For years, industry observers have been anticipating an onslaught of retiring baby boomer advisors who will begin to engage in succession planning en masse and sell their firms over the next decade. Yet year after year, the baby boomers get older and the sellers don’t materialize. With an astonishing paucity of sellers to external buyers and an abundance of buyers, it remains a seller’s market for financial advisory firms.
Yet in a new book, David Grau, founder of FP Transitions (whose firm has potentially been involved with more advisory firm sales than any other consultant or service provider in the industry) makes the compelling case that for advisors’ focus on big-headline external sales misses the real opportunity. That opportunity is an internal succession plan executed over a period of years that ultimately delivers radically more to the founder than a third-party external sale ever could.
In order to harvest the greater long-term value from an effective succession plan, though, Grau points out that advisory firms are still too attached to the wirehouse-style “eat what you kill” revenue-based compensation. That model simultaneously destroys value for the business owner and disincentivizes the next generation of owners from wanting to be successors in the first place. Instead, Grau suggests that firms need to shift from compensation based on top-line revenue to a greater focus on compensation built around bottom-line profits. That compensation model can ultimately help to focus the business on maximizing its value, and truly incentivize the next generation of advisor owners to want to step up, buy in, and contribute towards—and be rewarded for—enhancing that long-term value.
Selling or Exiting Vs. True Succession Planning
Most professional services businesses aren’t really businesses, because they’re not built to survive as a business beyond the founder who creates it. It’s no coincidence that from doctors to dentists to many lawyers, the “business” wrapped around the practitioner is not actually called a business, but a “practice” instead. A practice might ultimately still be sold to another practitioner, but ultimately the only thing that really transitions is a list of clients/customers/patients, and perhaps a little ongoing revenue attached to them. The original business itself generally does not survive.
In “Succession Planning for Financial Advisors”, David Grau Sr. points out that most advisory firms are also, ultimately, little more than practices that might generate some very positive cash flow for the practitioner, but are not structured to survive the founder’s death, disability or retirement. Again, a client list might be sold, and the advisor might exit with some lingering value, but the business itself will not survive as an ongoing business.
By contrast, a true succession plan, according to Grau, is one that does allow the business to continue and survive intact. In fact, Grau’s definition of a true succession plan implicitly assumes that for a business to continue, the continuity must come within:
A succession plan is best defined as a professional, written plan designed to build on top of an existing practice or business and to seamlessly and gradually transition ownership and leadership internally to the next generation of advisors.
When elevated to this standard, there is remarkably little succession planning happening in the financial services industry today. Grau estimates that as few as 1% of firms are prepared and positioned to execute on a real succession plan, and that as many as 99% (!) of today’s independent advisory firms will not survive beyond their founder. Instead, the firm will simply attrition to the point of worthlessness as the advisor’s career winds down, or perhaps with a list of clients being sold for some terminal value but without the survival of the business itself.
Notably, Grau acknowledges that for many advisors, they may not want to leave the business in the first place. Many (most?) financial advisor entrepreneurs are not hard wired to sell and exit their practices, since much of their financial net worth and personal intrinsic rewards are tied up in the relationships with their clients. Nonetheless, even if there’s not a desire to sell and exit the business for personal reasons, Grau makes a compelling case—and increasingly, so are regulators—that the continuity of the business as a business is crucial if only to ensure a continuity of care for the clients Yet for an advisory practice to effectively function as a business upon which a succession plan can be executed, it’s crucial to structure it like a business in the first place.
(As an example of how regulators are getting tougher on succession plans for advisors, see ThinkAdvisor news article, State-Registered Advisors Prep for New Succession Planning Rules.)
The Problem With Revenue-Sharing Advisor Comp
Among today’s experienced advisors looking to sell their independent advisory firms, it’s almost impossible not to find someone who either started their career in a wirehouse or were trained by someone who was. As a result, almost all of today’s independent advisory firms continue to structure their compensation in the manner of a wirehouse: compensation tied directly to top-line revenue, often accompanied by an implicit “Eat What You Kill” (EWYK) (and don’t eat from what you didn’t kill) mentality.
In the context of a wirehouse, where advisors don’t ultimately own their underlying business anyway, this is a fine compensation structure. In an independent advisory firm, however, Grau makes a compelling case that it is ultimately highly destructive of both the value of the business and the ability to craft a succession plan.
The key problem with an eat-what-you-kill style of compensation in an independent advisory firm is that it ultimately provides too much of the long-run rewards of ownership to advisors, without the associated long-run risks.
In the early years, the burden of risk in an eat-what-you-kill environment is on the advisor; after all, if the advisor doesn’t “kill” anything (get his own clients), there’s no revenue to be paid upon, and as we know, the attrition rate for new financial advisors is very high. However, once the advisor accumulates a base of clients with ongoing revenue, the tables turn. Now servicing clients is easier, there’s little or no pressure to grow, yet the advisor has no responsibility for managing the ongoing risks and challenges of the business itself, from hiring to technology to office leases and more. And what advisor wants to buy into an advisory practice for which they’ve already borne the upfront risks in getting clients in the first place, and are now already reaping the rewards of a high income tied to their clients with little remaining risk?
The solution, in Grau’s view, is to back away from our traditional wirehouse-based approach of tying compensation to revenue, and instead compensate advisors with a (healthy) salary plus (reasonable) incentive compensation for key results like retaining clients and bringing in new clients…but not tying that compensation directly to revenue (or targeting it based on revenue).
The end goal of such an approach is to flatten compensation out across advisors, and shift the “excess” revenue from compensation to the advisor off-the-top (as a percentage of revenue) into compensation as a profits distribution from the bottom line.
(Angie Herbers responds to Mr. Kitces in her latest blog for ThinkAdvisor, Why You Should Use Team Bonuses Based on Firm Revenue.–Ed.)