The New Critical Mass

In the late 1980s, I had a conversation with Larry Carroll, a financial planner in Charlotte, North Carolina, whom I regard as one of the sharpest business people in this profession. I asked him what he thought constituted “critical mass” for a financial advisory practice: How big does a practice have to be, I wondered, to achieve maximum operating efficiency? “When you can afford a full-time business manager,” Carroll replied drolly.

I’ve often thought of this exchange when I’m musing about defining the optimal size for a financial planning practice. I’ve struggled with a conclusion, though, because I continue to observe that as advisory practices grow, they hit a series of walls. It happens at certain levels of revenue and it happens at certain levels of staff. Popular wisdom for a long time was to think that when a firm had one senior advisor (the owner) and two associates, plus some administrative staff, and when they were doing about $1 million in annual revenue, that this would be regarded as a “decent-sized” practice. Now, I have concluded that the new definition of critical mass is an advisory firm that does $5 million of annual revenue generated by at least three teams, each led by a senior advisor, supported by at least two associates. But there are two major stumbling blocks to getting there. The first concerns a concept called “span of control,” which is the point at which managers can’t touch their growing staff in a meaningful way and staff no longer feel they are getting direction or attention from their leader. The second involves how to deal with speed of growth and the evolving sense of purpose in a practice.

We’ve already written quite a bit on the financial management aspects of this issue, so this month we will take a more detailed look at the organizational issues that can raise these stumbling blocks on the path to growth.

Having worked in and around the planning profession for almost 30 years, and having looked at thousands of practices, either through our studies or our direct consulting, I have noted that advisory firms hit walls when they get to five people, then eight, then 13, then 21 …. Almost in the manner of the famous Fibonacci sequence (where every element is the sum of the previous two elements), you can project when a firm will hit the wall again. At first it seemed largely anecdotal, but advisors nod their heads when they hear me describe this pattern. There is also solid research to support this hypothesis.

Organizational design specialists attribute this phenomenon to span of control. There are management science studies suggesting that one manager can effectively manage no more than five to seven direct reporting relationships. The implication for advisory firms is that they will need to develop managers along with staff to ensure there is a consistent means of overseeing different aspects of the practice as it grows beyond the ability of owners to manage it.

Unfortunately, this puts most advisors in the position of stepping on the accelerator and the brake at the same time. Each time you add a person, you feel the need to bring in more revenue to pay for this added overhead. When you sell more, you put more pressure on your organization to keep up, thereby beginning the ugly cycle. Does it ever end? Yes, but not without some pain. The cycle begins to ebb at a point much higher than most advisors used to think, partly because of the rising costs of labor, compliance, E&O insurance, and associated expenses.

I now think of critical mass as the point at which a practice achieves optimal efficiency as measured by its overhead expense ratio (all overhead expenses divided by revenue); optimal effectiveness as measured by the productivity of its staff; and optimal profitability. Typically, as a firm’s revenues grow its profit margin shrinks, and then, ideally, the margin starts to grow again. This happens because advisory firms add fixed costs in the form of added staff to support their growing size.

There should come a point in staff productivity when the practice is at optimal capacity, as measured by the ability to grow profitably with each new hire and without a hiccup in the operating margin. Put another way, there is a critical mass point where the organization becomes systematic enough so that the addition of one more person is instantly productive rather than a drag on the bottom line.

Envision a large philharmonic orchestra and compare it to the garage band you played in when you were 17. Adding another clarinet player in the orchestra is a smooth process–everyone is an experienced professional, there is a conductor, everyone knows their role, and has their music in front of them. In my garage band, when Jimmy went to college, the band fell apart because the new drummer never learned our songs. We never gave him any printed music, either, but if he was good he would have learned–or maybe not.

The organizational challenge manifests itself in the financial results in a very dramatic manner. I had a breakthrough in my thinking about this as a result of some interesting analysis done by my colleagues at Moss Adams, Bethany Carlson and Philip Palaveev, for the recent financial performance and operating study they conducted for the Financial Planning Association. As you can see in the “Economies of Scale” chart below, firms do not dip below 35% overhead and become fully efficient until they reach $5 million in revenue.

We have observed that real operating leverage is not achieved until advisors build out capacity in their practices through the addition of professional and administrative staff. Most advisors will agree that they waste time doing things they shouldn’t do. Leverage allows you to delegate work to others so that you can focus on your unique abilities and use skills that have the greatest impact on your business.

Julie Littlechild of Advisor Impact in Canada did an interesting study of this issue. She found that there is a certain amount of time that the typical advisor dedicates to each type of client–top priority, average, or low priority–every year. For a top-priority client, she found that a senior advisor averages three face-to-face meetings, eight proactive phone calls, and an additional 11 hours reacting to inquiries and requests: The total time an advisor spends with a top-priority client is around 20 hours a year. Assuming that you only have 1,800 hours in an average work year, this would tell you that the most relationships you can manage would be 90 (1,800 divided by 20 hours). This also assumes that all you do is client service, which we know is not the case.

In further studies, Littlechild found that the average advisor spends 39% of her time on client service, with the remainder spent on “stuff” like business development, practice management, continuing education, and so on. This seriously constrains the amount of quality time an advisor can devote to client service, and consequently, constrains the ability of the firm to grow.

A Four-Step Process for Growth