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5 Key Issues for a Succession Plan

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In recent statements, Securities and Exchange Chairwoman Mary Jo White has indicated that some requirement for succession planning will be incorporated into the much-heralded and anticipated uniform fiduciary duty rule being crafted by commission staff. Because of its investor protection focus, the SEC mandate will likely include business continuity. Regardless of the impetus for action, the anticipated SEC mandate may prove to be a useful motivator to the large majority of industry professionals who have not taken the time to thoughtfully develop a business succession plan.

As a result of White’s comments, I asked my partner, Dan Sheridan, who has been drafting succession plans for many years, to give me his thoughts.

Sheridan advised that there are many benefits from succession planning, but the greatest benefit by far—which should resonate with investment advisory professionals—is value preservation. Every investment advisory business, regardless of size or complexity, has an ascertainable value. Unless a plan is in place, at the point of business transition, that value will migrate to others.

There is no “one size fits all” solution for business succession plans. That said, there are several core considerations that will be addressed in a well-designed plan. The more thoughtful and thorough the planning process, the better the result is likely to be. At the very least, a good succession plan should:

Address planned and unplanned events. Many business owners have an identified retirement horizon. While a succession plan should address the owner’s ideal situation, if that is the only scenario addressed many other situations are left to chance. The most critical of these are death and disability. In many cases (depending largely upon the age and health of the business owner), insurance can be used to protect value and provide liquidity.

Address tax implications based on entity type. I often advise clients that the only number that matters in a transaction is the number that represents what you keep—after taxes. Tax implications vary considerably based upon entity type (e.g., “C” corporation, “S” corporation, LLC). If life insurance is used, tax considerations are heightened. A succession plan ought to carefully address the tax implications of the transaction structure and the potential funding mechanisms (insurance, earn-out, etc.).

Identify likely successors. Businesses with multiple owners have a distinct advantage. For sole proprietors, there are generally two options. The first is to identify a similarly situated practice owner who is willing to purchase the business (preferably at a pre-approved valuation formula) upon the occurrence of specified events. The second is to bring on a junior partner capable of assuming the business, thereby converting the business from solo ownership to multiple ownership.

Establish a formula or process for valuing the business. Business valuation is perhaps the most important and most difficult aspect of the succession planning exercise. Should the formula be based on revenues or profits? If profits, what expenses ought to be eliminated to normalize earnings (e.g., owner perquisites such as automobile allowances, retirement plan contributions)? An important but often overlooked issue is client attrition. Despite a successor’s best efforts to retain the business of a retiring or deceased partner, some percentage of the business is likely to be lost. The associated economic risk should be allocated between the parties.

Address regulatory constraints. Several industry specific considerations must be taken into account in a succession plan. This is especially sensitive for a business that may derive revenue (directly or indirectly) from commission-based compensation. In such an event, the requirements of the affiliated FINRA-registered broker-dealer must also be considered.

While succession planning may appear to be a daunting task, when approached thoughtfully and methodically, it will pay dramatic dividends. Value is preserved, and peace of mind is enhanced for business owners and clients. Regardless of whether or not succession planning for investment advisors becomes mandated, for the reasons set forth above it is prudent for all advisors who have yet to do so to consider adopting a plan soon.