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Practice Management > Compensation and Fees

Follow the Money in Succession Planning

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You might think that financial advisors are financially savvy, and when it comes to personal finance, they usually are. But when it comes to business finance—particularly the buying or selling of advisory businesses—I am constantly amazed that many advisors are just as susceptible to a good sales pitch as anyone else.

Like many others, I believe the looming retirement of baby boom advisors will shape the independent advisory industry for many years to come. Some advisors are simply selling their firms to institutions or other advisors, but I’ve found the vast majority prefers to transition their ownership to their junior advisors. Consequently, we work with many of our clients to create and implement succession plans.

However, I encourage our clients to bring in succession planning experts because I firmly believe all succession plans (including the ones we create) should have a second set of eyes on them. There are myriad issues to consider, and I encourage these outside perspectives to ensure the business and the owner are protected. Yet, as of late, I have been dismayed (if not scared for the industry) to find that many of those plans were unworkable, and that their flawed structures all too often cost owner-advisors millions of dollars in compensation and equity.

Here’s just one example of a problematic succession plan that was recently proposed to one of our clients. According to the plan, the firm owner would transfer 75% of the ownership of his solo practice to two junior advisors over 10 years. The good news was we were ahead of the curve, with plenty of time to make a workable transfer of a majority stake in the firm. The plan didn’t call for selling 100% of the firm because the owner was in his early 50s and didn’t yet know when he wanted to retire, but he did intend to eventually transfer the balance of his equity.

The succession expert used a complex valuation method that essentially came out to 2.5 times revenue to value the firm’s roughly $1 million in annual revenue at $2.5 million. Then, assuming a 5% annual growth rate, it was projected to be worth about $4 million at the end of the 10-year period.

Unfortunately, that’s about where the good news ended. As usual, the junior advisors had no capital to buy the business, so the plan called for the owner-advisor to “lend” them the money to purchase equity each year, paying it off out of the growing profits from their increasing ownership stakes in yearly installments. At the end of 10 years, they’d own their 75% equity free and clear.

However, to make this plan work, the expert had to modify the current compensation structure of the owner. (Dear Business Owners: I don’t care what kind of business you own, if the proposed plan requires you to significantly reduce your total compensation, it’s a pretty good tip-off that you have a bad plan. With Love, The Ambassador of Your Dough.) Currently, my client is grossing about $400,000 a year in compensation. Adding no partners over the next 10 years, at a meager 5% annual growth rate, his compensation would grow to $620,000 a year, totaling about $5 million over the period.

But, under the expert’s plan, that annual compensation would be cut to $200,000 to start, growing to $310,000 a year and totaling $2.5 million. Not to worry, said the expert, as the difference would be made up with $2.3 million in note payments to the owner by the junior advisors over the same 10 years. (This was also made possible by increasing the junior advisors’ compensation from $75,000 per year to $150,000 to start, and culminating with $240,000 at the end of the 10 years).

Instead of earning a projected $5 million over the 10-year transition, the owner-advisor will receive $4.8 million. Only $200,000 over 10 years, you say? Where’s the beef? The “beef” is that also during this time, the owner-advisor transfers ownership of 75% of a firm worth $4 million by the end of the transfer, which works out to be $3 million in value. That’s one heck of a deal for the junior advisors. The owner-advisor essentially gave away his firm.

At first I thought my projections just had to be wrong. How could a succession expert propose such a deal? But sadly, after checking with a different expert, I had made no mistake. My client and I met with the expert, who pitched the plan this way: “You’ll make the same total amount of money that you would have made over the 10-year transition; you’ll have collected $2.3 million in payments for a firm that is currently worth $2.5 million; and you’ll have two new partners who can buy you out when you decide to fully retire. Sound good?”

In all honesty, I can’t tell you what my client’s answer would have been because we reviewed the spreadsheets in advance, and I prepped him on why this was a bad deal. (Tip for future consultants: Part of your job is keeping your clients from embarrassing themselves.) What I can tell you is that the expert didn’t take it very well when I pointed out the flaws in the plan (the rule against causing embarrassment doesn’t always extend to other consultants). In fact, after questioning my credentials and experience—he should have just called me a dumb blonde—he continued to defend the plan.

The big takeaway, though, is that advisors need to be very careful about implementing any plans proposed by so-called experts. (As much as I would like to believe I am perfect, I also encourage my clients to question me.) Whether it’s a new organizational structure, a compensation plan, buying new technology, or buying or selling an advisory firm, take a step back and look at the big picture. Ask yourself: “What’s the end result going to be, and how much am I going to pay or get paid for it?” “Does that seem reasonable?” And: “Is it reasonable from the other side, as well?”

More specifically, the key to making succession plans work (without having the firm owner underwrite the purchase of his or her own firm) is to let the firm’s growth pay for its acquisition. Typically, the reason owner-advisors hire junior advisors is to leverage themselves in order to grow their firms. Let that growth pay for those junior advisors to buy you out. It’s really that simple.

To do this, I restructured that succession plan several ways. My client decided to hold the owner-advisor’s total compensation at his current level of $400,000 a year. (We thought it was unfair for him to take a pay cut, but by keeping his compensation constant, we let the growth of the firm pay for the succession). We also kept the junior advisors at their current base salaries with revenue bonuses and increased their profit participation as their equity grew. Half of those profits go to pay off the owner-advisor.

The employees are happy because they get steady raises every year (doubling their current compensation by the sixth year), and when the equity is paid for, get a big jump to some $300,000 a year. The owner is happy because he actually gets paid for his 75% equity of his firm and takes no hit to his lifestyle.

Of course, both of these plans are projections based on an assumption of the future growth rate of the firm. Currently, it’s growing at 17% a year. When we ran the succession plan using a 10% growth rate, the junior advisors are able to pay for their equity in seven years and everybody still makes a lot more money.

This creates exactly the kind of incentives that are the foundation of our entire advisory firm management philosophy, which we call P4: Pay your key employees a fair wage, add junior partners, and a lot more if the firm grows. Maybe it’s just coincidence, but our firms tend to grow—a lot. We expect the same from the firm above: Those junior advisors have a huge financial incentive to grow the firm as quickly as possible because if they do, they pay off the loan faster. The owner-advisor has an incentive too: His remaining equity will be valued by the size of the firm at the time he’s bought out. That could easily be another $1 million. Once again, that should easily be covered by the growth of an even more successful firm.


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