#FASuccess Ep 424: Executing A Successful Internal Succession Plan In The Private Equity Era Of Advisor M&A, With David Grau Jr.

Resources Featured In This Episode:

• David Grau Jr.: Website | LinkedIn
• Succession Readiness Checklist – Download (PDF)
• #FASuccess Ep 395: The Rise Of Bank Financing To Fund Independent Advisor Acquisitions And Succession Plans, With Dustin Mangone

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Full Transcript:

Michael: Welcome, David Grau Jr., to the "Financial Advisor Success" podcast.

David: Welcome, Michael. Thanks so much for having me. I am an avid listener and very excited to join you here today.

Michael: Well, I'm glad you're willing to join us on the other side of the microphone, as it were, and getting to dig in today to a topic I'm really excited to get to nerd out on with you, which is all things succession planning because, to me, it's gone through a really interesting evolution over just a relatively fast, maybe ten years or so. If I look historically, succession planning was the way you exited the business as a financial advisor. Like, "I've built up these clients and now someone can take over my clients. If I was in a broker-dealer, I'd probably had some kind of split rep code, effectively an earn-out style structure. Hey, you take over my clients. I'll hand them off to you. I get a declining percentage over a couple of years off our split rep code, and then I'll go away." Then eventually, we started moving to RIA models and it was cool because you have an entity. You could literally sell the entity or the goodwill assets of the business. We saw the stability of the revenue eventually start to bring in bank financing.

I feel like succession planning really started to heat up and gain momentum, and then private equity showed up a little under ten years ago in a big way. We're suddenly willing to buy firms at just much higher valuations than anybody had seen before and that a lot of next-generation owners, a lot of successors had been willing to buy at, which to me has now quickly turned into these really challenging questions for a lot of firm owners like, "Do I sell to an internal successor at a "discounted price" or do an external buyer like a PE-funded firm at a much higher valuation?" I'm not even sure that's a fair comparison because those are different buyers and what's going to happen to clients, what's going to happen to team, how likely this transition necessarily even is to succeed, what kind of strings might be attached to the money. I'm excited to talk about, I don't know, even as you'd maybe view it, what is the current state of succession planning in advisory firms in this private equity era for the business overall?

David: The industry in all things seem to go in cycles. I think that's kind of where a lot of firms have started to end up now or where they have ended up now in that they get to a point where they have shifted from the lifestyle advisor, solo producer, great business model, super efficient. They decide they want to start building a team. They build said team. They usually end up being a little siloed at first. Eventually, they'll shift gears and become more of an integrated ensemble. It's more efficient, helps them grow and scale. And the problem is, then they start to have a little bit too much success, and they outgrow their successor's ability to afford them.

But the key there is to make sure that as they get to that size, again, until we recently had private equities starting to enter the space, you got to $10 billion, $20 billion in AUM, you better have built your internal succession team because there weren't a lot of firms that could afford to have bought you anyway. So, you're right back to where we were decades ago, where if you didn't build your succession plan internally, you might not have one. And then the white knight rides in in private equity, in the industry aggregators. Now, even some of those larger firms that have maybe outgrown their team's ability to acquire, they actually have a solution now. So, there are definitely some instances where I'm seeing PE industry aggregators providing real value to the industry.

The Challenges Of Internal Successions Amidst Higher Firm Valuations [07:13]

Michael: So, all right. So, I've got some questions in that regard, I guess, in that framing. I feel like there's been a lot of discussion in the industry about firms growing...sort of two related challenges. Firms growing to the point that the next generation can't afford to buy them out, and firms transacting at valuations that the successors don't necessarily want to pay, which I feel like are dovetailed together. Obviously, if the valuation like multiple and such is higher, then it also makes the price harder to reach. But I will admit, I struggled with this a lot, this framing, at least before valuations expanded. We can maybe come back to that in a moment. I remember these conversations with peers. I went through a version of this in a prior firm as well, where the business got pretty big, and it was selling for something in the neighborhood of two to two and a half times revenue, and it had a healthy 30% EBITDA margin, give or take a little, which basically meant it was selling for something like seven times earnings, give or take a little, right? Seven times a 30% margin is 2.1 times top line if we math through it.

