Future Faces
Not enough advisers think about how they will transition their practice as they approach retirement, says Dick Darian, founding partner of retirement industry mergers and acquisitions (M&A) firm Wise Rhino Group in Charleston, South Carolina. “Very few if any of the firms we work with already had a succession plan or a sale plan. These folks are amazing entrepreneurs: They have great selling skills, they are able to recruit talent, and they serve clients well,” he says. “But there’s less focus on their business plan. Having a plan is important, and, today, many folks are just getting to the point of realizing that.”
It is crucial for a well-run advisory business to have a succession strategy, and the pandemic has made that clear, says Wendy Leung, senior consultant at Diamond Consultants, a recruiting and business consulting firm for financial advisers, in Morristown, New Jersey. “I think COVID has highlighted the need for a formal, written succession plan for owners. Some owners have been putting it off, and now they realize they shouldn’t be doing that,” she says. “Having a succession plan protects the value of the business for an adviser. And it also protects the clients if something should happen to the principal.”
Advantages and Challenges of Internal Succession
The vast majority of independent advisers have a natural bias to sell internally, to a colleague at their firm, versus doing an external sale, says David DeVoe, founder and CEO of DeVoe & Co., a registered investment adviser (RIA) M&A consultant, in San Francisco. “The concept of continued independence is really attractive to them,” he says. “In many cases, these are people who left the wirehouses to be independent, so they have to think through, ‘Hey, do I want to give up any degrees of independence?’”
An internal succession appeals to many advisers, for several reasons, Leung says. “We find that, often, the principals of firms would ideally like to homegrow a successor,” she says. “That’s the least disruptive thing to do, and it offers the most continuity for clients and staff. It also allows the principal the maximum amount of control over the process. [It’s not necessary] to change anything about the business, and the principal has the ability to determine his or her ongoing role. There’s a natural inclination to want to do that.”
Opting for an internal succession over an external sale brings with it some challenges, which advisers need to think through as they plan. For those who have not already been developing a next-generation leader for years, they need to find that person. “The biggest challenge is that talent is hard to find,” says Jeremy Holly, chief development and integration officer at SageView Advisory Group in Newport Beach, California. “Internal succession plans are difficult: Even if you try it with someone, it may turn out that you have not found the right person. Identifying that person, and then developing them, is hard work. Star advisers are hard to replicate.”
It is taking a big chance to depend on a recently hired adviser as a practice’s next-generation leader, and it creates a “key-person risk,” says Jeff Nash, CEO and co-founder of Bridgemark Strategies, a recruiting and consulting firm for financial advisers, in Charlotte, North Carolina. “Internal succession can be a good solution if you already have a junior adviser in place whom you’ve been developing—and a better solution if you have two junior advisers already in place whom you’ve been developing,” he says. “But the scenario of bringing in a new junior adviser can be too much risk for the selling adviser.” He has seen instances of how badly that can play out, from the junior adviser ultimately deciding not to buy the business, to the person trying to steal the business, to the person unexpectedly becoming seriously ill and needing to be bought out of the equity stake.
Moreover, advisers need to keep in mind that a successful internal succession involves years of work. “That process takes upwards of 10 years or longer,” Nash says. “Developing the junior adviser could easily take five years. Then it often becomes a ‘tranched’ sale, so the senior adviser is selling a bit of the business at a time to the junior adviser over a number of years. If the junior adviser is not willing or able to take a loan to finance the sale, then you’ll need to sell pieces of the business over time, which is usually what happens. That tranched sale could easily take five years, too.”
In most internal transactions, it is the owner who takes all of the risk, because that person is basically financing the transaction, says Rick Shoff, managing director, adviser group at CAPTRUST in Doylestown, Pennsylvania. “There are situations where the minority shareholder[—i.e., the acquiring adviser—]has the means to get external financing for a deal,” he says. “But, normally, the seller will do a ‘seller’s note,’ essentially saying, ‘I’m going to give you the equity, and you’re going to pay me what the equity is worth over time, out of the operating profits of the business.’” Because of the lengthy payback schedule and the fact that the profits are the source of the payments, “it’s risky,” he says. What happens if the business hits a bump in the road, and profits decline?
Further, in an environment of rapid consolidation, with bigger advisory businesses achieving scale and developing an increasing depth of talent and capabilities, choosing to remain independent may make it harder to attract and keep clients. “There’s a lot of M&A activity in the space,” says Vince Morris, president of OneDigital’s retirement and wealth division, in Atlanta. “In any industry, when it starts to consolidate, scale begets scale. At some point, you’ve got to wonder, ‘Are we going to be able to keep up with what the larger firms can offer?’”
The next-generation advisers need to benefit more than the senior adviser, Shoff says. “If you do a sale, you have to be able to go to your employees and your clients and answer the question, ‘Why did you do this?’ The answer better be, ‘I really believe this is better for you,’” he says. “Doing an internal sale is really just because you want to leave the business. You’re not changing anything about the services.”
