In my last columns (April and May 2007), we addressed the importance of restrictive covenants that protect an advisory firm's client relationships.
But there's a broader issue that RIAs need to address. Because of the "graying" of the industry, it is increasingly important for advisory firms to consider succession planning issues, whether via internal succession or an external acquisition or sale. Critical to any successful succession is having the appropriate underlying documents in place, including: to protect the firm's client relationships, the appropriate restrictive covenant agreements; for an internal succession, a well-drafted operating agreement or shareholders' agreement addressing the terms and conditions for the disposition of ownership interests upon the occurrence of various events; and for an external succession, a well-drafted purchase/sale/merger/joint venture agreement that protects the parties' interests before and after the transaction.
For advice on these issues, I interviewed my Stark & Stark colleague, Stuart Mickelberg, an associate of the firm who represents advisors on corporate and regulatory compliance matters.
What's the purpose of a business succession plan for an advisory firm?
The plan should accomplish a number of objectives: providing a mechanism for the orderly transfer of the business; establishing a valuation mechanism which avoids disputes between owners as well as possible disputes with the IRS; reducing possible disputes between owners, an owner's heirs, and possible unwanted business partners to whom an ownership interest in the company may otherwise be transferred; and providing financial security to a deceased or disabled owner's family.
Are all buy-sell agreements the same?
The three most common types are cross-purchase, redemption; and hybrid cross-purchase/redemption. The type of buy-sell that should be used in the succession plan depends on a case-by-case analysis of various factors such as each owner's succession planning objective, the number of owners, and the liquidity of the company and each of the owners.
How is a cross-purchase buy-sell agreement structured?
In a cross-purchase agreement, the remaining owners directly purchase the shares from the selling owner or the selling owner's estate. The owners depend on each other individually for the payment of the purchase price of the stock. Accordingly, a cross-purchase agreement may require that each of the individual owners maintain liquidity in amounts sufficient to buy out the other owners at any time. Some owners favor the cross-purchase structure because it allows the owners flexibility in allocating differing percentages of ownership to the remaining owners or other interested parties.
From a tax perspective, in a cross-purchase agreement the surviving owners receive a "step-up" in tax basis to the extent of the purchase price paid for the stock. This means that when the acquiring owners sell their shares, the capital gain will be lower. However, if the acquiring owner plans to retain the stock until death, the step-up in basis may not be realized, because the heirs who inherit the stock will get the inheritance step-up in basis. A cross-purchase structure should only be used if the acquiring owners have the ability to satisfy the terms of the buyout. Unless the acquiring owners have adequately reserved cash or kept up with insurance premiums, the selling owner may not be able to cash out according to the terms of the buy-sell agreement.
How is a redemption buy-sell agreement structured?
In a redemption agreement, the company, not the individual owners, buys the stock from the selling owner. So in a redemption structure, the company must have liquidity and has the responsibility to maintain cash reserves and the insurance policies on each of the owners' lives. For some owners, placing the responsibility of payment in a buyout on the company rather than on the individual remaining owners makes a redemption agreement preferable.