And there was a fascinating phenomenon to me that cropped up when shares started to come to the table at this multiple, which was some people came up and said, "Okay, look, if we're going to make this work, I do need to be able to amortize it over a reasonable period. So, I need someone to finance this thing for me for seven to ten years." More than a dozen years ago, you probably had to do that seller financing, maybe a decade ago, you had a couple of bank financing options that cropped up. But if you were buying for something at seven times earnings and you could amortize it on a ten-year note, the math kind of works. The cash flow basically covers the note.

There's risks to that, which is if you don't manage the business well, the cash flow is not going to cover the note, and then you're going to have a problem. But nominally, whether you were buying a practice for $0.5 million, or $2 million, or $5 million, or $10 million, if the amortization of the note was longer than the multiple of the earnings, the deal kind of cash flowed itself at any size. And the phenomenon I saw...I guess I'm curious whether you would agree or disagree with this, the phenomenon I saw, people would say, "It's too big. I can't afford it." And what they really meant was, "I just don't want to take the risk of having a seven-figure loan to buy a seven-figure business. It wasn't that the math didn't work and that it wasn't affordable. Essentially, it was more of a risk tolerance issue than an actual, "There's no way to buy this as the successor."

David: Yeah, I could not agree more. And that's been one of the bigger challenges that I have observed in the industry from the ivory tower as a consultant working with these firms is oftentimes they just end up waiting a little too long, unfortunately. And now that they're waiting too long and doing nothing around succession planning, at the micro level inside the office, they're active with succession planning. They're mentoring, they're training, they're hiring with that end state in mind. But the problem is in the meantime, the firm continues to grow, which is great, don't get me wrong. But when they finally get the opportunity as next-gen advisors and leaders in the organization to buy that first tranche of ownership, Michael, the number on it is, to your point, it's seven figures. And sure, the math works. But whether they initially look at that number and have a little bit of heartburn, they come to terms with it. And then they go home and they talk to their spouse, or their CPA, or their brother-in-law who's an attorney. All those people just cringe because it's a million dollars, it's $2 million for your very first purchase.

Michael: You're just like, "My mortgage used to be the biggest debt I have and now you want me to take one that's many multiples of that."

David: Right. For what exactly? Again, to your point, "The house, it's tangible. I know the value. I can influence the value. Here, I'm a minority shareholder." So, there's just so many layers to it beyond the math and the spreadsheets and the contracts, frankly, the stuff that I know and love that deals with the human element and the emotions of these transactions. And we have to manage both as founders, owners, certainly as M&A consultants. And that's not easy.

Michael: So then, we had this world where, "Okay, at least maybe the math works if you're willing to take the risk, and you can find someone, a bank, or a seller to finance it long enough." And then valuation started going up, and then PE firms started coming in. I guess in the simplest sense, PEs have access to giant swaths of capital, which for ten years was at ridiculously low interest rates. And so, I got to presume in the simplest sense, just PE firms could come in and say, "I'm willing to finance this in a way that's even cash flow negative for me for a while because I have a lot of borrowing power, and I'm confident it's going to grow well enough to be successful in the long run. So, I'm willing to actually go negative for a while to get a decent positive in the long term. And that means I can afford to pay more upfront."

David: Yeah, I couldn't agree more. And you and I both know this. When you work on these deals, yes, there's value and it's important. Don't get me wrong. As a fellow founder, business owner, when my day comes, value will be in the top five. Don't get me wrong. But it isn't the only thing in the top five. And even if it's number one, number two has got to be a close second is the terms. You've got the taxes, you've got the compensation, you've got the timeline, and just so many other components to these deals. But, of course, you can't cover all that in a marketing email or trade publication article. And don't get me wrong. Again, the industry pundits do a really good job of writing about and covering this stuff. But the interesting sexy topic is the multiple and the value being paid. The hard part is the way you get to those high multiples, to your point. On the surface, you would assume if the EBITDA [Earnings Before Interest, Taxes, Depreciation, and Amortization] multiple you're paying is less than the amortization on the loan or close to because there's down payments to consider and taxes, if it's close to or less, it's probably got legs. It will probably work.

