David Grau can be fairly called the granddaddy of the advisor-transition business. His firm, FP Transitions, founded in 1999, has done nearly 5,600 valuations of wealth management firms, given advice on about 1,200 transactions and has more than 1,700 continuity plans in place.

Grau has incorporated the data he’s acquired over the years into a new book, Succession Planning for Financial Advisors: Building an Enduring Business (John Wiley & Sons Inc., 2014).

The gist of the book is that advisors must start the succession process early enough to transition from the usual “eat-what-you-kill” business model, where advisors manage their own books (even as part of a team), into an entity that will endure after the founder is gone. This enduring entity needs to be a single firm with employees compensated with a salary and bonus. It needs to make ownership stakes available to the next generation of advisors, who pay for shares with bonuses paid out of profits. A complete transition will take a decade or longer.

An outright sale to a third party is another option, but rarely happens because founders can’t afford to give up the cash flow from their businesses. A sale also doesn’t produce as much total value. Neither does a revenue-sharing arrangement with a successor, which is the option available to advisors who can’t or won’t build an enduring firm.

A long-term internal transition can produce a final value of six or seven times revenue—several multiples higher than a straight sale, Grau says.

That makes an internal sale the obvious choice for an owner—as well as the next generation.

“When you sit down and think about the choices for the next-generation advisors, they can either hang out their own shingles and try to do it all, or become part of a team and take a million-dollar practice and grow it into a $10 million business over 15 or 20 years,” Grau says. “The question is, which one will be more satisfying? And which will be more lucrative? When we lay out the arguments in a spreadsheet in front of 30-year-olds, 85% of them sign up and commit.”

FA: How would you describe a true succession plan?
Grau: Succession planning isn’t about shutting down and putting yourself out to pasture. It’s about building something. That’s the fun part. That’s what entrepreneurs are wired to do. Advisors’ businesses are not just their most valuable asset—those businesses are what fuel their lifestyles. And they can’t let that asset die.

FA: But most advisors never develop a true succession plan. Why is that?
Grau: First, they struggle with what a succession plan is. They think it is selling their practice. They quickly conclude that they don’t want to sell. So if selling is the only option, they’re just going to work forever. They don’t need a succession plan. But that’s wrong. Selling is not a succession plan. A succession plan is building a business to outlive you. When you reframe it that way, and explain that it’s about the future, not just about you but about the staff and your clients and their families, then advisors get very interested in the proposition.

Second, we’ve found after doing thousands of cases that more than 90 percent of firms do some form of the eat-what-you-kill compensation system. It’s almost everybody. But that is not how you build a business. It is how you build a broker-dealer, though. It’s how you build an OSJ.

It’s how you build an office complex in a wirehouse. But it has nothing to do with how to build a business in an independent model. That’s absolutely the wrong model if you want to build a practice that will outlive you. When you do an eat-what-you-kill system, the business takes no money to the bottom line. It’s an unprofitable business by definition. The advisors get paid off the top line and get paid like owners without taking on any of the risk, and worse, never taking on the skill set of an owner. With that kind of compensation system, a firm is built to die when the founder is gone.

What independent firms need is a culture of ownership, not a culture of production. Granted, you have to produce revenue. But you have to create an ownership culture where, if advisors do a great job and want to invest in their careers there, they have an opportunity to become shareholders. In a business that has $2 million in revenue every year, if you can get $450,000 of that to the bottom line where it’s distributed on a tax-advantaged basis, and only to the people who invest in the firm, you’re going to start a line of investors wanting in. Everybody who works there and produces will want to be an owner.
        
FA: A lot of advisors don’t think their younger staff have what it takes to be owners. In your book you say, give them a chance, you’ll be surprised.
Grau: The common objection we get from a founder is, “Hey, I don’t think any of my people are entrepreneurs.” And our response is, “Thank goodness!” Because taking a business out of dry dock—from zero revenue to a million or two—that’s about as far as most founders get.

That’s a tough job. That is probably not a job done well by most people. You need an intrepid decision-maker, someone with a short memory, because if it goes wrong tomorrow, you’re going to be right back there the next day to get it right.
That’s an entrepreneur’s job. But in building that firm up to $5 million, we would argue that is not the skill set you want. As a larger firm, you can afford to have somebody who’s a producer and good at marketing do that job. You can have another producer who’s also good at human resources, another who’s good with technology. As a founder, you had to do all those things and you weren’t great at any of them. So now you can get people in your firm with a passion for those tasks and they can all do them better than you could. That’s how you turn a practice into a business and give it legs for the next generation. You’re not describing an entrepreneur’s job.

We described a case in the book where one firm got psychological assessments done on three younger potential owners and the results were that none of them would work out as owners. Just before the book was published, those same three employees went out and got a bank loan for $3 million to buy out the owner before he thought he was even ready.

FA:  What about just selling to another firm? There seem to be plenty of willing buyers.
Grau: Ninety percent of advisors never sell. That is a fact. They think that’s going to be their exit strategy, but we tell them statistically, no it won’t be. So part of what we wanted to say in the book was, yes, selling your business is a fine way out, you can realize a lot of value and with a 50-to-one buyer-to-seller ratio, you’re going to feel wanted and appreciated and loved. And somebody will step in and take it over for you.

But in truth, if you’re married to the income stream, it won’t happen. The business supports your lifestyle and you’re never going to let that sale happen. When you have a son or daughter entering college next year, probably a private school, and a master’s degree after that, well that’s six or seven more years you need to work. And you have eight or nine years left on the mortgage. By the time they get to the bottom line, advisors see that they can’t afford to sell and live off the proceeds.
That’s the reality. They need the income. So how do you keep the income up while you get older and start working less? That’s what a succession plan does. It’s what everybody wants; they just don’t think it out far enough ahead of time to go get it.

FA: How much time does it take to do a full transition?
Grau: More than five years. We have an unofficial program called the five-year plan. When they go into a five-year plan, the focus is not on building, it’s exiting in five years. But we love to see people start about age 50. We tell them, take your total plan length, say 20 years, and divide by two. At that 10-year halfway point, we would like to see you still working, but only about half the time.

FA: What is a business worth if transferred with a true succession plan?
Grau: People talk about typical multiples of two times trailing-12-months revenue. But try six or seven times. That’s what these internal plans will generate if you give them time. That includes the salary, bonuses, profits, plus the sale of your equity at long-term gains, and the growth of your remaining shares of equity as your business grows at the hands of the next generation. That combination is powerful. The payoff will take at least 10 years. So my advice is to get started.

FA: You’ve been critical about the lack of true succession planning in the industry. What’s the problem as you see it?
Grau: Broker-dealers are all setting up internal matching services. But these firms have to understand that out of a thousand reps, they’re solving the problem for maybe 60 to 80 people. And those are likely to be job and practice owners. My question for B-Ds is, what are you doing for your business owners? Those internal matching programs are not the solution. And they spend money to bring people in. Then they have annual conferences and provide practice-management support. But why is it that the one thing they don’t do is help advisors build stronger and bigger businesses? All the focus is on one-generation practices. If your recruiting department is doing the thinking, then they’ve got job security banked all the way through that model. But how can it possibly be good to have a business model that will die before the core clients die? I would argue that this problem is the Achilles’ heel of the independent channel, and if we don’t get it fixed, clients and their assets are going to move to a more durable model.