Most firms are too big and yet too small

    SINCE THE EMERGENCE of the independent financial advisor in the 1970s, many practitioners in this business have characterized themselves as entrepreneurs. Since they're no longer employees of a parent organization, the notion is that they are, in fact, business owners. They have the same risks and responsibilities as those who leave the cocoon of an employer-based organization and begin their own enterprise. In reality, many of these financial advisors are not entrepreneurs; they are simply self-employed. What's the difference?
    Entrepreneurs start a business and build it into an organization that invests in people, systems and branding. Self-employed advisors, on the other hand, consider themselves employees of their own business, not investors in that business. These firms are operated by individuals who avoid putting money into their business, respond and react to opportunity, and consciously limit growth primarily because they have an aversion or fear of working with other people. That's not to say one approach is better than the other; it's a fork in the road. The right path to take depends on each individual's personal definition of success.

The Entrepreneurial Crossroads
    The profession is at a crossroads. Will individual practitioners opt for independence rather than depth? Will they struggle to serve clients and grow? Will they be able to respond to the growing need to invest in technology? How dependent will they become on their broker-dealers or custodians to help them build infrastructure? How will this dependence change the economics of their businesses?
    Most financial advisory firms are in that awkward adolescent state. They're too big, yet they're too small. Once an advisory firm begins to add any staff, it has started to accelerate its growth. It will need to monitor and measure performance, coach and counsel people, produce an increasing amount of revenue to cover the added overhead, and invest in more technology solutions, office space and employee benefits. The joy ride begins, with the owner careening around corners and into dead ends-one foot on the accelerator, the other on the brake.
    But most practitioners are consumed by the daily grind. Although it may be intuitively appealing not to expand your practice so as to avoid the associated headaches, the reality is that every practice will experience problems in each of the management areas much of the time. If you choose not to grow, then you do not provide a career path for the outstanding individuals you hire, which may cause them to leave and in turn force you to hunt for talent again. You may also find it hard to produce sufficient cash flow and profits to reinvest in your business in a way that will help you serve your clients better. And by staying small, you preempt one of the best options for succession.

Vital Signs
    The most successful advisory firms have several common characteristics:
        Clear vision and positioning
        Human capital aligned with their vision
        A compensation plan that reinforces their strategy
        A conscious attitude about profit management
        A process of systematic client feedback
        Built-in leverage and capacity
    These concepts apply whether you're a one-person operation or ensemble practice. We believe that the concepts of strategy, financial management, staffing and client feedback are relevant and meaningful to solo practitioners, but it has become clear to us that the one thing solo firms lack is the built-in leverage and capacity that distinguishes the elite ensemble firms.
    We sliced the data from our benchmarking studies produced in partnership with the Financial Planning Association (FPA) to evaluate the operating performance of solo practitioners versus ensemble firms. Size did matter among the general population of advisors who opted to become ensemble businesses, meaning they had multiple principals, partners or professionals (nonowner advisors). The gap was especially startling when we compared the top-performing solo practices with the top-performing ensemble practices. The top-performing ensembles generated almost 20% more revenue per professional, nearly twice the revenue per client, and about two times the take-home income per owner than their top-performing solo counterparts.

The Limits Of Efficiency
    For the solo model, an even more daunting problem relates to profitability: The more clients the firm acquires, the more it needs to add administrative staff to support them. When a firm adds administrative staff (this includes management, support staff and others involved behind the scenes), the cost is charged to overhead expense. In other words, the addition of administrative staff adds nothing to productive capacity.
    It's becoming more apparent that at least in terms of cost, the level of volume that must be generated in an advisory practice is redefining "critical mass." Critical mass in this context is the point at which a firm is achieving optimal efficiency in its cost structure, optimal profitability based on its client-service model and optimal effectiveness in the number of clients it can serve well. In terms of effectiveness, the less time an advisor spends dealing with clients, the more sluggish the business becomes and the less valued it is by the clients themselves. In terms of efficiency, advisory firms would ideally keep their overhead costs as a percentage of revenue below 35%.
    The data from a study we did of financial-advisory practices for the Financial Planning Association in 2004 shows that expenses as a percentage of revenue actually increased as the firms generated more revenue, peaking at an expense ratio of 44% when practices hit $1 million in revenue. The expense ratio declined after that point, as practices became more efficient and added more productive capacity in the form of professional staff.  But it isn't until practices hit $5 million of annual revenue that they consistently achieve the optimal expense ratio of 35%.

Cornerstones Of The
Professional Practice
    As elite firms have discovered, building an organization that has the professional capacity to help manage relationships and extend the enterprise often brings more reward than pain. Without growth, it's almost impossible to provide a career path for staff members. Without a career path, it's almost impossible to recruit, develop and retain excellent staff. And without excellent staff, it's almost impossible to build capacity and create operating leverage in a practice. Ensemble models provide an opportunity to do all of this: handle growth, offer career development and create leverage-the cornerstones of every professional practice.

Growing Concerns
    Of course, there are legitimate concerns about whether growth can work for you, such as:
        Rising costs
        Loss of management control
        Loss of quality control
        Client satisfaction
        Training staff that may later become your competitors
    But these threats exist whether you grow or not. Let's break them down.