Well, and you get these PE firms coming in, and sure, they can aggregate businesses, they've got other considerations, maybe a little bit longer horizon. And they're offering these much higher multiples. The funny thing is, and it's frankly not really that funny when you get into working on these deals, and working to help folks understand and reset expectations is it's not just the value, which they know, but the value is into being so much higher than everything else they've heard that it's hard to not focus on that. But the only way you can make the values work that you're seeing talked about out there with these outside aggregators and investors is to manipulate something else. And it generally is the terms. It's not until you get much farther into the transaction where the advisor finally has that revealed to him or her, and they quickly realize, "Okay, well, you are paying 10 times or 14 times my earnings. But number one, you pretty heavily manipulated my earnings." Normalizing is what they call it. I'll say manipulating. "And then you're not delivering to me a duffel bag full of cash, which is what I would have gotten if I sold for two or three times to my internal team or to a peer." So, it's always the devil's in the details. And folks, unless they really get into these deals, you just don't see those details.

The Deal Terms That Can Make A Sale To A PE-Backed Firm Less Attractive (Despite The High Multiple) [14:46]

Michael: So, can you help us then unearth more of those details, like how that works, how the proverbial sausage is actually made between what we see in some headline announcement about a multiple that's usually been a multiple of revenue at that point, even earnings multiples aren't often publicly reported. Help us dissect what, I guess, a prototypical deal...I don't want to get any particular deal in trouble. How does a prototypical deal break down when you nominally see someone got this 3X revenue or more? What was actually going on there to get to those numbers?

David: So most of the firms that an advisor is going to be talking to, on the PE side, these would be larger firms that have taken a PE investment, and they're now using that money to go grow, scale their business, aggregate, partner with firms. You have to keep in mind, those are firms now that they've done enough in the merger and acquisition and recruiting space, that they've effectively been given somebody else's money to go gamble with. So, just know they're really good at what they do, else they wouldn't have that private equity investment, let alone dealing with private equity directly. So, these folks are professionals. I would say as a rule of thumb, they win, or they go home. If you walk away from those deals thinking, "I got one over on them, I won," you're probably just misinformed, unfortunately. But there are still instances where you can get a good or what I call a fair deal. They do pay, in many cases, higher multiples than you would otherwise expect in an arms-length transaction between two peer firms, big or small.

The way they do that, though, is by adjusting the deal terms. So, if you and I, Michael, are two independent RIAs, a couple million dollars in revenue, and I'm going to buy your firm because you're obviously so much older than me, I would go take a loan from an industry lender. I would pay, right now, not the best interest rates, but the math would still work. I'll pay three times top line, seven, maybe eight times earnings, generally equates to your earlier math, and I'll pay the bank back over a decade, and I'll write this thing off over 15 years. So, that's the general baseline when folks are saying, "Okay, well, I've received offers and talked to my peers, but then I got this other offer coming in, in this PE firm, this PE-backed aggregator that I'm talking to, and they're talking about much higher numbers. So, let's put that conversation on pause, and I'm going to see this through with this firm and just see if there's anything there." And they get into financials and, "Okay, it seems like this might have legs." You get to the terms, and you find out, "Well, how are they affording to pay 12 times or 14 times my earnings?" You and I both know, said in plain English, they are giving me the next 14 years of income. Everything that comes out the bottom of this machine, they're going to be giving that back to me, in theory, for the next 14 years. Now granted that there might be some growth, that can help, but still 14 years...

Michael: Or as I view it the other way, an earnings multiple, you can flip into an earnings yield in the inverse. So, I'm like, "You buy a thing for 12X to 14X, that effectively means you're getting a 7% or 8% yield on it, cash yield on it." I'm like, "Okay, but I can buy a corporate bond for not much less than that and have debt covenants." So then, help us understand how do these deals show up with these kinds of earning multiples. What's the part we don't see in how this deal gets written?

