Smaller Pieces Make a Bigger Pie

Across all stages of development, better-performing advisory firms distribute equity more broadly among their team members. While firm owners often view transferring shares as a way to “cash out,” distributing shares is as much about creating value as it is about realizing value. Sharing equity with team members can serve as a powerful incentive for attracting and retaining key talent. Broader equity distribution also improves succession options by reducing the amount of shares that owners need to liquidate prior to their exit while concurrently creating a pool of acquirers for any future equity transition.

Our study data provides strong proof that the benefits associated with distributed ownership have a meaningful impact on the performance and, ultimately, the value of an advisory firm. In “The 2011 FA Insight Study of Advisory Firms: People and Pay,” as with our previous studies, we designate the best-performing firms as “Standouts.” Standout firms represent the top 25% of firms at each stage of development in terms of two key performance indicators: revenue growth and owner income as a percentage of revenue. A clear correlation exists between Standout firms and broader distribution of ownership (see Figure 1, below).

At every firm stage, primary owners with a 5% or more equity stake account for a greater share of total full-time employees (FTEs) within Standout firms compared with others. The implication is clear: Cutting the pie into smaller pieces creates a bigger pie as the superior performance associated with broader ownership translates into more valuable firm shares.

The role of ownership structure in the success of an advisory firm is one of several pressing human capital issues explored in “The 2011 FA Insight Study of Advisory Firms: People and Pay.” Our focus on the transition of equity for this article is the last for the 2011 “People and Pay” series and follows articles examining succession preparedness and the development of team members. (See “Sounding the Alarm,” Investment Advisor, January 2012 and “Building a Talent Hothouse,” Investment Advisor, April 2012.)

Transitioning equity is an important part of a departing owner’s succession plan. As addressed in the previous articles of this series, transferring shares joins the transition of client relationships and management authority as the three key elements that make up a succession solution. Additionally, without an ability and willingness to share equity, staff retention is put at risk and succession options are obviously limited. Developing and retaining key talent is vital for continuing the growth of a firm and upholding its value. Experienced employees are a valuable commodity on the job market and retaining them will typically be difficult unless there is an opportunity for equity.

Crisis Looms as Ownership Concentration Grows

Despite the benefits of wider distribution, advisory firm ownership is gradually becoming more concentrated. Over the last two years, just 13% of firms, about one in eight, added a primary owner. The addition of new owners, however, has not kept pace with the departure of existing owners. Growth in owners has not kept pace with growth in employees either, resulting in owners accounting for a shrinking share of firm personnel in recent years. In 2010, fewer than one in six advisory firm team members owned a 5% or more share in the firm.

As ownership grows in concentration, shares become more valuable, and finding creative ways to transition equity is increasingly critical. An inability to develop new advisors and future ownership prospects at a rate that keeps pace with the wave of owners that are soon heading for the exits threatens the sustainability and growth of the industry.

As illustrated in Figure 2 (left), ownership is especially concentrated for larger firms as fewer and fewer individuals hold increasingly valuable firm shares. Innovators have just one primary owner (those with an equity share of 5% or more) for every 10 staff members. The share of secondary owners (an equity share of less than 5%) does increase with firm size, however. Despite this, owners of any type continue to account for a smaller share of FTEs as firms grow.

Few, if any, owners can afford to ignore the implications of concentrated ownership. A lack of distributed equity restricts succession options and hampers firm value. Conversely, broadening ownership can serve as a recruitment and retention tool as well as sustain firm financial performance and enhance firm value. It is not likely a coincidence that at every development stage, the Standout firms in our study show a much wider distribution of ownership.

Setting the Standard for Ownership

Internally progressing a team member toward ownership is typically a firm’s preferred succession path. Over the past two years, firms were nearly three times as likely to progress an existing employee into an owner or partner role as opposed to admitting an outside owner. All things equal, an internal succession is lower risk and less disruptive for clients as well as employees. The challenge is in defining the expectations around ownership, identifying and developing an internal successor and structuring the buy-in to be affordable.

Frequently, firms defer equity decisions because of uncertainty as to what to look for in a potential successor. Questions arise concerning the importance of client relationship skills, technical expertise, business development ability, management skill and personal qualities when evaluating ownership candidates.

According to study results, personal qualities are most often deemed the important criteria in owner selection. Leading the results was “character and values,” cited by half of firms as most important for an owner (see Figure 3, right). Unlike most other potential ownership criteria, character and values cannot be learned or acquired. Leadership and management ability, another attribute not readily taught, followed in importance, although its desirability will likely vary depending upon the presence of existing management in the firm.

A Question of Control

A reluctance to share control is another common hurdle preventing owners from more broadly sharing equity. Often, current owners, particularly founders, may be hesitant to let others influence the direction of the firm. Some firms (16%) sidestep this concern by not granting voting rights to certain ownership share classes. For these firms, voting rights are typically restricted to founders.