When it’s time for the founders of successful advisory firms to start planning for their eventual exits, oftentimes they discover that their firms have become too valuable for their successors to buy. The younger partners may have been carefully groomed to take over clients, responsibilities and management, but they don’t have the financial resources to buy out retiring partners. And even if they could find the money in their checkbook, they likely couldn’t afford the risk such a huge investment represents.
To succeed at an internal succession plan, advisory firms must focus not just on the sophisticated equity models but on teaching the new owners how to develop business, take risks and make decisions together. If the new owners are capable of those three things, the financing will fall into place. If they fail, the equity models will all prove meaningless anyway.
This problem is frequently discussed among the founders at the largest firms. When their enterprise valuations range from $20 million to $40 million, the next generation will not have nearly the amount of capital they need to absorb these firms. Often there is no way out other than selling the firm to somebody else, yet the majority of partner-owners would still prefer to pass their companies, which they built through passion and labor, internally to their younger colleagues.
Can they? I believe the answer is yes. They can overcome the capitalization challenge as long as the younger partners show the same entrepreneurial drive, risk tolerance and leadership that got the firms started in the first place. To do that, they must be able to develop new business and take calculated risks.
Unfortunately, these qualities are frequently lacking. Junior partners are often simply passengers in a luxury car that’s being driven by somebody else. They might be unwilling to grab the wheel and pay for the gas. The firms they work for create that problem by training them to be passengers and not drivers. Every generation has ambitious and driven people, but my experience has been that there are simply not enough of them to complete the change of leadership at many top firms.
Financing Ownership Change
Let’s start with the assumption that the transition financing is a minor problem. A change in ownership is usually a very straightforward mathematical problem that has solutions. Most owners of large firms who prefer to transfer their companies to younger partners are willing to sell at (slightly) lower valuations than full market price and take payments for their firms over time. That is all they need for success. Simply put, if they chose instead to take the maximum valuations possible and get paid all at once, the internal succession wouldn’t stand a chance.
Most of the largest advisory firms today are very profitable. But when the valuations are expressed as a multiple of profitability, they aren’t so daunting. (I won’t get into multiples because I don’t want to be responsible for “back of the napkin” calculations. Advisors should hire a professional for that.) Yet, in most cases, the majority owners or founders of a firm can be successfully bought out using five to eight years’ worth of profits and some reasonable assumptions about the retention of clients and the growth of the firms.
That’s all it takes—five to eight years’ worth of profits and the firm is yours. Taxes complicate things, of course, and lawyers and investment bankers will make it even fancier, but it usually comes down to this fairly simple equation, at least as long as the next generation can do several things:
• Sustain and grow the profits of the firm in the next five years;
• Accept the liability of a large loan that they personally guarantee (scary!); and
• Commit to not increasing their personal income during that period of time.
The younger partners have to ask themselves, though: Can they invest five to eight years of their lives with no increases in income? Do they believe the departing generation can really help them finance this?
Immensely sophisticated spreadsheets have been built to help partners address these succession issues, and they involve the creation of management company structures, serial redemption provisions and preferred streams of income. But it all tends to come down to the same conclusion—someone has to take the risk for sustaining the firm’s profits and growing for the next five to eight years. Only then will the investment “pay for itself.” The question is, who will take the risk?
It works differently when a private equity firm gets involved. These firms take risk by carefully selecting their targets, diversifying across many companies and only buying a portion of each, thereby essentially chaining the owners to the boat (until the owner can pass the oars to somebody else). The private equity firms also offer owners a great amount of liquidity, a sale price at a higher valuation and a clear path to the exit (sort of).
But that choice is less popular for owners than transferring internally. The question is, can the younger generation do it?
Can You Do It?
Time and again, younger partners ask questions such as, “How do we know this firm will be profitable in the future?” “How do we know clients will stay when the owner leaves?” “Why should we believe this firm will grow?” These are all good questions to ask. In fact, they are fantastic questions—if you are a passive investor.
But if you are the future managing partner of your firm, you should instead be saying things like, “I know how to make this firm profitable.” “I can retain the clients.” “I will grow the firm!” These are the statements made by an entrepreneur and an owner.
There’s a well-known quote: “MBAs never start a business, because if you really analyze it, starting a business does not make sense.” Perhaps that’s what the second generation needs—that passionate leap of faith that says, “I can do that!”
That said, entrepreneurs can help the second generation a lot by doing the following things:
1. Teaching and encouraging advisors to develop new business;
2. Allowing leaders to emerge within the second generation, letting group dynamics play their course; and
3. Removing the “training wheels” by exposing the second generation to risk and letting them make risky decisions, the results of which will be unclear.
Developing New Business
Developing business means, in part, sales training. No matter what your attitude toward “sales,” you would likely agree that a firm cannot exist without them. Firms must be able to add clients, revenues and assets, and the need for sales training is particularly pressing at larger firms with a cadre of service advisors—professionals who have always relied on the firm to bring in new clients and have no experience in sales.
The sales process can be broken into three steps. The first is lead generation (or prospecting), in which an advisor uncovers and engages potential clients. The second is the “proposal,” in which the advisor presents the services to the prospects, persuading them that the practice is a good solution to their needs. And the third is “engagement,” or closing, in which the advisor finalizes the details of the deal, including pricing and other terms.
Most advisors, in fact, struggle with the lead generation part, not sales or closing. Advisors who are not “good at sales” tend to have trouble identifying quality prospects rather than trouble converting prospects into clients. In other words, they bark up the wrong trees.
