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Meet John and Jean Dokes, the owners of ABC Investments. The couple has devoted 25 years to building a successful registered investment advisor (RIA) firm with 200 clients, growing its assets by 15% annually. They have decided to retire and sell their firm, but they are about to get a rude awakening and learn a valuable lesson: An RIA without a succession plan is an owner who will watch much of his or her firm’s value disappear.
While John and Jean are not real people and ABC Investments is not a real RIA, their predicament is all too real and happens to too many RIA owners.
John and Jean’s predicament
John and Jean have no children in the business, and they make all of the decisions. They develop financial and investment strategies and handle the marketing and trading. While the firm has a sales assistant who helps clients over the phone with simple requests, the Dokes handle all investment-related discussions with clients.
The company generates $1 million in revenues, and after all expenses, it is left with $500,000 each year, making this a very successful small business with very high margins (the industry average is about 40%).
Unfortunately, John is now 90 and feeling strains on his health. Jean takes care of him at home, but at age 80, she’s finding this to be a bigger job than she’d expected. Meanwhile, neither has much energy to run the business.
The Dokes decide the best thing for themselves and their clients is to sell the company. There are many potential buyers – ABC Investments is well-known and respected in town. An RIA typically will sell for 5-7-times EBITDA, and given the firm’s growth rate and high margins, the Dokes feel that 7x is very reasonable (7 x $500,000 =$3.5 million). And because they worry about how the next owner will manage the business as well as the Dokes have, John and Jean want 50% of the sale price up front.
But any new owner is going to be very concerned about retaining clients, maintaining staff and attaining continued growth. First, the potential buyer recognizes that the Dokes were the sales team and without Jean and John, there are no sales. Second, without their client relationships, many clients could leave in the next 12 months, making a 50% up-front payment very risky. At best, the Dokes are likely to get closer to $2.5 million paid out over three or four years – far less than John and Jean had hoped.
As disheartening as this story sounds, in reality it happens frequently. Now that you recognize the problem, the question is, what do you do about it? You need a succession plan. But what does that mean, and how can you get one?
What is a continuity plan? Is it different from a succession plan?
While the terms “continuity plan” and “succession plan” are frequently used interchangeably, each type of plan points a firm in a different direction.
A continuity plan focuses on keeping a company afloat if the key person becomes incapacitated. Typically, it involves another person in the industry stepping in and either managing the business temporarily or winding down the firm. It is not unusual to also set up a buy/sell agreement, whereby the temporary management agrees to purchase the assets of the firm upon the owner’s death, with the proceeds going to the owner’s estate.
While this can be an excellent stop-gap measure, it will not maintain the value of the firm or increase it over time. According to a study published by CNBC, most clients will leave a firm within six months of a small business owner’s death. This is not surprising, as the clients had a relationship with the owner and do not know anything about the person who temporarily is stepping into their shoes. Given the risk that clients will leave quickly, the value of the firm can drop substantially upon a change in the management.
A succession plan, however, puts the emphasis on maintaining value through a transition that starts before there’s an emergency. It is a long-term strategic plan that builds in a second layer of management that understands the firm and its clients. Certain parts of the succession plan may be activated only upon the owner’s retirement or death – but the preparation, including training staff and building relationships with clients, is put in place and developed well before the activating event happens.
By its long-term nature, a succession plan not only provides for continuity but, more importantly, helps ensure the longevity of the firm, the financial safety of firm’s clients and the financial value of the firm.
How to build a succession plan
The key to a successful succession plan is a structure that enables you to pass the firm along to another owner, whether it’s the next generation at the company or a new, outside owner. In either case, the glue that retains the firm’s value is that the company has already developed the infrastructure to operate without its original owner.
Creating the infrastructure required is not easy – and may not even be possible – for many small RIAs, leaving the owner with three choices:
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Don’t worry about it and accept a lower valuation when it’s time to sell.
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Plan the sale well in advance of retirement, so that the both seller and buyer are comfortable that the clients will stay.
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Build the necessary infrastructure to maintain the firm.
