you would pay the equivalent of 10 times annual revenue to acquire that client. What has the referral source done to justify such a premium?
Remember, the practice must manage to a gross profit margin (GPM), optimally of 60%. Whatever they pay in referral fees must leave enough to compensate the advisor for his labor as well. What is left over in the form of gross profit must cover overhead like rent, administrative staff, compliance costs and technology (see image). Assuming a target GPM of 60%, this means the direct expense (cost of services sold) would be 40%. If the advisor pays an up-front fee of 25%, that leaves only 15% to cover the advisor's time (40% – 25% = 15%). How do you feel about serving a client for a fraction of the fee you get for generating the new client on your own?
Both parties must be clear on what success looks like in a referral relationship. I strongly believe that if an advisor is going to enter an arrangement in which they make payments, then the source of the referral should have a systematic process for driving business and there should be measurable goals. For example, an advisor could increase the payout based on the volume of actual signed business, just like breakpoints in a broker-dealer. Whatever the arrangement, it must be systematic and managed.
Proper training and communication between the advisor and the referral source must ensure that the proposition is represented properly and that the service experience is what the client expects. If the referral source treats this relationship as a mere financial transaction, they may be putting their own reputation at risk and, in some states, exposing themselves to financial liability.
If the referral arrangement involves another professional, for example a CPA firm, there should be a clear delineation in roles and responsibilities between the two professional disciplines. Who will lead on tax planning and estate planning? What role will the CPA have in looking over the shoulder of the advisor? Will the accountant reciprocate with a referral fee to the advisor for business that flows back?
Any agreement should have performance measures and a specific term subject to renewal. The relationship must be actively managed. Money does not motivate, period. It is a reward for creating opportunity, but it is not an inducement. The sooner both parties grasp this concept, the healthier their relationship will be. If anyone doubts this, just watch what happens to the lead flow after the initial flurry — if money motivated, it would be a golden spigot of opportunity. In truth, the stream usually dries up in short order if the relationship isn't managed and the interests aren't aligned.
Strategically, advisors must be clear about how they define success when they rely on third-party referrals. They must understand the financial impact when giving up a portion of their fees to compensate for leads. Ultimately, any business driver not controlled by the advisor puts the practice at risk because the flow could stop at any time. To remain in charge of their own success, advisors should regard such referral programs as supplemental and not key to their business growth. They should also make sure that they are properly licensed as RIAs or broker-dealers or registered reps, and are aware of important disclosure requirements. The implications of not following the rules in this realm have real consequences.
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