In my last columns (April and May 2007), we addressed the importance of restrictive covenants that protect an advisory firm’s client relationships.

But there’s a broader issue that RIAs need to address. Because of the “graying” of the industry, it is increasingly important for advisory firms to consider succession planning issues, whether via internal succession or an external acquisition or sale. Critical to any successful succession is having the appropriate underlying documents in place, including: to protect the firm’s client relationships, the appropriate restrictive covenant agreements; for an internal succession, a well-drafted operating agreement or shareholders’ agreement addressing the terms and conditions for the disposition of ownership interests upon the occurrence of various events; and for an external succession, a well-drafted purchase/sale/merger/joint venture agreement that protects the parties’ interests before and after the transaction.

For advice on these issues, I interviewed my Stark & Stark colleague, Stuart Mickelberg, an associate of the firm who represents advisors on corporate and regulatory compliance matters.

What’s the purpose of a business succession plan for an advisory firm?

The plan should accomplish a number of objectives: providing a mechanism for the orderly transfer of the business; establishing a valuation mechanism which avoids disputes between owners as well as possible disputes with the IRS; reducing possible disputes between owners, an owner’s heirs, and possible unwanted business partners to whom an ownership interest in the company may otherwise be transferred; and providing financial security to a deceased or disabled owner’s family.

Are all buy-sell agreements the same?

The three most common types are cross-purchase, redemption; and hybrid cross-purchase/redemption. The type of buy-sell that should be used in the succession plan depends on a case-by-case analysis of various factors such as each owner’s succession planning objective, the number of owners, and the liquidity of the company and each of the owners.

How is a cross-purchase buy-sell agreement structured?

In a cross-purchase agreement, the remaining owners directly purchase the shares from the selling owner or the selling owner’s estate. The owners depend on each other individually for the payment of the purchase price of the stock. Accordingly, a cross-purchase agreement may require that each of the individual owners maintain liquidity in amounts sufficient to buy out the other owners at any time. Some owners favor the cross-purchase structure because it allows the owners flexibility in allocating differing percentages of ownership to the remaining owners or other interested parties.

From a tax perspective, in a cross-purchase agreement the surviving owners receive a “step-up” in tax basis to the extent of the purchase price paid for the stock. This means that when the acquiring owners sell their shares, the capital gain will be lower. However, if the acquiring owner plans to retain the stock until death, the step-up in basis may not be realized, because the heirs who inherit the stock will get the inheritance step-up in basis. A cross-purchase structure should only be used if the acquiring owners have the ability to satisfy the terms of the buyout. Unless the acquiring owners have adequately reserved cash or kept up with insurance premiums, the selling owner may not be able to cash out according to the terms of the buy-sell agreement.

How is a redemption buy-sell agreement structured?

In a redemption agreement, the company, not the individual owners, buys the stock from the selling owner. So in a redemption structure, the company must have liquidity and has the responsibility to maintain cash reserves and the insurance policies on each of the owners’ lives. For some owners, placing the responsibility of payment in a buyout on the company rather than on the individual remaining owners makes a redemption agreement preferable.

However, unlike a cross-purchase, the other owners do not receive any step-up in tax basis of their stock when the company redeems the selling owner’s stock. The repurchased stock is simply retained in the company as treasury stock, and each individual owner’s stock basis remains unchanged, although the ownership percentage will increase proportionately.

And the advantages of the hybrid buy-sell “wait and see” structure?

The hybrid provides the greatest flexibility of the three types of buy-sell agreements. Generally, the remaining owners may “wait and see” at the time of the triggering event and choose to cross-purchase or execute a redemption. The agreement will specifically give either the company or the individual remaining owners the first option to purchase the exiting owner’s stock. If the remaining party, either the company or the owners as the case may be, elects not to purchase the shares, the secondary option to purchase any or all of the remaining stock will go to the other party, either the company or the owners.

How do you go about setting a value for an exiting owner’s stock?

There is a lot of flexibility in defining the buyout price for the exiting owner. The key is to address the valuation issue specifically in the buy-sell agreement. The best method is to formulate a purchase price depending on each of the various triggering events. For example, the buyout price in the event of death should differ from the buyout price in the event the exiting owner was terminated for cause. Also, if an employee-owner failed to adequately transition her client accounts/relationships to the remaining owners, then that exiting owner’s buyout price should be reduced.

The buy-sell will contain the buyout price for each share of stock in the company, and will usually be based upon a valuation formula that the owners previously agreed upon, a capitalization method, or a formula based upon a multiple of the company’s cash flow, gross revenue, or net operating income. Some agreements require an appraisal by a qualified professional to determine the stock’s fair price.

There is no right or wrong method of ascertaining the buyout price. However, if the valuation formula for computing the buyout price depends on a moving variable such as the company’s cash flow, gross revenue, or operating income, the buy-sell agreement should address the possibility of adjusting the buyout price after a certain period from the purchase to reflect the leaving owner’s impact on the price.

Advisory firms are unique from many other privately held businesses in that the valuation of the investment advisory businesses, albeit the value of each owner’s stock, is directly attributed to the number of client accounts and assets under management. For this reason, the buy-sell agreement should contain a mechanism of recalculating the buyout price within a certain period of time after the selling owner has left the company. Otherwise, if the agreement does not address this issue, the remaining owners or the company may be trapped with a payment obligation to the exiting owner that does not accurately reflect the fair buyout price.

How does the firm afford to buy out a deceased owner’s estate?

In the event of death or disability of an owner, a practical method, and more often implemented, of funding the buyout is through life or disability insurance policies. When an owner dies or becomes disabled, the policy benefit is used to buy the stock from the selling owner or the estate.

Generally, the insurance premium payments are not deductible, and the insurance proceeds are not taxable. When funding a buyout resulting from a triggering event other than death or disability, the required cash must come from the remaining owner’s personal assets, company cash reserves, or loan proceeds. Otherwise, the buy-sell agreement needs to provide for the remaining owners to purchase the stock under a promissory installment note. The terms of such a note need to be incorporated into the buy-sell agreement and negotiated prior to the execution of that agreement. The idea here is that the buyer funds the installment note obligations from the successful business operations so that outside financing is unnecessary.

In my next column, I will address external succession issues.


Thomas D. Giachetti is chairman of the Securities Practice Group of Stark & Stark, a law firm with offices in Princeton, New York, and Philadelphia that represents investment advisors, financial planners, broker/dealers, CPA firms, registered reps, and investment companies. He can be reached at tgiachetti@stark-stark.com.