"What was just 20 years ago a fledgling industry made up of young, ambitious entrepreneurs is now a big business dominated by geezers," wrote Mark Hurley in Investment News ("Don't Put Off Succession Planning," September 2010). "Our data suggest that more than 60% of the industry's participants are over 50, and the average age of an owner is rapidly approaching 60."

Assuming the data is correct, a tremendous number of practices will change hands in the next decade. For certain advisors, selling to an external buyer will be the right move; for others, an internal transition will make the most sense. In this article, we outline some of the pros and cons of selecting an internal successor, with a focus on transfers from a senior advisor to a junior advisor. (In the next installment of this two-article series, we'll discuss the pros and cons of choosing an external successor.)

The Pros
In terms of providing a seamless experience for clients, choosing an internal successor can certainly have its advantages. Typically, a junior advisor has developed relationships with clients, knows the firm's processes, and will continue to follow the senior advisor's investment philosophy.

Established relationships. A junior advisor who has worked for five to ten years alongside a senior advisor likely knows the firm's clients well. Of course, this depends on the extent to which the junior has been involved in client work. If the junior's main role has been to prepare for and follow up on meetings without a lot of client face time, he or she may not be in a much better position than an external candidate. In fact, clients may have pigeonholed the junior in a support role if that's the only context they've ever seen him or her in. But if the junior advisor has developed beyond the service role, interacting with clients and perhaps meeting with them in the senior advisor's absence, he or she may be a prime candidate for purchasing the practice.

In addition to relationships with clients, it's also likely that a midcareer junior advisor has formed relationships with the firm's broker-dealer, custodian, external technology partners, compliance or regulatory auditors and other business providers. If the junior takes over the practice, he or she will be able to hit the ground running, without needing to spend time building those relationships.

Shared investment philosophy. A junior advisor's investment philosophy is often shaped by the senior advisor's opinions and biases, especially if the junior has worked alongside the senior for many years. For example, a junior is likely to share the senior's attitudes toward alternative investments, hedge funds, fee-based models, investment outsourcing, annuities, and the like. If the junior ultimately takes over the practice, the investment message to clients will likely remain the same. During a transition, clients sometimes question the value of the relationship, and investment alignment supports client retention.

Familiarity with firm processes. An internal successor is usually well acquainted with the firm's processes, which helps smooth the transition experience for clients. For instance, if the firm's "A" clients get quarterly meetings, birthday and anniversary cards, monthly market updates, and an invitation to the annual client appreciation event, the junior advisor knows the details and can sustain these processes without change. A sense of continuity helps reassure clients that all is well when a new advisor takes the helm.

The Cons
Now, let's look at the potential downside of having an internal successor, again focusing on transitions from a senior advisor to a junior. The frequently overlooked factor a senior advisor needs to take into consideration is that developing a junior takes time and attention. Knowledge and experience cannot be gained overnight. And the energy required to educate the junior is energy the senior advisor would typically put into rainmaking, so there is a financial cost involved in this process. In addition, there can be an emotional cost, as mentoring can start out as a pleasant experience for the senior but deteriorate over time into a task that becomes harder and harder to fit in.

There are other potential downsides to consider as well:

The risk of losing clients. The biggest fear senior advisors have about an internal transfer is that, as the junior becomes adept at developing and maintaining client relationships, clients may begin to value the junior as much as the senior. If this happens, the senior may lose clients should the junior decide to pick up and start his or her own practice. Even with a non-compete agreement, an aggressive junior who leaves the practice may create messy issues for the senior advisor and the firm's clients.

The question is, how much client relationship management should the senior advisor delegate to the junior? On one hand, the goal is to help the junior develop professionally so that he or she knows the clients and has the confidence to take over the firm. On the other hand, if the junior and senior have a rift, the junior may leave and possibly take the firm's clients along.

Potential for misunderstanding. Without clear succession time frames and expectations, misunderstandings can arise. For example, a junior advisor who has put in sweat equity over the years may well expect that to factor into the valuation of the practice if he or she eventually takes it over. But senior advisors rarely discuss in advance whether sweat equity applies and, if so, what it's worth. After all, there's no need for the conversation until the senior recognizes that the junior advisor might be a worthy successor.

On the other hand, what if the senior advisor addresses the potential for succession too far in advance, and the junior doesn't prove to be a good fit? Or what if one of the advisors changes his or her mind for another reason? The junior may discover that she'd really prefer to work in an institution, or that she dislikes the rainmaking responsibility that goes along with being a business owner. Instead of exiting the industry as planned, the senior may decide that he'd miss his work too much, that he hasn't saved enough money to retire or that he can get a better deal by selling externally. Unless both advisors are on the same page and the same time line, it's all too easy for difficult situations and hurt feelings to develop.

Limited resources. Often, a junior advisor hasn't saved enough money for a down payment on the practice, especially if it's a larger firm. If that's the case, the deal must be done as an earn-out, with the senior taking the risk position. Assuming the senior is very comfortable with the junior, the arrangement may not be much of an issue. Typically, internal transitions are considered less risky than selling to an external successor.

Still, no one can predict the future. What if something happens to the junior shortly after taking over the practice? Or what if, after transitioning the business, the former senior advisor dies? While a nonregistered spouse can be paid for the practice for a certain amount of time, regulatory issues may arise if the agreement involves an exceptionally long payment term (ten or more years, for instance). Often, these concerns prompt discussion of cross-purchase insurance policies.

Hard feelings on the team. In order for the junior advisor to succeed in the new role, the firm's other employees must embrace the transition. Occasionally, this presents challenges. Say, for example, that another staff member was hired at the same time as the junior advisor who's being groomed as the successor. This can cause tension in the ranks, creating a new authority situation between those initially hired as peers.

A Note On Partnerships And Enterprises
While our focus has been on transitions between a senior advisor and a junior, internal transitions can also be made between a retiring advisor and another equity owner in the firm. In a partnership arrangement, a transition from one partner to another often makes sense. In some cases, however, a firm is a partnership in name only. Although they share office space, the partners don't necessarily have similar investment philosophies or internal processes. Often, these firms have no formal arrangement for transfer between partners if an advisor exits the industry. In fact, such situations may require as much negotiation as they would if there were an external buyer.

Enterprises, by contrast, tend to be more formal, with consistent practices and philosophies that extend to all advisors. Their approach to industry exit is often established upon joining the firm.

The Best Advice: Plan Ahead
One key to a smooth transition is to anticipate it well in advance. Unfortunately, industry data shows that advisors put off succession planning as often as clients put off creating a will. With great change expected in our industry in the coming years, planning a succession strategy is more important than ever.

Ten years ago, anyone and everyone wanted to buy a practice. But as the industry grew more experienced, buyers became more selective, seeking practices with fewer clients and more recurring revenue in more populous and favored locations. What will the next decade hold as the baby boomers retire? Will there be buyers for the practices they've created? While it's tempting to put off thinking about succession, procrastinating will only hurt your chances for a successful transition-not to mention your clients.

With more advisors leaving the industry than entering it, an internal candidate may be the best choice of successor for some advisors. If you've been working with a junior advisor who is clearly cut out to be your successor and the two of you can sustain a healthy relationship, consider yourself lucky. But no matter how perfect the fit seems, be careful to avoid the succession pitfalls discussed here. Without a realistic time frame or a clear plan for how the transition will be made, you may find yourself with no successor at all.

Commonwealth Financial Network does not provide tax or legal advice.

Joni Youngwirth is the managing principal of practice management at Commonwealth Financial Network®, member FINRA/SIPC, a registered investment adviser, in Waltham, Mass. She can be reached at [email protected].