To paraphrase Oscar Wilde, independent advisors who rely on revenue sharing versus equity for compensating junior advisors are aware of price but not value. If your goal as an independent advisor is to build a valuable and enduring business, then the focus should be on compensation structures that underpin the creation of a team of advisors working together in support of a single enterprise.
Traditional revenue sharing does exactly the opposite: It provides participants with every opportunity to focus only on building individual books, and every incentive to subsequently leave the practice with “their” clients when the time is right.
Revenue Sharing – Building A Fractured Practice
Typically, revenue sharing as a compensation structure works as follows: An advisory practice owner hires a junior advisor whose earnings are substantially based on a 50/50 split on client revenues between the practice owner and the junior advisor, or any similar eat-what-you-kill approach. These are shared revenues on either new clients the junior advisor brings in, or shared revenues on smaller relationships that the practice owner has transitioned to the junior advisor.
Under this arrangement, the independent advisor saves on the costs and complexities of setting up payroll, and if the new advisor doesn’t work out, well, the practice owner didn’t pay for anything he didn’t get. Sounds great, right?
Unfortunately, it isn’t. In a best case scenario, all the advisor did was position himself to cut his losses on an arrangement that didn’t work out, but time was still lost and there is still the need to go through a new hire and training and evaluation process all over again.
What’s the worst-case scenario? The junior advisor builds a strong book of business, and the practice owner, while getting half the revenues, is still completely on the hook for all the overhead – which only expands as the junior advisor’s book of business grows. Moreover, it’s not unusual to see such junior advisors eventually decide to strike out on their own, or aggressively use their expanded book – built on the practice owner’s overhead expenses – as a negotiating chip with the practice owner.
The “eat-what-you-kill” revenue sharing compensation structure undermines any effort to build a valuable and enduring business. Owners erroneously think they control 100 percent of the equity value of their practice when they don’t control 100 percent of the asset base. Junior advisors enjoy maximum cash flow with none of the necessary investment and risk, and little incentive to think about what is best over the long run for the firm.
Equity Builds Businesses Of Enduring And Transferable Value
So what’s the alternative? How does the independent practice owner both adequately compensate junior advisors for producing, while also creating structures and incentives for junior advisors to think, act and be rewarded as owners who are focused on the good of the entire firm? Quite simply, the key is for independent advisors to transition to an equity-centric organization and compensation structure with the goal of creating significant, long-term upside opportunities to next generation advisors within a single, enduring business.
While equity has always existed in the independent practice model, in the past it has generally been more theoretical than practical. Fortunately today, affordable and accurate valuation processes exist. Advisors interested in building a long-term, intergenerational practice using equity as a cornerstone compensation vehicle should consider the following:
• Annual valuations conducted by an outside professional expert are an essential part of the equity management process. Such an annual process eventually provides a “library” of valuation results, creating a historical record that is of great interest to key staff members, new partners or recruits being offered a current or future ownership opportunity in the practice.
• Equity grows from year-to-year in most cases, certainly over a span of time if the business is growing. As such, the gradual sale of equity through an incremental transition plan (versus a change-of-control transaction that happens all at once) has the ability to provide an additional regular income stream to the founder or founders of an independent financial advisory practice with proper planning.
• A frequent mistake is to equate cash flow with equity or practice value (or to link the two with a multiple of something other than 1.0 x T12). To this end, doubling the amount of cash flow in an ordinarily incorrectly structured practice model often results in little to no change or improvement in the value of the practice. In other words, if value is created and retained by individual advisors, it makes little difference whether you surround yourself with two, three or ten advisor/producers – More money may be made in the short term as cash flow, but no long-term business value will be built. And when you stop working, by fate or by design, the cash flow stops too, and with no enduring or transferable business value, the practice dies.
• By the same token, equity valuation is not based solely on a multiple of revenue, which would be like measuring the sufficiency of your cash flow by what’s left in your checking account at the end of the month.
Validation of the efficacy of equity as a compensation structure can be found in whether buyers of independent practices actually pay the values sought by sellers who have put in place durable and clearly measurable equity structures: Based on current totals in the FP Transitions’ Comprehensive Valuation Report, there is a 50 to 1 buyer-to-seller ratio today. Moreover, the financial consideration for transactions that are completed are within a 4% range of the original valuation, demonstrating the strong probability that an accurately valued practice will go for something very close to, or even above, the asking price.
Once valued correctly, equity becomes the best possible compensation vehicle for building a long-term business of enduring value: One unified firm with all relevant professionals pulling forward in the same direction. It is what separates a one generational job or practice from a firm that stands the test of time.
David Grau Sr., JD, is the president and founder of FP Transitions (www.fptransitions.com), which partners with independent advisors to build businesses of enduring and transferable value. The above is adapted and excerpted from his first book, Succession Planning for Financial Advisors: Building an Enduring Business, which will be published in June by John Wiley & Sons.