Across the industry-and in the minds of most advisors-the debate between internal and external succession continues to bubble. Where can I get the most money? How can I best accomplish my personal objectives? How can I best take care of my clients? My staff? My family? The questions we hear from advisors are remarkably consistent, and the questions they are asking are good ones. Of course there isn't a right answer when choosing between internal and external options for succession, but for most when the questions above are considered, and the business owners are honest with themselves about how they prioritize these questions, the preferred method of transition emerges pretty gracefully.

For those who opt for the internal succession route-which is for many at least their initial preferred option-there are questions of how to develop the people they need, how to keep people, how to transition clients and ultimately how to transition the ownership internally, each of which could fill multiple columns with juicy content. In this column we'll start with what to think about in planning for internal succession and the admission of new owners.

There are many scenarios in which sharing equity is an appropriate consideration: as a succession strategy for existing owners, of course, but also as a potential business-building strategy for existing owners, a driver for motivated employees and a recruiting tool for experienced professionals. If you are growing, you need people (more than just you and your partners, if your plan is to continue growing) who can:
develop new client relationships;
retain existing clients;
provide strategically important expertise;
manage people;
train new professionals;
provide leadership.

Depending on your growth plans, you may need colleagues at a peer/owner level who can share (or take on entirely) responsibility in these areas. We find that in most firms, it is difficult to retain the most talented individuals in these roles without an equity opportunity, and it can be difficult to create an environment of growth and opportunity unless ownership (or an attractive alternative) is available.

Most firms that are considering offering ownership to internal candidates start with the questions of, "What will it cost and how will they pay for it?" I commend those firms for recognizing that internal employees should pay for their ownership interest. It should only be given (as opposed to sold) if it is in lieu of other compensation. (If an employee is not nor has not been fairly paid for their job role, you may consider giving him or her equity instead-think dotcom start-up-but if they have already been paid fairly for their job, then they should pay for their equity interest.)

But before getting to the question of cost and financing, you first need to think about the questions of who and why. The first questions you should think about in considering the addition of new owners are:
1. What is the goal of sharing equity?  
2. What does it mean to be an "owner"?
3. What does someone have to do to qualify?
4. Are the current owners ready?
5. Is the firm ready?
Only then can you think about the tactics, which I will address in the second part of this two-part column in the April 2008 issue:
6. What is the ownership interest worth?
7. What is the appropriate financial structure for ownership transition?
8. What should be the terms of the ownership agreement?

What Does It Mean To Be An Owner?

The first question I urge you to consider is "What is the owner role in your firm?"  Is "owner" a job title? Is it an actual functional role? (If so, what does that imply? What are the owners' actual job responsibilities?) Is "owner" simply an investment status indicating you have invested in the firm, but does not have implications on your job role?

Consider what the responsibilities are for an owner in your organization. Though this varies quite widely among firms, many firms would say that owners:
set the tone of professional and personal behavior within the firm;
have decision-making power and responsibility;
make a financial commitment to the business (take financial risk);
have a role in firm management (in some firms);
have an impact on growing and training others.
For those firms that consider "owner" a job role, not just an investment status, this usually implies the owners have specific job responsibilities above and beyond their role as lead advisor, CEO, COO, CIO, etc., which may include:
client acceptance and defining the service offering;
resolving client issues and conflicts;
exercising technical judgment and ethical judgment in the resolution of errors or miscommunications;
dealing with employee problems, issues and conflicts;
evaluating business opportunities for the firm;
negotiating contracts on behalf of the firm, from simple vendor contracts to complex formal alliances;
evaluating the work of other partners and staff;
representing the firm in the community;
representing the firm before regulatory agencies.

This question of what it means to be an owner is not just about an owner's role, it's also about an owner's rights. This is frequently an area of disconnect between current owners and future owner candidates. It happens very often that an employee, maybe a junior advisor, comes to the current owners and says, "I would like to be an owner. What is the path?" The owners then come to us and say, "Help us develop a path to ownership. We really want to keep this person."  

As we dig deeper to understand what it will mean for this person to become an owner, we find the current owners want to share very little ownership, not usually because of the financial implications, but because they want to give this person a token recognition and no real input or insight into the business. They don't want the person having real authority or meaningful input into the firm's direction. They frequently don't want the person to have access to firm financial information. They often don't want the person to have to take much risk. Which makes us go back to the question of, "What does it mean to be an owner?" and, "Are the current owner's and owner candidate's understandings aligned?"  The candidate may be happy with just the title and token recognition, though her becoming an owner will have little meaning to anyone involved. Usually future owners (especially good ones) want more. I would strongly suggest that if you don't want this person sitting side by side with you as your partner (even as a minority partner), you should consider a form of short- or long-term reward (like profit-sharing or deferred compensation) instead of equity.

