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.

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