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Formulas for Success: What's a Young Advisor to Do?

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One reason for the emergence of advisory firm consolidators is that many in the next generation of professionals are either unwilling or unable to buy into the practices that employ them. If this is our reality, what does it forebode for the independent financial services profession? What will young advisors do if they remain employees and not principals? What will owners do without successors in place to purchase the firm?

While statistics from a variety of studies do not validate a massive trend toward firm sales to roll-ups, there is evidence that young advisors feel stymied in their efforts to acquire interests in their firms. The obstacles are not constructed by firm owners alone, however; many of the barriers are self-imposed by the young advisors. This scenario frustrates firm founders as well as the people they employ.

Why are young advisor’s reluctant buyers? There are four big reasons:

1. The high cost of purchasing an ownership interest

2. The desire to own 100% in a smaller firm over a minority stake in a larger firm

3.The perception that ownership means “more work”

4. A sense of entitlement that their labor has earned them equity in the enterprise

An obsession with the financial aspects of the business begins early in an advisor’s career. It starts with a feeling of being underpaid, proceeds to an illusion that his contributions have saved the business from ruin, and culminates in the belief that several years of toil add up to thousands of dollars in sweat equity that should be paid out in shares in the company. This combination of emotional and financial angst often creates great stress for both the current and prospective owners.

Cost to Purchase

It is generally true that sellers of advisory firms have an inflated perception of firm value which, for some reason, has not been tempered by the market disruption we’ve experienced of late. Many sellers calculate that their years of pain growing the business, plus their assets under management, plus their personal reputation, plus the sacrifices they made to hire the young advisor in the first place, add up to a valuation that will ensure their financial independence through their retirement years.

Further, they are certain that others in the industry have sold their practices for high multiples of revenue and cash on the barrelhead. This assertion is usually the opening volley in negotiations with younger prospective partners who challenge the asking price. When prospective buyers calculate the cost of purchase based on the current perception of value, they cannot make the numbers work.

Even when the valuations and terms are reasonable, young buyers still balk because they are uncomfortable with the risk of such a large outlay. To overcome this obstacle, both buyer and seller must approach the price in a more rational way, and structure the terms of purchase so that the seller receives fair value for the risk he is taking in self-financing the sale, and the purchaser may meet his obligations out of the cash flow from the business. But the young buyer should also frame their decision in the context of a personal financial plan, and make decisions based on his own risk tolerance and their immediate future needs for liquidity.

The Desire to Own It All

Founders are shocked to hear young advisors state they do not want to be an owner in the firm because they do not believe in the value of a minority interest. This position is especially common in firms with no history of career progression that has led to ownership, or where the current principals are so controlling that the thought of being in partnership with them incites sleepless nights and trips to a therapist.

In a recent conversation with two prospective young minority owners of a well-established advisory firm, one was quite clear that he sought simplicity in a small firm where he could work at his pace rather than the economic upside that the larger firm could provide.

As a result, the firm’s business continuity and succession plan is being set back several years because this issue was not addressed early enough in the development of the young associates, and alternative candidates were not being groomed.

When building a large, complex practice with the objective of having it last through another generation, it is important to attract and develop people who are philosophically in tune with your business objectives and aspire to be a leader and owner of the enterprise. Not everyone will rise to this level, but there have to be enough candidates so that a last-minute decision not to play does not undermine the business succession plan.

Ownership Means Work

Entrepreneurs struggle with the concept of “a balanced life.” They work longer hours, produce greater volume, and experience more strain in their relationships than those who work for them. They often complain about the work ethic of the younger generation, not appreciating that they themselves are driven by different demons than the people they hire. Unfortunately, this behavior creates the perception that ownership and management mean never having a holiday or spending quality time with the family, and an insane addiction to the Blackberry.

From the young associate’s point of view, the rewards aren’t worth the pain. There is also a lack of appreciation in owners for the responsibility they have to make the firm an attractive place to invest in. As advisory firms develop and as owners attempt to build succession and admit partners, they must adopt a more balanced culture than when they were just starting out. A little fear of failure and urgency over getting things done is not harmful, but excessive behaviors in this realm are not appealing either and do little to ensure the success of the practice.

In the end, recruiting potential partners is like recruiting clients and recruiting staff. What makes them come to you in the first place, and what makes them stay? If your culture is not aligned with their interests, it will be difficult to attract and develop the right successors. If you make partners of people who do not share your vision, you will accelerate the demise of the firm.

A Feeling of Entitlement

Young advisors often believe that their years of hard work and their contributions have created an obligation on the part of the principals to give them stock. While this may be true in some cases, most firms pay advisors fairly for their labor throughout their careers. New advisors often work for their first few years with low productivity yet the business invests in their development. As they progress, the firm usually awards raises and bonuses that are in line with their experience, credentials and contributions. Of course, if this is not the case, those undervalued, underpaid, underappreciated associates should seek opportunity elsewhere.

The idea of ownership is a different concept, however, and not necessarily tied to compensation for labor, though some firms do reward people with equity in the company. So as long as the practice is paying people fairly, there is no obligation to add equity to the mix, unless this is a means of driving long-term behavior. In fact, it is usually prudent for new owners to have “skin in the game” by purchasing the stock, even if this is done over time and financed by the current owners. When you lay out money, it just feels more like ownership than a gift.

Awarding equity or cash to someone who feels entitled is a formula for a bad business relationship. Firms with a fair compensation plan and a coherent process for admitting new partners or sharing ownership will manage ownership transfer most effectively.

Ultimately, the process of developing and adding partners should begin well in advance of the event, meaning at least five years. Throughout this process, include instruction on the obligations and responsibilities of ownership and frankly discuss financial implications. Prospective partners should be vetted early about their willingness to become an owner and their understanding of the financial choices they will need to make. In the end, planning to buy into the firm is not unlike having a sound financial plan and investment strategy. This time, the vehicle is the closely held enterprise that also drives the advisor’s current income.