That means advisors should be focused on patient, persistent networking rather than unproductive and discouraging sales seminars. If an advisor makes it a point to be active in the community, to meet many people within his or her targeted demographics and to spend time getting to know attorneys and CPAs (for referrals), chances are the advisor will be quite capable of generating leads in two to three years. But many advisors never network, never go out of their way to participate in charities or clubs and never bother to meet with other professionals who can spread the word about them.
When advisors instead put their efforts into a “business development campaign,” it puts pressure on them, creates awkward situations, discourages networking and leaves everyone feeling “cheap.” Still, the key to business development is to start early and be consistent. Network when you don’t need to so that you can have the leads later when you do need them.
The next generation of advisors in many firms often don’t know how to deal with each other without the founders around. They don’t know how to make decisions together, how to disagree or even fight. They don’t know who their leaders are and frequently do not trust each other enough to take a great risk together.
Advisory firms frequently adopt family-like values in dealing with people, and a family treats all the children the same. But such values may stand in the way of progress at a firm where leaders need to emerge, the same way they would in a sports team. Someone must step up who is willing to take the risks of making decisions when the cost is high and the information is imperfect. Someone who can inspire, encourage and hold others responsible. Someone who will be willing to show the way when there is no map.
These people may be hard to find, and advisors may be chasing them away by enforcing an undesirable and unsustainable “equality” among the younger partners. To avoid friction or conflicts among them, the firm steps in to mediate and engineer every contact between them. The result is that these partners can’t learn to function without a “mom and dad” present.
Instead, advisory firms should look early for those employees who have leadership potential and perhaps encourage them to take on new challenges and develop their skills. This does not mean just having them read books and attend seminars but instead letting them oversee projects, lead committees and make decisions for the firm. Let them take risks, let them succeed and fail and, most important, let them lead their peers and take responsibility for the results. And they must be able to do this while the owner is still around.
Without such emerging leaders, the successor group will frequently be frozen and indecisive. Even if they are willing to take risks as a group, they won’t know how to make the decisions.
In some firms, the leaders emerge naturally and are very authoritative. In others, different members of the group will take turns and assume leadership in the situations they are most familiar or comfortable with. Sometimes the next generation will figure out how to organize themselves, and you can let them go through the natural evolution of an effective team.
There is no other way to really learn about investing other than to invest. Yet oddly, many advisors, even as they encourage investing among their clients, aren’t willing to take the real risk of investing in their own companies.
Partner “introduction” models are frequently heavily subsidized and do not ask advisors to give up much, if anything. Nor do incentive compensation plans. The result is a generation of owners that have never really taken a risk with their career or their money. If they have never risked losing a bonus, how will they ever be able to stomach borrowing $20 million?
Instead, firms should be taking the opportunity to expose their new partners to risks—and thereby teach them how to make decisions when they face real losses. Otherwise, they are like boxers who have never been in a real fight and have only trained with a heavy bag. If it’s not punching back, it isn’t teaching you anything about being in the ring.
One of the ways to expose junior partners to risk is to compensate them with bonus plans that might not pay out. After all, that is what ownership is like—you make decisions and you live with the consequences.
Also, the senior partners should give younger advisors the ability to buy equity on a smaller scale well before the big “ultimate purchase.” Retiring minority partners can sell some of their stock to the upstarts, and so can the founders. This both reduces the concentration of equity and exposes the new owners to risk.
Meanwhile, there are always projects at a firm that beg for someone’s attention. These could be geographic expansions or a new service. For the young partner learning to take responsibility, it’s important that these projects are risky and their outcome unclear. Maybe San Diego will be a great market. Or maybe a young partner will find out while testing it that it is impenetrable. Maybe dentists will be a great financial advisory niche. Or maybe there are already too many competitors in it. You must encourage your future leaders and partners to take the risks and find out. They may lose some months and years, but they will learn more than anything you can teach them about ownership.
Are Generations Really That Different?
Advisors study laboriously how Gen X is different, how Gen Y uses social medial, etc. Frequently that “research” influences the approach to younger colleagues. But was an entrepreneur in the 1990s really that much different from those today? Is an effective CEO more influenced by what computer game he played and how old he was when he watched Seinfeld?
People learn and adapt—it is perhaps one of the most fundamental features of our species. We can learn how to be entrepreneurs and leaders and managers. We just need exposure and constructive experience—let us give it a shot and we learn from it. We will never learn to drive just by watching other people drive us around.
It’s relatively straightforward to finance a change in a firm’s ownership. What’s harder is finding somebody with the qualities of leadership, entrepreneurial drive and charisma. The profits and the money are there, but the human qualities required from new owners are much more difficult to obtain, develop and bring into the transition.
John Adams said in one of his letters that he would be a soldier so his son could be a farmer, so that his son could be a poet. True, but perhaps a healthy advisory firm needs to have all three—soldiers, farmers and poets—in the same generation working together and helping each other. If a firm doesn’t have that defensive strategy, it might not only be too valuable for the younger generation to buy, but also too vulnerable to survive.
Philip Palaveev is the CEO of The Ensemble Practice LLC. Palaveev is an industry consultant, author of the book The Ensemble Practice and the lead faculty for the Ensemble Institutes. More information about the institute and the book can be found on the Web site for the Ensemble Practice (www.ensemblepractice.com).