While advisors strive to grow their business, an unfortunate consequence of that growth is the very clients who helped make the firm successful could be the ones costing it money, warned advisor Michael Kitces, co-founder of the XY Planning Network. 

Speaking as part of the online eMoney Summit this week, Kitces said that all firms eventually have to figure out what to do with their lower-tiered clients. As most firms scale up, they do so not by adding a greater number of clients, but by adding clients with more money, Kitces said. When that happens it means clients with less may become less profitable or even a drain on profits, he said.

“If you build a really good service offering that supports half-million-dollar clients, million-dollar clients, $2-million-dollar clients, the staff it takes to serve them effectively makes it very unaffordable to serve those smaller clients that you started with,” he said. 

Calling it a legacy client problem, Kitces said one way to address it is to hire associate advisors who can provide services to clients of lower wealth at less cost. The drawback is that clients could still end up costing more than they provide in revenues.

Firms can also offer fewer services to those clients, he said. Kitces said another option is to charge those clients a base fee that at the very least allows the firm to break even for servicing them.

If the problem isn't addressed, what eventually winds up happening is firms start overcharging their higher-end clients to subsidize the less-profitable ones, Kitces said.  

“If you’re feeling some pain around this, it is entirely normal because this is the trajectory of how advisory firms grow,” he said. “As we expand our capabilities to move up in revenue and provide deeper higher touch service, it creates tension around our difficulty to serve the clients profitably who were originally profitable for us.” 

Kitces said the problem is only one example of how the growth of a firm aren't directly proportional to profits.

He cited Earnings Before Owners' Compensation (EBOC), which is the profit an owner takes in after their expenses and salary. For a solo firm, he said, this is about 70% of the firm’s overall revenue. In comparison, it is only 40% for firms with revenues of $1 million to $10 million. 

“When we’re a solo advisor and we do the planning and the investment operations and the trading and we’re chief cook and bottle washer and everything that is in between. We do a lot of stuff in the business and we get paid for all that stuff in the business,” Kitces said.

However, once the firm expands and brings on another advisor, that means the expenses go up, while the EBOC goes down, he explained.  

“Now, I’m not serving all the clients and getting all the client service income and profitability,” he said. “I’m just getting profitability and service from my clients but other advisors have to get paid for the work they do.” 

One of the reasons why the EBOC does not grow when a firm's revenues go from $1 million revenue to $10 million is that the number of owners also grows. When a firm adds a new owner, that owner becomes entitled to a portion of the profits, he said. 

“As advisory firms grow, the profit pool gets bigger, and then it gets divided amongst more owners,” he said. “In order to sustain the business, the people that grow it need to have equity and they tend to expand equity at the same rate that they’re growing.” 

The owners are getting a percentage of a larger number in profits, Kitces said, but they are still splitting it up among a greater number of partners. So, as the firm grows, the owners do take home more profits, however it may not be comparable to the growth of the firm, he added.  

When firms grow, they also have to manage their growth. he said. They must only bring in more staff and advisors as the need fits.  

“The primary determent of an advisor firm’s profitability is how effectively their staff is structured,” he said. “When we have team efficiently placed... we tend to get better numbers and metrics here, when we are mis-staffed ... we tend to get numbers that have material deviations.” 

In fact, Kitces told the audience that the mantra of building economies of scale just does not hold up. A firm that brings in $1 million in revenue brings in the same percentage of profit as a firm with $10 million in revenue, he said. 

“The idea that as advisory firms grow, they’re going to get economies of scale, we literally can’t find anywhere in the data [where that happens],” he told the audience. “[We see] remarkable little economies of scale.”