It’s no secret that RIAs have a succession planning conundrum. Over the years, a few common explanations have emerged to explain why.
One is that succession planning is a drawn-out process and busy founders often find it difficult to devote the time and effort required to design a proper plan.
Another is that being a CEO and leader is an integral part of many founders’ identities. If they relinquish those roles, they fear losing some of those intrinsic rewards and worry that their lives afterward may lack a sense of purpose.
There are more pragmatic reasons as well. Being a founder/owner can be lucrative, and it’s hard to let go of the financial rewards.
The Founder’s Dilemma
And then there’s the reason nobody likes to talk about because it’s a bit of a dirty secret: It’s simply not in a founder’s economic interest to pursue a succession plan.
Finding, hiring and onboarding a potential successor (or two in case the first one doesn’t work out) is a process that can take up to nine years, though the average is about five. And even then, there are no assurances that they will be ready to take over the firm.
The other option is to sell to an outside buyer. In that instance, founders don’t have to shoulder the costs or put in the time to train and develop someone else to take over for them.
And because of that, it’s not hard to figure out why some do not take the steps necessary to create succession plans—their economic self-interest is just too great. Business owners considering succession plans have to ask themselves a number of questions.
Should they ensure the continuity of the business by sharing equity with the key employees who helped them grow their firms? Or should they try to get as much as possible by selling externally? These questions are core to the dilemma but don’t get mentioned very often.
The Numbers
Consider a hypothetical founder who owns an RIA that manages $500 million and charges clients a conservative 70 basis points. Her annual revenues would be $3.5 million.
If she manages the business well (if she is organized and efficient and uses tech to create capacity leverage), the profit margin may reach 35%. That results in annual earnings of just over $1.2 million, which, using a multiple of five, would produce a business valuation of $6.125 million.
If that same founder pursued an internal succession plan, her human capital costs would be higher. For example, let’s say she would need to spend an additional $525,000 on salaries and benefits each year. Her earnings would decrease by that same amount annually—which would naturally lower the firm's valuation.