The average age of financial advisors creeps higher each year, approaching the traditional age of retirement. A growing chorus of voices have warned of the looming onslaught of advisors retiring, the lack of young talent to take over their firms, and thus a wave of advisory firms that will come up for sale resulting in a competitive buyer’s market that will make advisors regret having waited to sell.
Yet despite what has been portended by demographics, the wave of selling has not come and advisory firm merger-and-acquisition activity has remained relatively flat for years. If anything, the drive for larger firms seeking inorganic growth through acquisitions and tuck-ins has led increasingly towards a seller’s market, despite nearly all predictions to the contrary.
Given that industry studies still find the overwhelming majority of advisors have no succession plan (and aren’t taking the steps to create one), it raises the question of whether the entire succession planning crisis may actually be a mirage.
Why? For the simple reason that most advisors would be financially better off staying in their practices than selling them anyway, and many find their advisory work a professional vocation so personally fulfilling they wouldn’t want to leave it anyway. That’s especially true if the practice can be adjusted to better accommodate their later years’ lifestyle preferences.
So while succession planning may remain relevant for a small subset of firms that wish to pursue such a strategy and are prepared to execute it, perhaps it’s time for the companies that support financial advisors and the industry at large to recognize that the majority of advisors need support for exit and continuity planning, not succession planning.
The focus should be on how to redesign a firm into a lifestyle practice, with ways to ensure that clients are well served evenif an advisor stays in their practice until the very end. An advisor’s spouse or heirs might even receive some “terminal” value to the practice once they are gone (in addition to enjoying the cash flow from the business along the way) rather than continuing to collectively attempt to “guilt” advisors into leaving a practice that they don’t want to personally or financially let go of anyway!
Still a Seller’s Market
In order to evaluate the current state of succession planning, we must first define what is meant by succession planning. As I discussed recently, perhaps the best definition of the term comes from David Grau’s recent book “Succession Planning for Financial Advisors” where he defines it to mean:
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.
Notably, in this context Grau suggests that a true succession plan is entirely about an internal transition to the next generation of advisors (and owners), which occurs gradually over time and preserves the integrity of the business as is.
When viewed from this perspective, the reality is that there doesn’t appear to be much succession planning occurring in the world of financial advisors. A recent SEI study suggested that only about a third of advisors claim to have a succession plan, barely half of those actually have a binding and actionable agreement.
Even then it’s not clear at all how many fit Grau’s definition (versus just planning an outright third-party sale), and more important how many will be executed successfully (or at all) when the time comes. Grau estimates from his own experience at FP Transitions that in the end as few as 1% of firms may be prepared to effectively execute a real (internal) succession plan.
The implied consequence of this dearth of succession planning has been that advisors are “leaving money on the table” and potentially harming their clients who may be left like dust in the wind if the advisor/firm goes away. Or alternatively, that clients may be declining to work with advisors who don’t have a succession plan in the first place.
Yet since overwhelming majority of advisors still don’t have a succession plan, despite all of the implied downsides, and advisory firm AUM being sold is still at half the level in 2014 that it was in 2007, it raises this question. Perhaps succession planning isn’t really perceived to be as valuable as it’s cracked up to be?
The True Valuation of Most Advisory Businesses
While industry studies often throw around “typical” advisory firm valuations like 2X revenue, the reality is that a business is ultimately valued based on the estimated cash flows it can provide to its owner: i.e., the profits of the business after all expenses are paid. In point of fact, a 2X revenue multiplier can simply be viewed as shorthand for a valuation of 8X profits with a “typical healthy” 25% profit margin. Although 8X profits may be viable for a large, established advisory firm, a smaller/solo practice often sells for an amount closer to 3X-5X of profits (which in turn may be paid out over several years in an earn-out), which is closer to a multiple of 0.75X to 1.25X revenues..
The greater problem for most advisory firms beyond the lower multiples is that their true “profits” are far less than often realized. For the large number of advisors who are still solo practitioners (or loose siloed partnerships), the raw cash flow from an advisory firm can be quite significant and imply their practice could be sold for a hefty amount, but may overstate the true value of the practice.
That’s because a large portion of the advisor’s cash flows are not actually profits and instead represent the income they generate for being an advisor in the practice. For instance, if an advisor takes home $200,000/year, but it would cost at least $150,000 to find another advisor to do the same job providing financial planning services to the existing clients, then the true profits of the firm would only be $50,000.
So at an 8X profits multiplier, the practice is not worth $1.6M but a “mere” $400,000, and at a 5X profits multiplier is only worth $250,000.
In this context, it suddenly becomes clearer why it is that few advisors are making succession plans. If the advisory firm is “just” worth $400,000 (or $250,000, or less), and the advisor is already taking home $200,000/year, then working a “mere” one or two more years generates the same cash flow as selling the practice. Working two more years! And of course, at the end of the two years, the advisor still owns a practice that might still be worth close to $250,000 – $400,000, and can still keep working and earning that cash flow as well!
The end result: unless the advisor can find a successor who not only buys into and takes over the practice over time but can materially grow it along the way as well, the most financially rewarding path is generally not to execute a succession plan and/or to sell the business, but simply to hold on for two more years.
After those two years, the story is essentially the same, the math doesn’t change much, and so it still makes sense to hold on for two more years. Suddenly, the lack of succession planning doesn’t seem so surprising: unless it’s impossible to work, there’s little incentive to do it at all!
Furthermore, as a recent CLS study on succession planning found, the majority of advisors are planning on the proceeds from the sale of their practice to cover half of their retirement needs, and the sales price just isn’t enough to meet the goal. That is, not without working several more years anyway!
The Rise of the Lifestyle Practice
Of course, the fact that continuing to work provides better cash flow doesn’t necessarily mean everyone would/should keep working. Some advisors don’t need the money, so there’s not much incentive to continue to pursue it. For others, they are tired of the work itself, and would rather wind down the practice than continue to work as hard as they have been. Yet unless the advisor just isn’t mentally/physically capable of the work, the decision doesn’t have to be an all-or-none proposition; the ongoing rise of “lifestyle practices” signifies a happy midpoint.
What is a lifestyle practice? Although there’s no formal definition, it’s essentially a characterization of an advisory firm—typically a solo practitioner—who is not necessarily trying to maximize the growth or economic value of the business as an entity, but instead is simply trying to fit the business around his/her lifestyle and maximize the cash flow (to the extent possible) along the way.