Consider your neighborhood. Some houses are rented, some houses and lots will be bought by builders and a few condos will go up. Some houses have fallen into disrepair. What you hope for, though, is that the majority of houses in your neighborhood will be occupied by the owners. Homeowners are the ones who make sure that the schools are good and the streets are clean. Owners will plant trees and throw a good block party. Builders may provide liquidity to the market, but they can’t maintain the spirit of the neighborhood.

In the same way, if we want to have a good financial advice industry, we need to own it. One way to do that, among others, is to sell our firms internally to our subordinates. Internal succession—passing the baton to people actively engaged in the business—is one of the best ways to keep a firm’s culture alive and keep promises to clients and employees.

Often, a firm’s founder actually prefers to sell to the younger generation, (or “G2,” to borrow a term from Tim Chase, the CEO of WMS Partners in Baltimore). But there are things standing in the way:

• The next generation might not be around. The founders have never found or have never tried to find younger professionals.

• G2 may be there, but the younger employees might be underdeveloped in their skills and not yet ready to take over.

• The next generation also might not want to take on the significant financial and business risk necessary to buy out the founders.

• The price of a big, successful firm might be too much for the younger partners to buy into.

• The capital younger advisors need may not be available.

Where there’s a will, there’s a way. But it takes a commitment from both G1 and G2 to do it. Otherwise, it does not work.

An internal succession plan is not for everyone. Sometimes, it’s better for an advisor to simply sell or turn to private equity to grow. But if a firm is committed to creating continuity and if the next generation is motivated to lead, the financial issues can be overcome.

We often tend to focus on the equity transaction and forget that before we start discussing an equity deal, we need to make sure G2 can actually replace founders as professionals and leaders. They must be able to service clients equally well and be able to continue bringing in new ones. They must be able to take over as professionals, leaders and investors.

Before we sell the car to G2, let’s make sure they can drive it, otherwise we will have a car-crash disaster, no matter what the price.

The Big Purchase
A founder’s most straightforward strategy for selling internally is to simply sell his or her equity to the next generation in one big transaction. The purchase may be financed by the founder, or there may be a third-party lender.

The key in such a transaction is the relationship between the price and the cash profits of the firm. If the after-tax profits of the firm are higher than the payments on the “succession mortgage” (the loan taken to buy out the founders) then the transaction will be very smooth. All G2 has to do is maintain the revenue of the firm. Unfortunately, this is rarely the case as taxes will take a large bite out of the profits. That said, the longer the loan term, the easier it is to achieve that balance. Seven-year terms are common, and at times 10-year terms are used.

The second issue is the discrepancy between the “internal price” and the “external price.” The valuation external buyers such as banks or serial acquirers offer is usually higher than the “internal” price offered by the successors. Founders rarely insist that the younger employees match the external price. Most founders are content with a lower price, as long as they don’t feel that the internal offer is unfair. “Fairness” is difficult to define here, but if the internal price is half the external one, founders will start feeling as if they are being taken advantage of.

A Large Number Of Small Transactions
Most large firms make a lot of small equity sales to introduce key people to the ownership group (while small in percentage terms, these sales can be in the millions). New partners buy 1% to 10% each (the larger the firm, the smaller the percentage). These small purchases not only motivate new partners, giving them skin in the game; these deals are also instrumental in succession plans for a number of reasons.

• Over time, sales of 3%-4% to a growing group of partners can transfer a fairly significant amount of equity, eventually giving the junior partners 20% to 40% of a firm.

• The initial small transaction paves the way for future “larger” deals because the new partners will have had the experience of buying in and seeing the cash flow work.

Such transactions may not be nearly big enough for an eventual succession, but they are a necessary start.

Passive Ownership
If the equity can’t be transferred, a firm’s founder can merely remain a passive owner of the firm—holding on to a majority of shares, even as he or she steps away from day-to-day work.

For example, let’s say I started Bulgarian Managed Wealth (BMW) and have been the CEO since inception. Let’s say I have five partners who are very capable of running and growing the business without me, and their combined stakes make up 30% of the firm while I hold the remaining 70% of the equity. It might be logical for me to step down from the CEO job and perhaps retire—but keep my 70%. Why not? No one forced Bill Gates to sell his Microsoft shares when he retired as CEO.

Passive ownership has several key advantages that deserve consideration:

• There is no need for a massive buyout by G2 or, thus, for them to raise capital and take on the risk or burden of payments.

• The founders will be able to continue enjoying the cash flow from the business.

• The founder and the second generation will stay on the same page, since both groups are still focused on continued cash flow and profitability.

• The equity could be passed on to the founder’s children and family without disrupting the business.
 

This is a good strategy, but it has significant flaws. If I retain 70% ownership interest and my successors have to mail out 70% of all the profits every year, there will inevitably come a time when they feel it’s unfair. The working owners trying to manage a firm and invest in its growth will eventually clash with the owner who is merely collecting the checks.

Still, the passive ownership plan has its place, and there are a couple of things you can do to avoid conflict:

• The passive owner should never be the majority owner. If more than half the profits leave the building, the working owners won’t feel themselves having control or benefiting from the work they do. A 20% or 30% passive interest, on the other hand, may be a big improvement.

• There should be a very strong corporate governance structure. For the passive owners to feel that their interests are protected, there should be a board of directors representing the shareholders and providing the passive owners with the levers needed to exercise their rights. Furthermore, the firm should have a structured management process and a good deal of fiscal discipline. Such good housekeeping will keep both passive and working owners happy.

