The Fatal Succession Planning Mistake

I spent the beginning of my childhood living on a 10,000 acre ranch in the middle of nowhere-ville Kansas.

The “ranch house,” as we called it, sat on a long dirt road simply named North Kansas Road. The scenery on this road was beautiful—long green pastures with rolling hills bordering a state park. The road itself was pretty good, as dirt roads go, except for a blind left turn that swung straight west into the sunset in the afternoon. If you were going too fast or were blinded by the spectacular sunsets over the plains of Western Kansas or if it had recently rained, the car-eating potholes just around that curve made for a very dangerous situation where many people (and cars) got hurt. It was so bad that, as a child, I would fantasize about standing in the middle of the road, at that curve, holding a stop sign to warn drivers what was ahead.

Seems silly, but I’m reminded of that road nearly every day when I’m working on succession planning with my advisory clients. Succession planning is a lot like traveling that road for the first time. For many owners, transitioning their firm to the next generation can be a dramatic left turn into the sunset, blinding them to the dangers that lie ahead. Unfortunately, I have seen more than a few owners go into that turn way too fast and wreck their businesses. I have also seen them lose everything they spent years building because they focused on the wrong areas of the plan. I’ve consoled too many owners through their pain after hitting the potholes of an unrealistic plan and the drastic consequences that can follow.

The scope of the succession problem in the independent advisory industry is well-documented. We’ve known for years now that the baby boom generation of advisory firm owners are on the brink of retiring over the next 10 years or so, with some sources estimating that as many as 50,000 of their firms—and $4 trillion in client assets—will be changing hands or closing their doors. The vast majority of the owners of these firms would prefer to transition ownership to their junior partners in an internal succession. Yet very few have taken steps to make this happen, even at this late date. What’s scarier, many owners have failed to educate themselves and their juniors on how internal successions work.

A survey released last July by insurance giant John Hancock Financial Network’s renamed broker-dealer Signator Investors reveals three sad details about this situation. According to the survey, only 11% of independent advisors have a succession plan in place, and just 20% of advisors are certain about what they will do with their practice when they retire. At the same time, some 30% of firm owners have a successor advisor on staff, leaving 67% who plan to hire one in the future. Not surprisingly, advisors’ two primary succession concerns were training a younger advisor to succeed them (66%) and financing the transition (69%).

Yet the industry’s succession challenge isn’t limited to a lack of adequate planning, or even to finding and training appropriate successors. The fact is that succession planning for independent advisory firms has only been an issue for the past 10 years or so, starting when firms began to accumulate sufficient client assets under management to represent substantial, transferable value. Consequently, a consistently workable model for advisory firm succession hasn’t yet been developed. Many of today’s succession “experts” often use models designed for other industries, with templates that offer quick and easy solutions but ignore key issues. They repeatedly spend only a short time helping implement these plans and move on to the next job, with little or no involvement with the eventual outcomes—or the problems these models create.

In our experience working with independent firms on a long-term, ongoing basis, an internal succession presents numerous challenges that rarely have easy solutions—and virtually none of them is quick. Here are the often overlooked problem areas of internal succession, which every owner-advisor needs to understand and have a strategy for overcoming to manage a successful transition:

• Lack of financing options. This is the major challenge for virtually all internal succession plans. Unless owner-advisors are willing to essentially give their firms away to their junior partners, there are only two viable options, which can be combined into a successful succession plan: finance the acquisition out of the growth of the firm or lengthen the time for the transition of ownership to occur.

• The wrong incentives. Who’s going to drive that growth? If our experience has taught us anything, it’s that people tend to do what they are incentivized to do. Without significant motivation to grow the firm, junior partners may not get as much help as they need from a near-retirement senior advisor to meet the plan’s growth projections. If the compensation for junior partners increases too fast, too soon, it can have a dampening effect on their motivation, particularly in the early years of a plan when generating firm growth is most important.

• Unrealistic assumptions. Transition plans that are based on too low a growth rate over too short a time period usually prove to be unworkable. When it comes to succession planning, firm owners need to start early, providing time for firm growth to underwrite the buyout and tying junior partners to the firm—and eliminating turnover, which can be disastrous to any plan.

While each of these challenges presents its own set of issues, in our experience, the hardest challenge to overcome is focusing too much on valuation. While the buyout value of the firm is certainly a factor in a succession, it’s not nearly as important as many buyers, sellers and experts in this industry seem to think. Much of what is written and talked about regarding internal succession is valuation. This over-focus can lead to unfavorable deal terms, divisions between buyers and sellers, and a lack of options to get the deal done.

For example, we recently had an owner-advisor contact us to solve a big problem he had. He wanted to internally finance the transition of his 30-year-old firm to his three junior partners (one of whom is the owner’s daughter). So the owner first got a valuation as suggested by the expert and put a plan together in which the buyers didn’t have to come up with any of their own cash, and the growth of the firm would buy out the owner over the next 10 years.

Unfortunately, the junior partners were not happy. Instead, they focused solely on the selling price of the firm. They countered by getting a consultant to do their own valuation based on different assumptions, resulting in a price that was half of the original valuation. Then they negotiated to buy the firm immediately at the lower valuation, with a 10-year note that allowed them to defer any annual payments that couldn’t be covered out of profits into a “balloon payment” at the end of the term. If they defaulted, the unpaid equity would revert to the owner—and the owner was out from day one.

The owner took the deal (family was involved). That was two years ago: The firm, which had been growing at 15% per year prior to the succession, hasn’t shown a profit yet, and the new owners have made no payments on their note and don’t seem to be planning any. The owner understandably feels taken advantage of, and he and his daughter aren’t speaking.

As illustrated above, the real key to virtually every successful internally financed succession is firm growth. It provides the capital to finance the buyout and controls the time it will take, as well. Consequently, firm growth creates an incentive for the owner to keep working hard and for the junior advisors to maximize their contributions to the success of the firm. By focusing on valuation rather than the far more important deal terms and incentives to grow the firm, both owners and junior advisors can cost themselves millions of dollars, years to make the transition of ownership, and even jeopardize the succession itself.

We’ve found that the master key to reducing the emphasis on valuation and increasing the chances for a successful transition is education about firm growth, finances and the deal structures of succession. We outlined those principles in our recently released white paper, “Take Two: The New Direction of Succession.” Unrealistic expectations and false assumptions by the buying advisors can undermine the best of intentions of the owner-advisor. The first step is for the junior partners to understand that it’s an internal succession not an acquisition and the difference between the two. They need to realize that because they can’t get external financing, the firm owner is willing to share the growth of his or her firm to finance the deal and will probably receive less than the market value of the firm. They need to see the other options that the owner has: selling to another advisor, an institution or a roll-up firm—or simply banking the increased revenues for the next decade or so and then closing the doors.

What’s more, junior advisors need to understand that it is an internal succession based on internal (read: owner) financing. It’s not a negotiation like buying a house or a car. It’s a plan for a team effort to turn the owner’s firm over to them, usually at some cost to the owner. Firm owners need to understand the firm growth that will finance a succession is largely dependent on the junior advisors: Consequently, they deserve to share in that increased revenue and firm value.

Because there’s so much information—and more misinformation—about succession, junior partners need to understand the various models that they might hear about, and the pros and cons of each. They need to see the various valuation methods currently in use and then, through the use of sample deal projections, see that valuation isn’t nearly as important to a succession as the deal structure and the growth of the firm.