Every business needs capital. It’s your stake in that big lifelong game called Success. Your capital empowers you to do a lot more than keep the lights (and computers) on: it’s the foundation for your future growth and your protection during future economic downturns.

Traditional industrial companies have both liquid capital—their cash and financial assets—and capital goods: the buildings, equipment and inventory that could be sold off in a pinch to raise funds. In addition to accumulating profit, these companies raise capital in order to expand or to endure hard times by taking loans or inviting direct investment. The bigger the business, and the more capital it already has, the more likely it is to be able to obtain more.

Access to capital is difficult for small businesses, for new businesses, and particularly for service businesses whose capital is primarily intellectual. This includes financial advisors. These businesses need to leverage their ability to generate consistent cash flow to gain access to capital. Recently, this task has become a little easier, as the business community develops better understanding of the value of intellectual capital and the sustainability of financial advisors’ cash flow.

For financial advisors, the issue of capital is far from academic. We are at a time when the average age of a principal in a financial practice is 57,[1] and as many as 40% of financial practices are likely to change hands in the coming decade.[2] “There’s a lot of action in the world of inorganic growth. Some is first-generation owners passing to the second generation, and some is strategic,” says Jason Carroll, managing director at Live Oak Bank.

Financing business activities is an area that leaves a lot of financial advisors confused and uncertain. In fact, 48% of advisors who already have succession plans say that “researching financing available” to them is their greatest obstacle to obtaining the capital they need.[3]Clearly, this is an area that merits explanation.

This paper will outline the various forms of capital available to financial advisors for expanding their businesses, acquiring a business, modernizing a business, recruiting and other activities. The options will be presented in the order of most frequently to least frequently used today.

Of course, both buyers and sellers need to work closely with appraisers, tax professionals and attorneys to ensure that they formulate a deal structure that works for their needs.

Seller Financing: A Popular Way to Close a Deal

As its name describes, practice owners often find that in order to close a business sale, they have to finance it themselves with a note. Typically, they’ll expect a down payment of about 20–30% and the rest will be paid back over time, with interest.

Incentives for financial performance will be built into the deal. Buyers may protect their investment with an “earn-out,” which can require that the seller stick around to facilitate a smooth transition to new management and peg the final payout to the performance of the business over the next three to five years. Earn-outs can be based on retention of assets, revenues, profits—or a combination. Sellers need to be careful that they are not unduly punished for events beyond their control, such as market volatility. Both buyer and seller need to understand that they are equally vested in the firm’s success—and to trust one another to be equally committed.

For buyers, the advantage of seller financing with an earn-out is that it motivates the seller to do his or her utmost to help the new owner succeed. Why is this important? According to a study by Aite, one in three advisors who purchased a practice in order to build their own book of business reported that the acquisition resulted in a client retention rate of less than 50%.[4] A disappointment, to say the least. Keeping the seller actively engaged with retaining the clients is one way to fend off this gloomy statistic.

The disadvantage of an extended transition is that the seller may overstay his or her welcome, preventing the buyer from modernizing or otherwise upgrading the firm. This can lead to tension in the office and buyer’s remorse.

Friends and Family: Love Saves the Day

Many businesses begin with funds put up by family and friends—the original angel investors. Some of these businesses will make their financiers rich. Friends and family of financial advisors, however, will find that their potential rewards are much lower, as are their risks.

The ups and downs of raising capital among one’s inner circle are obvious. The lenders have to be supremely comfortable with the idea of investing in the advisor’s business–or Thanksgivings and other holiday gatherings could become fraught. The advisor has to live up to the expectations of loved ones. It can be an easy-going process or extremely emotional.

Nevertheless, loans from family and friends are still business transactions. For legal and financial reasons, it is essential to have written loan or equity agreements with family and friends, and have them reviewed by attorneys. The lenders need to charge interest or the IRS may view the loan as a gift. If the venture is not successful, family and friends will rely on the paperwork for their tax deductions. If the venture is extremely successful, the paperwork will protect the borrower, who will want to repay the loans and share the profits as agreed—and not necessarily beyond.