Preparing an Effective Internal Succession Plan
Advisers who want to put together an internal succession plan can take these five steps to doing it effectively:
Allocate enough time for planning. “Succession plans can be complex to think through, because there are about 30 different components,” DeVoe says. “Often, advisers start with the best of intentions, thinking that doing the plan is something they can knock out in a weekend or two. But then they realize, ‘Wow, there’s much to consider.’”
It is better to start soon and work on the plan a bit at a time, rather than intending to tackle it all sometime in the future, DeVoe says. “The one thing I’d say,” he adds, “is that the longer you wait to put together a succession plan, the lower the degree of likelihood that it will come to fruition.”
Decide on your goals upfront. “I think the right place to start is thinking through your goals and objectives,” DeVoe says. “What do you hope to achieve? What are your economic goals and objectives for your business? What are your goals and objectives for your own, ongoing role? And what are your goals and objectives for your team’s ongoing roles?”
Identify one or more potential successors. It is important to do an honest assessment of the advisory team, DeVoe says. “Do you have an internal successor already in-house, someone who can be coached to manage a range of day-to-day operations and also be a leader of the organization? And, if you do have that person, or more than one person, can they afford to buy your organization?”
The ability of an internal successor to buy an advisory business is becoming an acute issue, DeVoe says. “The good news is that many of these firms are growing and doing very well,” he says. “The bad news is that, often, the value of these firms now exceeds the grasp of G2[—the second-generation owner who would acquire the firm]. So in many cases, you won’t be able to do an internal deal without selling at a discount.”
Decide on the right equity timing. “The idea of pathways to partnership, and allowing folks a designated way to earn equity in the business, has become something that more and more top firms have been looking at,” Leung says. “Equity has become very valuable currency, and it incents everybody to be on the same page and work for the overall success of the organization. More firms realize now that having metrics and a pathway to equity can be a really smart way to retain their best people.”
Nash is not a proponent of allowing potential successors to start getting equity right from the start, unless they bring their own book of clients and assets to the equation. Instead, he thinks it works better to offer a salary and bonus structure initially, then add an ability to buy in on the firm’s equity in the future. The senior adviser may end up deciding to do an external sale, and if a junior adviser already has been given a 30% ownership stake, for example, that could complicate a deal for both advisers and the potential acquirer.
“Over time, you can let that junior adviser start to buy in, and you can do that at a discounted valuation if you want,” Nash says. “If you end up selling externally, the junior person [with an equity stake] ends up making money also and can continue working there with the salary and bonus structure. That way, it’s strategic, not just, ‘You automatically get equity.’”
Be OK with a valuation discount. “The economics of an internal sale are different, compared with an external sale,” DeVoe says. “Typically, if you are selling internally, you’re either selling a minority stake or selling a majority stake at a discount, and you’re discounting the value of the firm for emotional or personal reasons [such as selling to a family member]. If you sell externally, the valuation can be nearly twice as much, in today’s environment.”
“The marketplace is so hot, and prices are so high, that the gap between what the owner would get in the marketplace and what the owner would get in an internal succession is huge,” Darian points out. “So you might get $20 million on the open market, or do a $10 million succession plan.”
The External Sale Option
For an adviser thinking about succession planning, it is also important to consider the pros and cons of an external sale. “Part of it is going to be, what’s the goal of the seller?” Darian says. “Some advisers don’t have someone internally to sell the business to, so they do an external sale. Some feel the need for a growth engine for their business, and they need help to grow because they now have to compete with larger firms that have more capabilities. Some advisers say, ‘We can’t survive and thrive as an independent, so we need to sell.’ And the option to sell externally is so hard to ignore, when you look at where the [M&A] marketplace is right now.”
Strategic buyers acquiring advisory practices used to pay in the range of four to six times annual EBITDA—i.e., earnings before interest, taxes, depreciation and amortization—or two to two-and-a-half times a fee-based practice’s annual revenues, Nash says. “Those multiples have increased. Where we were seeing deals at four to six times EBITDA, now it’s five to seven or five to eight,” he says. “Where we were seeing two to two-and-a-half times revenue, it’s now two to three times revenue—and higher for the better businesses. Most buyers will be using the EBITDA multiple for their calculations.”
An external sale does have some potential challenges. “One is that the process can be somewhat arduous to go through,” Holly says. “It’s never fun to integrate a business, but it’s necessary work. It’s important to go into it realizing that it’s going to be work. You may be learning new systems and processes, and it’s important to set aside enough time for that.”
The adviser also needs to keep in mind the amount of time it will take to help clients make the transition smoothly, Holly says. “It’s all about reducing friction. Friction comes from transitioning clients and having new service agreements with them, and there could be differences in the services or the fees,” he says. “The largest friction for an adviser doing an integration initially comes from having those conversations with clients.”
Art by Philip Lindeman