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, and as many as 40% of financial practices are likely to change hands in the coming decade. “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. Clearly, this is an area that merits explanation.
We 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%. 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.