In a recent blog post (The Best Advisor Succession Planning? Internal Sales, With a Comp Switch), Michael Kitces reviewed David Grau’s new book “Succession Planning for Financial Advisors.”

One of the points that Michael focused on was Grau’s attack on “revenue-based compensation,” with which Kitces seemed to agree. While Grau and Kitces might be right that “eat what you kill” compensation for rainmakers based solely on a percentage of new revenue might be harmful to succession plans, I’ve never seen this compensation structure used in an independent advisory firm (except in “silo firms,” which create very little owner equity).

But we do use team “revenue-based bonuses” for all of the employees in many of our most successful client firms, and we find them to be essential to generating enough firm growth to internally finance most successful succession plans. It would be a shame for advisors to confuse Kitces’ and Grau’s comments about individual “revenue-based bonuses” with team“revenue-based bonuses” which we consider an essential element in a successful independent advisory firm today.

Here’s how Kitces sums up Grau’s position. 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…” 

Kitces then goes on to tell us what this “shift in focus” might look like: “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).” 

We, too, believe in “healthy” (but not excessive) salaries and “incentive compensation.” Yet, our experience and research clearly shows that a form of additional compensation which creates the greatest “incentive” is revenue-based bonuses. Here’s what we wrote on the subject in our 2011 white paper, titled “P4: Building Great Businesses by Creating Great Employees”:

“P4 research and our professional experience have shown that the single most powerful employee motivator is to tie a portion of employee compensation to the success of the business. The best way to do this is through team revenue- based bonuses (where each quarter, you simply pay each employee a percentage of the firm’s revenues, which are easy to calculate and eliminate issues surrounding ‘legitimate expenses and suppressed profits’).

This formula gives employees a direct stake in the success of the firm and shares some of the business risk with the employees (when revenues are down, so are bonuses). Employee incentives that increase as a firm grows create a sense of ownership (in lieu of actual ownership) that is essential to maximizing employee contributions to a business’s success.”

(See my November 2011 cover story for Investment Advisor, “Let Go to Grow.”)

We came to this conclusion about revenue-based bonuses when we conducted a five-year study of our current and past advisory clients, which isolated three factors: employee motivation; the structure of their salaries and bonuses (merit, profit sharing, or revenue-based); and growth of firm revenues. We found that virtually all of our top employees were paid revenue-based bonuses based on how the whole company as a team performed, not one isolated individual. 

Then we looked at the effect those high-performing employees had on the success of their firms. We looked at the revenues of each firm at their lowest point following the 2008 meltdown, compared with their revenues at year-end 2010. As a group, the merit bonus firms averaged an 11.8% revenue recovery, the profit sharing firms recovered to the tune of 19.1% on average, and the team revenue-based bonus firms came back an average of 34%. 

The increased motivation and performance of the workforce created by revenue-based bonuses (including the quarterly disclosure of firm revenues) has an extremely high correlation with the revenue growth of the firm—at least when it comes to recovering from a major catastrophe. And we haven’t yet see any reason this revenue growth advantage wouldn’t hold true during other times as well.

The conclusion? “Our data and experience is clear: Frequent, regular incentive payments (at least quarterly) based on the firm’s top-line success are highly motivational.” 

This increased employee motivation is crucial when it comes to succession plans. We analyzed the importance of higher growth rates from revenue-based bonus compensation in our July 2013 Investment Advisor column “Follow the Money in Succession Planning” and followed up in our November 2013 white paper “Take Two: The New Direction of Succession.”

Our succession plan in the column was based on an assumption about the future growth rate of the firm. At the time, that firm was growing at 17% a year. So we conservatively based the succession plan using a 10% growth rate: that enabled the junior advisors to buy out the owner in seven years—during which, everybody’s compensation when up. 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. 

To get those kinds of growth rates, we’ve found annual revenue-based bonuses to be by far the most successful in succession planning. Kitces and Grau may be right that a “sales-oriented” compensation model based solely on individual revenues may hurt the succession prospects. But a compensation model that includes team revenue-based bonuses creates higher rates of growth, which make internally financed succession plans possible.

In fact, without the higher growth rates from revenue-based bonuses, most internally financed succession plans would not be feasible without the owner(s) taking a huge hit to annual compensation for many years.

The bottom line is that revenue growth drives the success of a succession plan. Why would we put the incentive and the focus on any other driver than the one which reflects growth? That driver is revenue. So you wouldn’t focus on anything else. Unless, of course, you wanted your plan to fail.

See The Best Advisor Succession Planning? Internal Sales, With a Comp Switch, by Michael Kitces.