• Over time, perhaps the passive interest should decline. This is not absolutely necessary, but as a firm grows and looks to add more owners, it will need to use that extra equity. It might be best for the company to continue buying out the passive owners with an eye toward their eventual exit.

A Larger Equity Sale
Another gambit for an owner is to sell off a much bigger chunk of his or her company all at once, but stay on board. This strategy is underused, but very powerful. Imagine that I’d sold off 30% of the equity of BMW to my partners while I was still CEO. That would help G2 secure the loan (guarantee) necessary to buy out this chunk. The plan is for all the payments to be made while I am still the CEO. I’ve gone from 70% ownership to 40%, which would make it easier for me to hand over the reins and leave the firm someday.

The risk in this kind of deal is considerably less because I am still here and there is no danger of management disruption, the sort that would drive clients away. What is more, when completed the transaction would give G2 a significant existing stake in the profits and therefore significant access to the dividends generated by the firm. They would have the full benefit of 60% of the profits already in their hands while they service a loan for my remaining 40%.

The issue with these “intermittent” transactions, however, is that frequently G2 is not ready to take such a risk, and the group is not cohesive and well-organized yet. Imagine BMW is worth $10 million and we are trying to make a deal for 40% of the equity. This means that G2 needs to collectively borrow and pay off $4 million. They would have to forgo increases in income and personally guarantee large loans, putting their houses and everything else on the line. It could seem overwhelming.

There are also some technical problems. Many of the lenders who provide capital for successions use Small Business Administration (SBA) loans, and SBA rules prohibit partial redemptions. There could also be tax issues, since a partial redemption would be considered a capital gain, not a dividend distribution, in the context of a Subchapter S corporation. As always, consult your CPA to ensure that you have fully thought through the tax consequences.

Founders are also not often very eager to sell a substantial amount of shares while they are still working. They may feel that going from majority to minority interest is too big a step. They are leaving too much appreciation on the table, since that 40% would have grown quite a bit if they had retained it. This brings us back to the commitment to create a firm with longevity. If that commitment is made, these issues should not exist or be significant.

Equity-Based Compensation
Not many firms directly use equity as a form of compensation, but many formulate their bonus plans so that a portion can be used by employees to buy the equity. Suppose, for example, that BMW “paid” 1% of its shares each year to the executive team of the firm according to their performance and responsibilities.

The advantage of this stock compensation process is that it can be tied to performance and can channel equity into the hands of those most deserving. It can also bring equity to key executives who perhaps have not had the ability to purchase equity through other programs.

The problem is that this tends to undermine the value of other shares (employees would much rather earn shares than buy them). The program can also end up being too democratic, leading to a very broad ownership rather than concentrating ownership in the hands of the top contributors. If the ownership is too widely distributed, it can create corporate governance problems. How do you handle the management team’s fiduciary responsibilities to a very large group of owners? And what happens when an employee leaves?
Even when “granted” as part of a compensation program, shares have value, and therefore will be considered taxable income that the recipient has to pay.

Most of all, because of the “psychological devaluation” of the stock, equity compensation is not used very often for succession in the advisory industry (though a few firms we work with have succeeded with it).

Synthetic Equity
One favorite topic among RIA owners is synthetic equity (which includes more sophisticated compensation instruments such as options, phantom stock, stock appreciation rights, warrants, profit participation, etc.). For one thing, they allow owners to restrict some of the voting rights of younger successors until the next generation is ready. (Many firms give non-voting shares to G2.)

But I’m biased against using these types of instruments to shift ownership to employees. If I trusted my successors enough to take over my firm someday and buy me out, I probably wouldn’t set the right tone by giving them restricted access to their equity. If I want them to be my partners, I should make them my partners, not qualify that by calling them something like “non-voting partners.” All such restrictions tend to undermine the trust in the relationship and create the wrong atmosphere.

Synthetic equity is the “economy plus” of ownership. You get a little more legroom and perhaps a free drink, but you are keenly aware that you are not in first class (don’t try using that bathroom) and by the way, you probably don’t like those guys in first much.

Mergers Facilitating Succession
Another way to fill out the ranks of the younger generation is to acquire them—by buying up other firms. Bringing in new G2 members with mergers and acquisitions might not only increase the size of your firm but also boost the cash-flow available to finance a succession internally. You can do this by merging with firms of equal size or by making tuck-in purchases of smaller firms.

Unfortunately, it’s hard to find the right merger partner. And founders don’t want to paint themselves into a corner, relying on new mergers when candidates aren’t around.

Bringing the G2 Together
I’ve seen a lot of succession plans in which all the components are in place—the price is right, the financing is available and the terms are reasonable—but there’s the one problem: The second generation is finally, surprisingly, unwilling to take the risk and acquire the equity.

There is no way a succession can succeed unless members of G2 come together. But they still have to understand that owning a business is taking a risk. This is not even a matter of financial engineering or deal structuring. Being a business owner means putting your personal capital and reputation on the line. If you don’t have the passion to do it, there is no business.

And the financial advisory industry needs younger investors to have that commitment to continuity and the passion to accept those risks if it is to hold on to its independent spirit.

Philip Palaveev is the CEO of the Ensemble Practice LLC. Philip is an industry consultant, author of the book The Ensemble Practice and the lead faculty member for The Ensemble Institute. More information about the institute can be found by e-mailing [email protected].