    Cost. A key concept to keep in mind is the difference between operating profit and gross profit. If your gross profit margin is declining, it's likely to be due to one of five factors: poor pricing, poor productivity, poor payout, poor product or service mix, or poor client mix. If your operating profit margin is declining, any of three factors might be involved: reduced gross profit, insufficient revenue volume to support your infrastructure or poor cost control.
    Since we began in the mid-1980s to benchmark the financial performance of financial advisory firms, we've observed that overhead costs as a percentage of revenue have been steadily increasing, even in good markets. The three fastest-rising costs have been rent, salaries and payroll-related expenses like benefits. And these costs have been increasing at a faster rate than revenue has, making the trend even more alarming.
When practices add overhead costs without adding productive capacity, it's logical that their profit margins will suffer. So if the squeeze is on anyway, why not add professional staff who will add productive capacity and not costs alone?
    Loss of management control. The extent of control is a legitimate problem for any business, regardless of size. It appears that practices hit the wall managerially when they grow to eight people, then again at 15, and again at 25 to 30. It's as if the communication links get disconnected and the management process breaks down. Advisors in all firms, but especially smaller firms, are at a disadvantage when this happens, because they have no one to whom they can delegate key responsibilities. Larger practices need to build in structure to manage and communicate effectively.
    Loss of quality control. The increasing size of the business may cause the owner and lead advisor to lose touch with much of what's going on. The absence of protocols to manage client relationships simply makes the problem more glaring as the practice gets bigger and attracts more clients. These protocols are critical, regardless of the size of the business, to ensure clients are served and work is done consistently.
    Client satisfaction. In a firm headed by an advisor who has little time to manage the business and serve existing clients, and whose grip on quality control is loosening, client interaction and consequently client satisfaction are likely to suffer. Remaining small does not prevent this, although having competent administrative staff to tend to clients does help. Limiting the number of active client relationships per professional staff enhances your chances of having fulfilled clients. But putting a limit on relationships also puts a limit on growth if there is no one else in the firm able to deal with the new clients.
    Training your competitors. It seems that the No. 1 reason solo practitioners do not want to add professional staff is because they fear that by training them and giving them access to the firm's clients, they're spawning new competitors with an insider's edge. Yet we've seen many examples of firms that have provided a legitimate career path, including the opportunity for ownership or partnership, and consequently have retained outstanding people to help the business develop. Through the use of restrictive legal agreements, the firms are also usually able to protect their client base from poaching by a disaffected former employee or partner.

Models That Work
    Elite practices positioned as wealth-management firms have two common structures: the multidisciplinary model and the leveraged model. 
    The multidisciplinary model entails an integrated combination of skills that allows advisors to take a more comprehensive approach to the financial lives of their clients. Financial advisors of this type are usually relationship managers and have surrounded themselves with experts in relevant areas such as risk management, investment management, financial planning and estate planning. Of course, the disciplines represented on the team depend on the business' strategy and the predominant needs of the clients served. For example, if your optimal clients are business owners in transition, you may need to surround yourself with experts in management succession or family dynamics to assist with the emotional issues that inevitably arise. If your optimal clients are dentists, you might include on your team experts in dental practice management, since this is such an important part of the clients' wealth creation.
    The point is that you work from the client in, rather than the service out. Using a client survey process, as described in Chapter 3, you can begin to define the expectations and needs of your optimal client.
    The limitation of the multidisciplinary model is that it provides fewer opportunities for development of career paths. Typically, specialists stay within that role rather than evolving to primary relationship managers. Although this route may be acceptable to them, the challenge for you is to develop enough relationship managers to help you grow and attract more primary client relationships.
Some multidisciplinary practices create multiple teams that are all relationship oriented, then either outsource the specialties or treat the specialists as staff positions. From an organizational perspective, this means that the line positions (the advisors and relationship managers) focus on selling and serving clients; the staff positions (the technical specialists) focus on supporting the advisors and relationship managers. This is an effective way to leverage your business as well.
    The leveraged model seems to be the strongest model in terms of driving growth and building capacity, leverage, expertise and client focus. In this model, the senior financial advisors play a strategic role in client service, while the associates (or junior advisors) serve a tactical role. The senior financial advisor develops new business and leads discussions about critical planning and implementation decisions that the client must make. The associate implements the plans and is the primary day-to-day contact with the client.
    We've found that wealth managers operating alone can effectively manage between 60 and 90 primary relationships; pure investment-management firms may not be able to manage as many relationships if they have numerous accounts per client, but each firm can define the number for itself. In either case, by building out the leveraged model, the team is able to manage two to three times more client relationships than an advisor working alone.
    This approach also provides the context for a career path. For example, a professional staff member can come in as an analyst or a planner, rise to the next level of senior analyst or senior planner, then to financial advisor, and ultimately to senior financial advisor.
    In either the leveraged model or the multidisciplinary model, clients belong to the business, not to the individual advisors. Each staff person should be asked to sign a restrictive covenant agreement, which recognizes this fact and protects the firm against the possibility of its members hijacking clients. The team approach also helps protect the advisor against defectors, because the client relationships run deep and broad and are not tied to a single individual.
    Compensation to the participants in the team-especially the professional staff-should be a combination of base salary plus incentives. Base compensation will rise for the members as their responsibilities, experience, credentials and contributions increase. Incentives should be tied to team success and individual performance, revolving around critical benchmarks such as client satisfaction, revenue per client, profit per client, and the team's gross profit margin.
    It's important for leaders of such teams not to assign low-priority clients to the associates. A decision should be made about which clients you'll serve and why, and the whole team should be focused on serving optimal clients.
    The downside of this model is that it tends to involve a higher level of fixed costs in the beginning, especially costs related to staffing and infrastructure. But that is the power of leverage. Once you break even, your return over and above labor costs goes up exponentially. The basic difference is that solo owners can get a reward only for their own labor; in the ensemble model, owners can get a return for other people's labor as well. This is not to say the ensemble model is exploitative. In fact, it's entrepreneurial because you're leveraging resources-in this case, human resources-to add value for your clients while at the same time focusing on your own unique abilities.

From Practice Made Perfect: The Discipline of Business Management for Financial Advisers. ©2005 by Moss Adams LLP. Published by arrangement with Bloomberg Press.