What’s in a Plan?

What could possibly account for the most successful advisory firms paying so little attention to their ownership succession? Here's what Inveen and De Pardo offer by way of explanation: "These results could suggest that the current success of many Standouts may be coming at the expense of proper planning for the future." This would appear to make a good amount of sense, except in light of other data in the study. It seems that in all four size categories, the number of primary owners as a percentage of all full-time employees is higher for Standout firms than for the other 75%. While the ratio of owners drops dramatically as firms get larger, this is what we would expect, considering that their support staffs—both professional and non-professional—are proportionately larger.

Perhaps a more consistent explanation of the lack of "adequate" succession plans among the most successful firms would be that these firms consider sharing ownership with younger advisors to be, by itself, a sufficient plan. This conclusion is further supported by data showing that between 25% and 26% of the three smaller firm levels have career paths for all employee positions, while just 14% of the larger Innovators do—again, suggesting that the potential of ownership may be viewed as a panacea for all employee desires for advancement.

In addition to the data on succession planning itself, FA Insight offers a view of the mechanisms of ownership with far-reaching implications. Of the firms that are adequately prepared for succession, 45% offer long-term financing to purchase shares, and 82% sell shares immediately to new owners. Yet, only 29% of the new owners avail themselves of that firm financing; while 33% chose to pay cash up front, 17% buy in with an existing book of business, and 20% are granted ownership without payment under incentive plans or other arrangements.

Of those employees who choose to buy in for cash, 31% use personal cash reserves, and 24% either didn't require funding or used other financing sources. This strikes me as an extraordinarily high percentage of "younger" advisors paying cash for equity considering today's market value of even smaller advisory firms. David Grau at FP Transitions tells me that smaller firms are currently selling for around three times gross revenues, paid over three to four years, which would put the cash value at around two and a half times revenues. So, for a firm with $500,000 in revenue, we're still talking about $1.25 million in value, which would make a 10% stake worth in the neighborhood of $125,000—a pretty good chunk of change to have lying around.

My suspicion is that this data suggests many firms are selling ownership to in-house advisors well below market value, a practice that has broad implications for the industry. Certainly, if, as FA Insight and others suggest, the biggest issue facing the independent advisory world in the coming years is the succession of existing firms, the converse is equally troubling. How can today's junior advisors afford to buy out their firm owners? While selling at substantial discount is laudable for the current generation of owners, it's not really a viable solution. For one thing, it's not fair to the founders who created these valuable firms or to their heirs who may have to live on their financial legacy. What's more, it creates a huge financial incentive for the junior advisors to sell to a roll-up firm at full market value—the very thing that the owner/advisors had hoped to avoid.

Although transition programs that enable younger advisors to buy out their owners are becoming commonplace, they usually require up to 10 years or longer to implement, which ironically seems to be more planning than the majority of today's advisors are willing to do. Perhaps a more useful solution will be for custodians and independent BDs to offer truly workable funding for their affiliated advisory firms to buy the transitioning practices of their competitors. As I mentioned, we're looking at an estimated $3 trillion to $4 trillion in client AUM up for sale. A firm that enables their advisors to grab the lion's share of those assets undoubtedly will emerge as the industry leader of the future.