With today’s focus on growing advisory practices while managing costs, more advisors are entering into joint-venture or referral relationships with other professionals. In some cases, advisors are even becoming part of larger businesses–accounting firms, banks, and law firms–hoping they will get a steady stream of qualified clients in return for sending a cut of the action back to the parent firm. In many cases, especially when both firms serve the same type of clients and there is a mutual respect for and understanding of the services that each offers, these referral arrangements can yield significant, even dramatic, growth in the client base and the revenues of an advisory practice.
Unfortunately, the majority of the referral arrangements we have seen have not been very good deals for the advisors. In fact, many have been economically disastrous. The referral fees are usually too high for the advisor to make enough (or sometimes any) profit on the new business, and because a portion of the fee is often paid in perpetuity, it’s almost impossible to make up the loss out of future business. For instance, in many cases advisors will pay 25% of the fee forever. We’ve even seen the split as high as 50/50, which is especially onerous for the advisory firm involved.
What’s the problem with these referral arrangements? As our clients and readers of this column have heard more times than they can remember, to understand what’s going on with your business, you need to break your expenses into two categories.
First is direct expenses, which are those costs directly related to generating revenue, usually the compensation paid to professionals, including the owner/advisor, for advising clients and bringing in business. This category is the cost of services sold. The second category is overhead expenses, sometimes referred to as general & administrative costs. Gross profits, then, are revenues minus direct expenses, and operating profits are gross profits minus overhead.
To get a pulse on the business end of your practice then, we suggest (ad nauseam) that you track the gross profit margin, i.e., gross profits divided by revenues, and the operating profit margin, i.e., operating profits divided by revenues. By tracking changes in these ratios separately, you can quickly identify problems with your cost of goods or overhead, and take the appropriate actions. But the impact of these referral agreements is often irreparable without alienating the source of the referral.
Our 2004 FPA Financial Performance Study of Financial Advisory Practices found that the average advisory practice has a 55% gross profit margin, and an 8.4% operating profit margin. Solo and ensemble firms have essentially identical ratios. So consider the impact of just a 25% referral fee. If your usual cost of services run 45% and you add another 25% cost, you are now looking at a gross profit margin of 30%. If your average overhead is 46.6%, you are now losing 16.3% on that client. (See “The High Cost of Referrals” chart.) You can see that it wouldn’t take many of these clients to wreak havoc with your firm’s margins. And a 50/50 split? Fuhgeddaboudit.
Focus on Your Margins
Some advisors we know will argue that it is not necessary to recognize any level of compensation for themselves as a cost of services, because they always take what’s left over anyway. In their minds, increases in gross revenue are more important than improvements in margin. Unfortunately, it’s not that simple. Independent advisors are both the employer and the employee, so you are entitled to fair compensation for your labor (direct expense) and a return on your risk as an owner (operating profit). Put another way, the money that you’re not paying yourself is in reality an investment on which you should expect to earn a rate of return commensurate with the risk involved. For our purposes here, however, suffice it to say that to get an accurate picture of the cost of services sold, you have to put a value on your labor.
Others will rationalize a high referral fee by arguing that they need to pay a large percentage in order to induce people to refer them new clients. If you look at it as pure volume without regard to profit, that may work, but the economics are not logical, especially in the 50/50 case where you can never make it up in volume because this is a high variable cost in perpetuity. By evaluating the referral arrangement in the context of margins, you begin to see which kinds of referral business make sense.
If you had few clients and were desperate for the business, you might be inclined to be overly generous with your referral sources. But the good advisors become overwhelmed with opportunity and have to make choices. Eventually, the question arises whether you want to take on the unprofitable business, or decide whose call you’ll return first. To complicate life, should you do extraordinarily well with the referrals, you may even be forced to hire support staff or other advisors to manage the flow. When you lay those added costs into the model, the question of margins becomes even more important, and the problem more acute.
This analysis is not meant to discourage the practice of setting up referral relationships, but rather to suggest that there are several very big questions you must answer when framing any referral relationship:
What is a reasonable price to pay for sales versus servicing? It’s a challenge to judge what a reasonable price for referrals is, but there are some emerging benchmarks in the marketplace. For example, the partnering programs at Schwab, Fidelity, and Waterhouse all peg their referral fees at around 15 basis points on assets under management (assuming a management fee of 75 bps, that’s a 20% referral fee), plus an annual participation fee. The basis point charge is perpetual and there is an obligation on the part of the advisor to keep the assets with these custodians. There are several broker/dealers, such as
Securities America and Commonwealth Financial, that also provide guidelines for their advisors to follow.
When will the client reasonably decide to do business because of the quality of the service and not because of the referral? Ultimately, if the advisor is doing her job right, she will bond with the client, who is no longer doing business because of the referral itself. This would imply that the advisor should be receiving a higher portion of the compensation on a graduated basis to recognize this shift in the relationship. Furthermore, the advisor is also doing all the heavy lifting in the relationship, which further entitles her to a greater portion of the compensation.
How consistently and frequently should you demand referrals in return for the high payout? One of the more disturbing elements of referral arrangements is that there rarely is an obligation on the source of the referral to commit to a certain number of opportunities within a defined period of time. In other words, they can make referrals whenever they want to and the prospects don’t even need to meet a profile. Yet the advisor is forced to compensate the referral source for the business if they sign up the prospect, no matter how good that business is. In a world where breakpoints for volume have become commonplace, there are no such expectations on referral sources. Considering that the point of these agreements is to encourage a higher volume of new business, I would recommend a structure that rewards referrers for their consistency and frequency of opportunities, and ensure that these goals are reset each year. “Accidental business,” or opportunities that arise when the referrers trip over them instead of systematically creating them, should not be rewarded as highly. At the very least there should be some penalty or adjustment for not honoring a commitment.
What behavior does your referral model reinforce? You also must consider the behavior you want or expect. Referral sources do not typically provide ongoing service: Your whole expectation from the relationship is that they will sell, or provide referrals. If the referrers build up a large annuity pot, that incentive could go away. Emphasis should be on short-term generation of opportunity. This has always been the theory in compensation–the closer one is to the sale, the more variable and short one’s compensation should be; the closer one is to service, the more fixed and long term one’s reward should be.
A prudent referral program should probably pay around 20% to 25% of first-year revenue and 5% to 10% ongoing. It is desirable to have the source of referral continuously involved in the relationship and with you as the advisor so that the referrer can develop an appreciation of the value you provide and maintain a vested interest in the success of the relationship over time. However, you want to be careful to encourage sources of referral to continue providing new referrals by having a larger portion of the payment in the first year. In addition, it’s important to recognize that clients eventually bond to the advisor, not the original referrer, and therefore the burden of generating revenue into the future relies on the person servicing the relationship. If it’s possible, it would be good to have a finite life of payments to the referrer.
One other consideration is that buyers of your practice may not be too eager to continue the payments to a referrer once an acquisition is made, so you may need language in any agreement that anticipates an eventual transition. You will also want to consider who “owns” the clients, meaning that it should be clear that the advisor who is servicing the relationship has the right to transfer that client to a new advisor should he decide to sell his practice. Of course, it’s up to the client whether he or she wants to be transferred.
Referral relationships can be a powerful and effective way to build one’s business, providing that such relationships reward the right behavior and make economic sense to the servicing advisor. Don’t be tempted to make a deal to get the volume, however, or you will end up with a burdensome agreement, unprofitable clients, and potentially, a relationship with a professional associate that could sour over time.
Mark Tibergien is a nationally recognized specialist in practice management for financial services firms, and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S. You can reach him at email@example.com.