Do It Now; Do It Right

Investment management abilities. In firms that manage investments in-house, a successor obviously needs to be an expert at money management. At firms that outsource investments, an owner must be proficient at communicating the firm’s investment philosophy and approach to clients.

Once you’ve determined the most important qualities that you require in a successor, evaluate your staff to see how they stack up. Don’t expect any one person–even your best employee or junior partner–to fully possess all of the capabilities. Chances are, your top candidate or candidates will have many of the necessary qualities along with some gaps that need to be closed. This can be done through coaching and mentoring, or by building a team with unique skills that complement each other.

For example, Colorado advisor Sargent built a team that included his key employee (who focused on investments), another with strong financial and estate planning skills, and a third who was adept at administration and technology. After that team eventually took over the firm, they brought in a new partner with marketing capabilities. “The team had the skills and chemistry that told me they were highly capable of running the firm I had built,” says Sargent.

Stage 3: Detail the Deal

Plotting out the specific details of the transition is vital in order for the actual migration of ownership to flow smoothly. When making decisions about the terms and conditions of your succession plan, consider the following key areas:

Roles and responsibilities. Transferring various responsibilities can present challenges for many owners. Often there’s a period of one year or longer during which the new and old owners are both present in the office. This can create confusion among staff members about who to go to with questions and issues.

It’s therefore best to create a plan and timeline detailing when various duties will be handed off to the new owner. How that handoff works will depend on the objectives set by your firm. In some cases, investment-related duties will be the first to shift; in others, client relationship responsibilities will transition first while in still others, management roles such as employee reviews initiate the process.

You’ll want to take these steps at a moderate pace to ensure you don’t overload the future owner with too many responsibilities at once–yet another reason why it pays to begin your succession planning efforts as early as possible. In advisor Sargent’s case, he began early on by having his key employee prepare client reports and sit in on client meetings. That role expanded until the employee was adept at handling such meetings on his own. Sargent then built off that base by incorporating management duties over time.

Ownership transfer. The timeline you develop for transferring ownership will relate directly back to the goals you identified in stage one. If you hope to hit the golf course as quickly as possible, a rapid migration is appropriate. If, however, you plan to stay on in a limited capacity, you may want a slower transfer over several years. In general, larger firms transfer ownership at a more measured, methodical pace. Smaller firms, by contrast, tend to hand over ownership more quickly as a way to avoid confusion. At Roulston’s firm, for example, there’s a clearly designed timetable for ownership changes which includes a yearly re-evaluation that sets the price for anyone announcing their retirement over the following 12 months.

Ownership stakes. If you operate a larger firm with multiple partners, you’ll need to consider how to structure a new owner’s buy-in in relation to the existing partners. At Kochis Fitz, Kochis (one of nine partners) has developed a well-designed system. When an employee meets the criteria and is offered partnership, he or she has the opportunity to buy a specific stake in the business. Every two years or so, a third-party appraiser provides a formal valuation to confirm or modify the formula valuation. New principals are eligible to buy in at that externally determined price.

Deal Structure. It is important to remember that the deal structure is another tool to help you achieve the partnership goals. You should tailor the structure of payments based on the economic capabilities of the partners, the financial needs of the buyer, and the behavior that you want to incent. Although registered investment advisor transactions typically are seller-financed with an earn-out over five years, stretching the time frame to seven years (with an appropriate interest rate) can help increase the valuation for the seller and reduce the economic impact for the buyer. Bank financing is uncommon, because RIAs have few assets or secondary sources of repayment if a loan is defaulted. SBA loans, an often overlooked solution, are more flexible in their requirements.

Financing is one component used in the deal structure. For instance, at Kochis Fitz ownership stakes are acquired by a new principal over the course of three years–with 60% in the first year, followed by 20% each in years two and three. This staging, plus attractive bank financing negotiated by Kochis Fitz, enables the junior partners to ramp up slowly, and allows the senior partners to benefit from the growing value of the firm. Existing partners who own 15% or more of the firm have the first right to sell, with shares distributed on a pro-rata basis if no one wishes to sell.

At Sargent, Bickham, Lagudis, by contrast, Sargent set terms that enabled him to get paid in multiple ways–including a 20% down payment, a note paid quarterly for seven years at 8.5%, and a percentage of new revenues. Sargent also had set up a deferred-compensation plan for his key employee that was eventually used toward the down payment. “The deferred-comp plan was designed to encourage my employee to stay with the firm, not as a means to buy the company–but it ended up being a big part of the succession plan,” says Sargent. The key objective of the deal structure is to align the goals of the parties with the economics of the transaction.

Stage 4: Implement the Plan

Eventually the time will come to put your succession plan into action by transferring ownership. Here again, it’s good to have a timeline for key events. Sargent held a number of scheduled meetings with his employees to finalize terms among themselves before jointly drafting a letter of intent that got all the details on paper. Each involved party then retained an attorney to draft specific agreements and execute the deal. Of course, planning carefully and taking the right steps during the first three stages will help ensure that the final implementation goes as smoothly as possible.

Keep in mind, however, that as Kochis warns, the transition may take several months or even years to fully complete–for instance, if your terms call for an extended buy-in period or if you continue to play an active (if more limited) role in the firm. Any extended period of transition can result in moments of confusion or even conflict among principals, staff, and clients. It’s thus important to recognize issues when they arise, and work quickly to resolve them.

For example, Sargent’s initial plan was to slowly ease out of the firm over a two-year period. Soon, however, he realized there was uncertainty over who the “real” boss was–both from employees and clients–and that by sticking around, he wasn’t allowing the new owner to establish himself. As a result, Sargent accelerated his departure and clearly communicated to clients that he was no longer the appropriate primary contact. “I wasn’t doing anyone any favors in the long term by continuing to solve the problems that they encountered,” says Sargent. “You’ve got to be willing to move out of the way when it’s time.”

That said, Sargent admits that it was difficult to fully let go–a common problem when advisors exit their practices. “The emotional challenges of the transition were a surprise to me. Selling your business isn’t like selling Intel stock, and advisors who transition should be prepared for the emotional issues that you feel when someone else takes charge of your baby,” he says.

Clearly, business succession planning is an undertaking that requires a significant effort on your part. But you cannot afford to ignore it or take a half-hearted approach. The time you invest in your succession planning efforts now will yield tremendous rewards down the road and ensure that the business you’ve worked so hard to create will continue to benefit you, your family, your employees, and your clients for years to come.