What Does Someone Have To Do To Qualify?

Of course what someone has to do to qualify as an owner is going to depend on how you have defined what it means to be an owner in your firm. If "owner" is only an investment status, then to qualify requires simply being a qualified investor. If "owner" is a job role, then qualification will have more complex criteria. It is interesting to observe that the difference in what it takes to qualify to be an owner differs between silo firms-where a candidate usually has to simply contribute to the economics-and ensemble firms-where a candidate has to make a meaningful contribution to the firm.

The answer to the question of owner qualifications is actually surprisingly different among firms. In some firms, everyone is an owner, or everyone who develops a certain level of business is an owner, or all "key people" are owners, which may include the founders and the receptionist. My personal bias is that ownership should be reserved for those individuals who are driving value in an organization, and that ownership should be a privilege and an investment.
Criteria for ownership might include:
Contribution to the firm
Revenue
Retention and growth of existing clients
Intellectual
Management
Unique skills that drive the value of the business
Maturity
Decision-making
Employee management
Community presence and representation
Ability to bear risk
Financial
Professional liability

Character and Values

Internal candidates for ownership and those you might consider admitting from the outside should be held to the same admission criteria. If you are considering an external candidate, even a high-level one, but are not certain they yet qualify to be an owner, bring them in as an employee and make them an owner when you have had an opportunity to evaluate them in all the criteria for ownership, as you would an internal candidate.

Are The Current Owners Ready?
    The preparedness of the candidates is one consideration, but just because you have individuals who are ready to be owners does not necessarily mean the firm is ready to add new owners. Sometimes firms are pressured to make people owners-sometimes really great, qualified people-but it ends up messy because the existing owners were not yet ready to have partners.

Evaluating the preparedness of the current owners is part psychology, of course, and requires some introspection by the current owners. It also requires a clear answer to the question of what it means to be an owner. Does being an owner give someone input or some element of control? If so, how do the current owners feel about getting input or sharing control? Does it give someone access to financial information? (Yes, it does.) How do the current owners feel about opening the books? Does it tag this person as a future successor or eventual majority owner? If so, do the current owners envision this person in that role? Does it have implications on the current owners' incomes?  If so, are the current owners prepared for that?

Her are some signs to look out for to know if you might be ready to share ownership (or not):
When you have more responsibilities in running and leading the firm than you can handle personally.
When you are prepared to share those responsibilities.
When you are looking for partnership and collaboration in decision-making and setting the direction of the firm.
When you are prepared to share the financial information and financial rewards.
When you are ready to take some chips off the table.
When you need more skills/capacity/capital to continue to grow.

Is The Firm Ready?

Although the question of owner preparedness is mostly psychological, the question of firm preparedness is mostly financial. The key question here is, "When is the firm growing enough so that new partners will not dilute income or value of existing partners?" If a new partner receives a share of the firm that is proportionately greater than the financial reality of what they bring to the deal, it will result in immediate dilution of the other owners. In some firms this is acceptable and in some it is not, but in any firm it's important that you understand the financial impact of admitting a new owner.

Considering the dilution effect is a relatively simple financial modeling process:
1. Estimate compensation changes when a candidate becomes a partner (salary increase, additional benefits, perks and other).
2. Calculate how much profit needs to increase to afford the increased compensation AND an additional person receiving profit distributions.
3. Translate the target profit to target revenue ($X) based on your current or projected profit margins.
4. Every time you grow by this amount of revenue ($X), you can afford a new partner without dilution of the income of existing owners.
These are some of the considerations in planning for the admission of new owners into your business. From here it gets much more tactical:
determining a "fair" price;
financing the transaction;
structuring ownership.

We will drill into each of these areas in my April column: "Adding New Owners: Executing On Internal Succession."  In the meantime if you are thinking about admitting new owners into your firm, spend some time thinking about your objectives and what the owner role means in your firm, especially once it expands to include new owners. With planning and foresight, the development of employees into peers can be a very gratifying experience. Make sure you have the plan in place to make the ownership transition gratifying as well.

Rebecca Pomering is a principal of Moss Adams LLP and practice leader for Moss Adams Business Consulting. She consults with financial advisory practices on matters related to strategy, compensation, organizational design and financial management.