With today's focus on growing advisory practices while managing costs, more advisors are entering into joint-venture or referral relationships with other professionals. In some cases, advisors are even becoming part of larger businesses–accounting firms, banks, and law firms–hoping they will get a steady stream of qualified clients in return for sending a cut of the action back to the parent firm. In many cases, especially when both firms serve the same type of clients and there is a mutual respect for and understanding of the services that each offers, these referral arrangements can yield significant, even dramatic, growth in the client base and the revenues of an advisory practice.
Unfortunately, the majority of the referral arrangements we have seen have not been very good deals for the advisors. In fact, many have been economically disastrous. The referral fees are usually too high for the advisor to make enough (or sometimes any) profit on the new business, and because a portion of the fee is often paid in perpetuity, it's almost impossible to make up the loss out of future business. For instance, in many cases advisors will pay 25% of the fee forever. We've even seen the split as high as 50/50, which is especially onerous for the advisory firm involved.
What's the problem with these referral arrangements? As our clients and readers of this column have heard more times than they can remember, to understand what's going on with your business, you need to break your expenses into two categories.
First is direct expenses, which are those costs directly related to generating revenue, usually the compensation paid to professionals, including the owner/advisor, for advising clients and bringing in business. This category is the cost of services sold. The second category is overhead expenses, sometimes referred to as general & administrative costs. Gross profits, then, are revenues minus direct expenses, and operating profits are gross profits minus overhead.
To get a pulse on the business end of your practice then, we suggest (ad nauseam) that you track the gross profit margin, i.e., gross profits divided by revenues, and the operating profit margin, i.e., operating profits divided by revenues. By tracking changes in these ratios separately, you can quickly identify problems with your cost of goods or overhead, and take the appropriate actions. But the impact of these referral agreements is often irreparable without alienating the source of the referral.
Our 2004 FPA Financial Performance Study of Financial Advisory Practices found that the average advisory practice has a 55% gross profit margin, and an 8.4% operating profit margin. Solo and ensemble firms have essentially identical ratios. So consider the impact of just a 25% referral fee. If your usual cost of services run 45% and you add another 25% cost, you are now looking at a gross profit margin of 30%. If your average overhead is 46.6%, you are now losing 16.3% on that client. (See "The High Cost of Referrals" chart.) You can see that it wouldn't take many of these clients to wreak havoc with your firm's margins. And a 50/50 split? Fuhgeddaboudit.
Focus on Your Margins
Some advisors we know will argue that it is not necessary to recognize any level of compensation for themselves as a cost of services, because they always take what's left over anyway. In their minds, increases in gross revenue are more important than improvements in margin. Unfortunately, it's not that simple. Independent advisors are both the employer and the employee, so you are entitled to fair compensation for your labor (direct expense) and a return on your risk as an owner (operating profit). Put another way, the money that you're not paying yourself is in reality an investment on which you should expect to earn a rate of return commensurate with the risk involved. For our purposes here, however, suffice it to say that to get an accurate picture of the cost of services sold, you have to put a value on your labor.
Others will rationalize a high referral fee by arguing that they need to pay a large percentage in order to induce people to refer them new clients. If you look at it as pure volume without regard to profit, that may work, but the economics are not logical, especially in the 50/50 case where you can never make it up in volume because this is a high variable cost in perpetuity. By evaluating the referral arrangement in the context of margins, you begin to see which kinds of referral business make sense.
If you had few clients and were desperate for the business, you might be inclined to be overly generous with your referral sources. But the good advisors become overwhelmed with opportunity and have to make choices. Eventually, the question arises whether you want to take on the unprofitable business, or decide whose call you'll return first. To complicate life, should you do extraordinarily well with the referrals, you may even be forced to hire support staff or other advisors to manage the flow. When you lay those added costs into the model, the question of margins becomes even more important, and the problem more acute.
