Selling your advisory practice — a move stressed in a ceaseless torrent of industry advice — may be hazardous to your wealth.
Broker-dealers, roll-up firms and others who benefit from keeping or acquiring managed assets usually frame the necessity of succession planning in terms of the risk that clients won't commit to a firm whose principal is aging.
Therefore, the reasoning goes, advisors ought to sell for the good of the clients and to cash out their equity.
A new white paper and advisor survey by CLS Investments, an ETF-based third-party money manager, has a different take altogether on advisor succession planning, arguing that advisors lose out financially through an outright sale of the business.
As a third-party money manager, CLS' interests are perhaps at odds with roll-up firms, as it stands to lose business, potentially at least, from an acquiring advisor who might have different plans for investing client assets.
But advisors should consider its case for advisors not selling their practices, together with other interesting findings in its survey of 117 of its affiliated advisors.
The CLS survey found that 41% of advisors expected the sale of their practice to fund 25% to 50% of their retirement, with another 14% expecting such a sale to fund 50% to 100% of their retirement.
Thus, a majority (55%) of advisors expect the sale of their business to fund a significant portion of their retirement.
Given that the two largest segments of advisors surveyed expect to need between $750,000 and $1.5 million (27.7% of respondents) or between $1.5 million and $3 million (also 27.7% of respondents) to retire comfortably, do succession sales make economic sense?
Not according to CLS, which says that current industry norms value advisory business at from 2 to 5 times free cash flow, which is typically 20% of annual revenues.
So for $400,000 business — slightly higher than the average veteran advisor, CLS says — free cash flow would be $80,000. Using an optimistic multiple of 5, the advisor should get $400,000, equal to the annual revenue for his business.
While that seems like a decent payout to advisors, the whitepaper cautions that earnout provisions typically spread payments over a number of years (after a typical 40% down payment).
So the advisor would receive a $160,000 lump sum, followed by five years of $48,000 payments under these somewhat optimistic assumptions, which pales in comparison to an advisor's salary, which is typically 40% of revenue ($160,000 a year in the hypothetical business discussed here). And after the sale is completed in five years, the advisor has no asset left.
Aside from the faulty deal logic, the CLS survey highlights another strong reason to resist traditional succession planning: advisors like what they do.
A bare majority (50.5%) of respondents don't want to retire till age 71, if ever.
So not only is the sale of their business inadequate to fund their retirement, but it would deprive them of a personal and professional role they've invested their careers in.
The report approvingly quotes Michael Kitces saying "financial planning is a classic example of a profession that is not exactly a physically intensive business, and as long as the mind is able and the body allows for meetings with clients, planners can continue to work."
To that end, the CLS white paper, through case studies of its affiliated advisors, seeks to "reframe" succession planning away from an outright sale of the business and toward keeping advisors happily involved in a growing business.
One such case study concerns Robert Harrell, an RIA now in his 70s, who followed a classic approach to continuity planning by bringing in his son Will, who, now serving as senior vice president, handles many of the firm's day-to-day responsibilities.
That not only allows his father's active role in the business, but avoids a rash of potential problems that could occur with an outright sale, such an exit date that coincides with a severe market downturn.
As Harrell, quoted in the report, puts it:
