Only 17% of firms have a formal, binding succession agreement in place.

An astoundingly high percentage of advisory firms are positioned to go out of business when the founder retires if they don’t establish a solid succession plan. A report released Wednesday by SEI and FP Transitions found that 99% of practices could end up closing their doors when the owner stops working.

However, Brad Bueermann, CEO of FP Transitions, said that’s not necessarily what will happen. That percentage is so high because those firms “have not built enduring business that could survive the owner,” he told ThinkAdvisor on Thursday. “It doesn’t mean they might not sell the business, but they have not put in place a structure that would allow for succession to take place, or a second generation of advisors to take over the business the way it is now constituted and move it forward.”

Only 32% of respondents said they had a succession plan; however, the report found on 17% actually have a formal, binding agreement in place.

Without a formal succession plan, client accounts might be sold to a different firm, and “the firm that is currently operating is going to disappear. So it’s effectively an asset sale,” Bueermann said. “Changing that and creating a growth strategy out of succession instead of only viewing it as an endgame event is where we see the industry beginning to change.”

According to John Anderson, head of SEI’s practice management solutions, to a lot of advisors, a succession plan means “’I’m going to sell this to somebody someday.’ They may say that’s a succession plan, but when you say, ‘Do you have a formal agreement?’ ‘Well, no. I don’t know who’s going to buy it, what they’re going to buy it for,’ then it’s really not a plan.”

Part of the problem is that advisors start thinking about succession planning too late. “A lot of advisors start thinking about succession at the point they’re ready to retire,” Bueermann said. “At that point, succession planning for building an enduring business at that time is long past. Their only option is to continue to run the business and let it die to attrition as they wind down, or to sell the relationships in some sort of asset sale.”

To avoid those outcomes, advisors should early on “create a structure, an investable business, that their junior advisors would want to invest in” and build “ownership tracks to allow those advisors to begin to acquire equity in the firm and ultimately the ownership stake.”

Bueermann described ownership tracks in the plans FP Transitions helps advisors design. “There’s a value set for the business, and there’s a plan put in place for what we call G2, G1 being the founding owner,” he said. “Second generation of ownership, G2, allows them to start buying into the practice. Those are typically set up in distinct tracks that are a percentage of the business.”

As those tracks are put in place, Bueermann said, junior advisors begin to acquire an equity stake in the firm, and are rewarded with profit distribution out of the business. They then use those profit distributions to increase their stake.

“That’s why it takes time,” Bueermann said. “The advisors who are junior partners in many of the practices, particularly in the strong registered rep organizations and also RIAs, are really hungry to have an equity piece. Creating that kind of a track not only is helpful from a recruiting standpoint, because you have something to offer in terms of long-term equity stake in the business, but also retention.”

In addition to the recruiting and retention benefits, it also “shifts the energy, if you will, in the firm from a founding owner who may be slowing down to their more energetic juniors who are building up their equity in the business and are working harder.”

However, just a third of advisors said they wanted to grow their firm by bringing in a new generation of talent, the report found.

Bueermann said that advisors under age 40 are “keenly aware of the values of practices: of the growing value, the equity value. They want to participate in that. Whether that participation is a minority participation in a fast-growing large firm or the ability for them to step out and buy a practice, either way they want to ultimately own what they’re doing or a piece of what they’re doing.”

He added, “That’s a big change. Simply 10 years ago, 15 years ago when people were exiting [a firm], they were talking about payouts. What’s the compensation structure? While all of that is important, now that conversation has shifted. What kind of a business is being built here? What will that be worth to me 10, 15 years from now?”

Anderson suggested considering succession planning from the point of view of the buyer.

“If I want to buy a practice, do I want to buy a practice where the firm is key-person-dependent, where the owner has been slowing down, the business is declining, the age of the clients are increasing every year and they’re in drawdown?” he asked. “What we’re talking about is to think about succession planning as a way of growing your business because you’ll be able to pass that growing, thriving business on to the next generation, and they’ll be excited about buying into that business versus taking a look at a business that is just slowly dwindling away.”

The report found 34% of respondents have never acquired a firm but plan to in the future. More than half of new advisors, those who have been in the business for less than five years, have never bought a business but think doing so will help grow their firm. Anderson said this could prove to be a challenge.

“Typically when you see an acquisition it’s from a larger firm buying a smaller firm,” he said. “When you think about advisors who have been in the business under five years, chances are they have fewer assets, so that acquisition is probably going to be very difficult. I think what they are looking at is what we’re all seeing: there are a lot of advisors out there that are slowing down. What they’re probably saying is they’re probably not acquiring a whole firm, but acquiring portions of a firm or buying into equity.”

Anderson said a lot of advisors have an “I’ll get around to it” mentality and are “letting the practice manage me instead of me managing the practice.” He noted just 45% of respondents said they have a continuity plan and of those, just 55% have a formal agreement that can kick in if something were to happen to them. “The first step, even before the succession plan is the continuity plan,” he said. “If you read the numbers, it’s like 20% of advisors who even make that step.”

“More advisors are certainly aware of the issue,” Bueermann said. “They’re not saying, ‘What’s a continuity plan? They’re engaged in thinking about it and they’ve taken the first steps, but we should be seeing 80% or 90%, not 45%.”

He suggested, “For those 45% who have a plan, go back and review that, make it a written plan, make sure that plan is shared with the client and make sure they plan is funded and/or means-tested so that it’s executable.”

He added, “They’re aware that this is what they should be doing, but in the past they have not been aware of what kind of time it takes to put these plans in place and when they need to begin planning.”

He said FP Transitions and SEI are working together on a project called Business Pathfinder, “to have advisors focus on the business aspect of what they’re building and have a strategic focus much, much earlier and to look at succession planning not as an endgame but as a process; making acquisition part of a strategy rather than just something opportunistic.”

“The example I usually give is my father was an attorney who died without a will,” Anderson said. “The advisor is helping clients plan for the future, but they’re doing a very poor job of planning for the future for themselves.”

Check out Leading Your Firm From Beyond the Grave on ThinkAdvisor.