You might think that financial advisors are financially savvy, and when it comes to personal finance, they usually are. But when it comes to business finance—particularly the buying or selling of advisory businesses—I am constantly amazed that many advisors are just as susceptible to a good sales pitch as anyone else.
Like many others, I believe the looming retirement of baby boom advisors will shape the independent advisory industry for many years to come. Some advisors are simply selling their firms to institutions or other advisors, but I've found the vast majority prefers to transition their ownership to their junior advisors. Consequently, we work with many of our clients to create and implement succession plans.
However, I encourage our clients to bring in succession planning experts because I firmly believe all succession plans (including the ones we create) should have a second set of eyes on them. There are myriad issues to consider, and I encourage these outside perspectives to ensure the business and the owner are protected. Yet, as of late, I have been dismayed (if not scared for the industry) to find that many of those plans were unworkable, and that their flawed structures all too often cost owner-advisors millions of dollars in compensation and equity.
Here's just one example of a problematic succession plan that was recently proposed to one of our clients. According to the plan, the firm owner would transfer 75% of the ownership of his solo practice to two junior advisors over 10 years. The good news was we were ahead of the curve, with plenty of time to make a workable transfer of a majority stake in the firm. The plan didn't call for selling 100% of the firm because the owner was in his early 50s and didn't yet know when he wanted to retire, but he did intend to eventually transfer the balance of his equity.
The succession expert used a complex valuation method that essentially came out to 2.5 times revenue to value the firm's roughly $1 million in annual revenue at $2.5 million. Then, assuming a 5% annual growth rate, it was projected to be worth about $4 million at the end of the 10-year period.
Unfortunately, that's about where the good news ended. As usual, the junior advisors had no capital to buy the business, so the plan called for the owner-advisor to "lend" them the money to purchase equity each year, paying it off out of the growing profits from their increasing ownership stakes in yearly installments. At the end of 10 years, they'd own their 75% equity free and clear.
However, to make this plan work, the expert had to modify the current compensation structure of the owner. (Dear Business Owners: I don't care what kind of business you own, if the proposed plan requires you to significantly reduce your total compensation, it's a pretty good tip-off that you have a bad plan. With Love, The Ambassador of Your Dough.) Currently, my client is grossing about $400,000 a year in compensation. Adding no partners over the next 10 years, at a meager 5% annual growth rate, his compensation would grow to $620,000 a year, totaling about $5 million over the period.
But, under the expert's plan, that annual compensation would be cut to $200,000 to start, growing to $310,000 a year and totaling $2.5 million. Not to worry, said the expert, as the difference would be made up with $2.3 million in note payments to the owner by the junior advisors over the same 10 years. (This was also made possible by increasing the junior advisors' compensation from $75,000 per year to $150,000 to start, and culminating with $240,000 at the end of the 10 years).
Instead of earning a projected $5 million over the 10-year transition, the owner-advisor will receive $4.8 million. Only $200,000 over 10 years, you say? Where's the beef? The "beef" is that also during this time, the owner-advisor transfers ownership of 75% of a firm worth $4 million by the end of the transfer, which works out to be $3 million in value. That's one heck of a deal for the junior advisors. The owner-advisor essentially gave away his firm.