SBA Loans: Born in the USA

An advisor who applies for an SBA loan is not borrowing from the government directly. Instead, the Small Business Administration guarantees bank loans to small businesses that meet the SBA’s criteria. (“Small” is a relative term, which for advisors means businesses with up to approximately $3.5 billion under management.) These criteria are notably more lenient than a bank’s typical loan standards, which fits with the SBA’s mission to expand business ownership and create jobs. For financial advisors, these loans are most appropriate for businesses with $50 million to $3.5 billion in assets under management. Terms are generous, up to 10 years for a business loan with no prepayment penalty.

SBA loans can be used to acquire a business from a senior partner or from an outside advisor, so long as that advisor’s practice is based in the United States. The loans can be used for working capital to expand the firm to accommodate a new partner who is coming from a captive brokerage. The loans can also fund a technology upgrade or even building or buying an office.

But qualifying for a loan is far from guaranteed. Applicants must be able to demonstrate that the loan will be used for a sound business purpose. Many banks may offer SBA loans but not be adept at handling the paperwork.

Although a bank with conventional capital, Live Oak Bank specializes in SBA loans and has developed expertise in how to guide advisors through the application process. In addition, Live Oak’s online portal makes the application process much faster, easier and more transparent than the typical loan experience would lead business owners to expect. The key is being able to go beyond collateral and evaluate discounted cash flow—which depends in part on current assets under management, but also on the quality of the client list, among other variables. For acquisitions, the bank requires that advisors get a third-party valuation as part of the application process.

For advisors who are acquiring practices, an SBA-backed loan can serve as leverage for negotiating a better purchase price by reducing the need for seller financing. “Say you’re buying a practice for a million dollars,” Carroll says. “In a traditional seller-finance situation, you might put up $200 thousand as a down payment and sign a note for $800 thousand. But with a loan, you might be able to put up $800 thousand. We’re seeing that people who can do that have the ability to reduce the overall purchase price, because the seller likes having the cash in hand.” Cash is king.

Bank Loans: It’s a Wonderful Life?

Banks are the primary source of credit, and the first lending institution that comes to mind for most borrowers. Here, however, a business based on intellectual capital, and that lacks tangible assets, may have trouble qualifying for a loan. Banks do want their business loans to be collateralized, and an advisor’s laptop and file cabinets typically won’t suffice.

Commercial loans have never been easy to obtain in the Independent Advisory industry, but since the financial crisis of 2008, banks have further tightened their lending standards. Expect to supply several years’ worth of financial statements and to show a history of consistent growth. Also expect a general lack of comprehension of the independent advisor’s business model, unless the advisor has an ongoing relationship with the banker. Furthermore, be hopeful that your bank has an FDIC charter that will allow for collateral shortfalls.

An advisor who can qualify for a bank loan will enjoy several advantages. Interest rates are near historic lows, so the cost of the loan is relatively affordable. Although borrowers may have to show a plan for how they plan to use the funds, they also have more flexibility in how to structure their deals.

Mezzanine Capital: Fueling Rapid Growth

Advisors with more than $2 billion in assets managed by their firms may qualify for mezzanine capital, which is a type of debt that is best used by firms that are growing rapidly. Mezzanine debt is subordinated debt, which means that the lender’s rights to the borrower’s money come after he or she has paid off other, more senior loans.

Why would a borrower seek mezzanine financing?  For firms that are serial acquirers, for instance, mezzanine capital can be an additional source of capital to complement senior bank debt.   A firm that gains access to mezzanine debt could be able to execute acquisitions without being limited to senior debt or new investments by its owners.  Mezzanine capital, while bearing higher costs than senior bank debt, is less expensive and dilutive to ownership than outside equity capital.