Let’s address these three alternatives separately to better understand the benefits and issues of each.
Case 1: Do nothing
This is the case I run into all too frequently. The owner makes no plans for the business until it’s time to retire. This presents a number of issues to a potential buyer:
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As owners age and get closer to retirement, they often spend less time on growing the company (and according to a recent survey, company growth already consumes only 11% of an RIA’s time). In addition, only 40% of advisors actively seek younger clients to replace their older clients. As owners age, the books of business slowly die.
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Any sales growth was due to the networking ability of the owners, and this does not automatically shift to new owners, so any historical growth pattern of a firm is not relevant.
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The client relationships are all with the current owners. The new owners need time to build this same relationship to ensure that clients stay.
None of these issues is insurmountable, but the technique a buyer will use to reduce these risks is to pay a lower valuation and to pay it over time rather than all upfront. What the seller can do to help reduce these risks is plan to sell at least a year in advance or plan to stay on for a minimum of six months after the sale to help with the transition. The longer sellers can offer transition help, the more they help to reduce risk and increase the valuation, reduce the payout period or both.
Case 2: Sell the firm and stay on as an employee for at least 18 months
This takes some advanced planning but will help maintain and could even increase the value of the company. What are the advantages and disadvantages?
This is a more complicated arrangement. What will the former owner’s responsibilities be once he or she becomes an employee? It is possible that the new owner will make changes that clients don’t like, leading to client exits. However, without surrendering some control, there is no transition.
This risk can be mitigated by examining where the owner’s real expertise lies and spending an equal amount of time understanding the buyer’s expertise, record, experience and plans.
For instance, if the owner is strongest at financial planning and new client acquisition, then the buyer could be a good fit if his or her expertise is portfolio management – as long as the buyer’s investment style complements the owner’s and the clients’ expectations.
As long as the new management relationship is clear and is complementary, the advantage of the former owner’s becoming an employee is that clients see consistency, which will add to their comfort level about the change. The new owner can be introduced as a partner who will ensure the long-term continuity of the firm, while the old owner is there to ensure that nothing really changes.
This arrangement can help increase the multiple that a buyer is willing to pay (although there are a number of financial criteria a buyer will examine) and can potentially shorten the payout period. Most importantly, it allows the owner to participate in the upside over the next 18 months. To help offset the former owner’s risk in releasing control, the buyer will typically use a contract that allows for upside participation as well as some protection from client losses on the downside.
Case 3: Build the firm’s infrastructure
This case is the ideal solution, but is the most challenging for an owner. By having an entire team – portfolio managers, client relationship managers, trader and compliance and operations managers – the owner has a real business. However, this is much easier said than done.
Building infrastructure requires having the revenues or the capital to invest in the firm in advance of the revenues. It also means years of work. It is unlikely that a sole proprietor will be able to develop this kind of structure in just a year or two.
More importantly, building infrastructure requires the owner to have the desire to manage a growing organization. As a company adds employees, the owner becomes less of an investment advisor and more of a business manager.
Many advisors set up their own companies because they do not want to work for larger organizations and are not interested in running a company. They are interested in managing investments or working with clients.
However, the significant advantage is that having a complete infrastructure will provide the owner with a higher multiple and the fastest payout. It reduces the buyer’s risks and may offer economies of scale that are not achievable with the purchase of a one-person shop.
Final Thoughts
The biggest mistake small RIAs make is ignoring succession planning for their firms. By the time they are ready to retire, it is too late to implement the actions that will help retain or increase the value that a buyer will be willing to pay.
In the RIA industry alone, it is estimated that one-third of firm owners will be retiring in the next 10 years, the vast majority of which have no succession plans.
Do what you tell your clients every day – start planning for your retirement well before you retire, or you won’t achieve your goal.
Alan E. Rosenfield is the managing director of Harmony Asset Management, LLC, a Registered Investment Advisor specializing in assisting businesses with their succession plans. For a free copy of of Succession Planning Help, a list of sites, companies and consultants that can help with succession planning, contact us at [email protected].
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