For mezzanine lenders, these loans have the potential to generate high returns. In addition to paying interest, the borrower is typically required to provide warrants that enable the lender to purchase equity (typically “penny” warrants) with a put option to sell their equity stake back to the firm at a pre-defined price (agreed upon multiple of cash flow) in five to seven years. 

While mezzanine lenders expect a wide range of returns, they generally target an overall internal rate of return (IRR) based upon interest rate and equity return (or some other form of “kicker”) of at least 10 percent. For example, if a lender targets an IRR of 12 percent and receives interest of six percent on a five-year investment, the lender would also require warrants that attach to an equity ownership position in order to reach the target IRR. If the lender projects firm equity value in Year Five (the “exit” year) to be $5 million and needs the equity position to be worth $500 thousand to drive a 12% IRR, the investor would take warrants, up-front, equal to a 10 percent equity position in the firm. The mezzanine lender exceeds its IRR target if the firm valuation in Year Five is worth more than $5 million; on the flip side, the lender does not achieve the IRR target if the firm is valued at less than $5 million in the exit year. While we’ve addressed equity warrants in this paper, there are certainly other structural options with mezzanine debt that do not dilute ownership, such as sharing in profit or cash flow to meet IRR expectations  in excess of the interest rate.

Private Equity: The Power Player

Private equity (“PE”) firms have been making a splash in the financial advisor industry for the past few years. They’ve discovered the high profit margins and sustained cash flow, and they want in.

Bear in mind, though, that equity is the most expensive form of capital available to the advisor. Outside equity may come from PE firms that may take a passive (minority) ownership position or from strategic sources such as aggregators (consolidators) who desire to own the firm, or a controlling interest, at some point.

Private equity, like mezzanine debt, can be a source of capital for the serial acquirer to enhance acquisition capacity and accelerate growth. For the owner desiring to retain control of the firm over the long term, private equity is more desirable than strategic equity, which seeks ownership control at some future date. 

Advisors considering a private equity infusion should bear in mind the cultural ramifications of aligning with an outside equity partner, whether a PE firm or strategic capital. PE firms are focused on generating target returns based on a firm’s valuation in the exit year (typically five to seven years from the initial investment). To achieve that, they aim to maximize free cash flow (EBITDA)—the exit valuation is typically based on a pre-agreed multiple of EBITDA, so the bigger, the better. If your ownership horizon is longer term, you may want to make investment decisions which enhance your value proposition and client experience, but that don’t bolster short term profitability.  Although the additional discipline around creating scale and maximizing profitability that comes with outside investors can be positive for the business, advisors will need to reconcile in advance that different time horizons may create tension. It is up to both sides to ensure that discussions remain constructive.

In the end, private equity or strategic equity can be an additional source of capital to accelerate growth and build firm value. It is not, however, for the faint of heart!

Preparing for a Strategic Move

It takes time to prepare for a transaction and apply for capital. Advisors would be well-served to use that time to examine their own businesses and make them as efficient as possible. A focus on standardizing office processes and accelerating organic growth will make the advisor’s company more valuable and possibly help the firm qualify for additional credit.

Both buyers and sellers need to get their firms appraised by an objective third party. “A typical advisor’s firm valuation comes as a range with a middle line,” Carroll explains. “A low down payment pushes the valuation up, and a higher down payment pushes it down. The negotiated price can vary as much as 20%, depending on the cash up front.”

Using capital wisely can be the key to healthy growth for a firm and wealth for an owner. Have certainty in your financing partner; a bank uses its own capital and financing obligations are binding. Take the time to work through options and consult with experts to ensure that your next steps are successful.

(For more information check out Live Oak Bank.)


1 Cerulli Associates

2 Aite, Efficient Frontier of Succession Planning, 2012

3 Aite, Show Me the Money: How Access to Financing Affects Advisors’ Plans for Business Succession, 2014

4 Aite, Efficient Frontier of Succession Planning