David: Which, yeah, you got to think, "Okay, well, they're just going to go out there as PE firms or PE-backed aggregators and just grossly overpay for everything." It's going to be really hard to get the kind of returns that those PE firms are expecting in the timeframes that they're expecting them. So, the way that we have seen them done, and this isn't a good or bad thing, it is just peeling the onion back so the listeners, as they start talking to folks like this, know generally what to expect... Every deal is different, to your point. But fortunately, I'm not client-facing anymore anyway, so I just see the data in aggregate. When these deals are done, instead of having a cash payment upfront, generally, the entire purchase price provided by an industry lender and some cash in the deal from our firm, now you're talking about 20% to maybe 30% of a higher purchase price, but 20% to 30% cash upfront. The other two-thirds, it'll be categorized in a variety of ways, is contingent. As in like you'll see another one-third usually paid in the aggregator or PE stock, which, again, when they're done with their pitches, and I've heard these pitches, you want to take the whole deal in stock.

With the growth rates that they're talking about, it's hard to not get excited over it. But you've got a third of the deal in cash, a third of the deal plus or minus in stock in the acquiring firm. The hard part is the stock in the acquiring firm is not valued at 10 to 14 times earnings. It's usually going to be 25, 35 times earnings. So, you better buy the story that they're selling with that growth that they see. The final one-third, sometimes 20%, is that earn-out structure you talked about from the days of old where there's growth targets. If you can hit those growth targets, then you'll see that last 20% or 30%. Problem is, they're relatively aggressive growth targets. And also, once this acquisition has happened, you're generally going to be leveraging their marketing team and firm. There's going to be some changes. It just makes it sometimes hard to hit those growth goals. Plus, then you're relying on two-thirds of this thing, the stars have to align, the markets need to hold up, the transition needs to go well, we need to be able to grow. You're putting a lot of eggs in one basket.

Michael: So, when you talk about these backend structures with things like growth targets, I think it's such a relatively aggressive growth target, just can you give us some context? What does aggressive growth target mean in this environment? Because we all have different contexts about what is "normal growth" in the first place.

David: Yeah, that's fair, and it is relative. In most of these, they're going to be targeting 15% to 20% growth minimum, which, again, doesn't seem like we're shooting the moon here. But when you're talking about the firm they're buying has historically been growing at the size firms they're talking to…we're no longer talking about, "Okay, if I can just get to a billion, then someone's going to be interested from private equity." Yeah, that might get you in the door nowadays, but you need some size and scale for these firms to be interested because they don't want to buy your job. So, they're not looking for owner-operator businesses with $50 million in AUM or $100 million. That's not on the docket. So, they're looking for larger firms. These larger firms, you've got a couple of billion in AUM. The hope is that we can be growing by 8% to 12%. We've got the market appreciation when things are good. We've got organic growth activity, maybe the occasional win on the inorganic side, but to sustain 20-plus percent growth year over year, that size, that's not easy. I'm not saying it's not possible because we've got some clients that definitely do it, but it's not the norm.

Michael: I was going to ask like when you talk about things like can you sustain 15% to 20% growth rates at least if I'm AUM based, is that inclusive of market? Like I get some market tailwind, and I've got to make up roughly the other half from actual organic growth of new or existing clients?

David: Correct. Yeah. It would be inclusive, and in its totality, we're looking at 15%, 20% plus. But I'm also trying to be conservative. I've seen a lot more aggressive growth figures where you think, "There's literally no way that that will happen. Why would you sign that document with that expectation to get the final one-third of your payment? You've never grown that fast." It's just about going in with eyes wide open. I think the bigger challenge for me is, aside from folks not having full information when they hear about these multiples, but they get it eventually as they do their research and they talk to the firms, is it just creates this unreasonable expectation, unfortunately, that when I realize this and then I come back and you and I work on doing our deal at three times, I now understand what the alternative was, but now, I feel like I'm settling when I do the deal with you.

And so, the expectations impact the peer-to-peer deals where people are still doing those deals, but they're just not excited about them, and they should be. Those are really, really good values relative to where we've been at in the industry. And I got to say the private equity in the multiples and the conversations around 10 to 14 times EBITDA, it's sabotaging a lot of firms' ability to do internal succession planning by creating these unreasonable expectations that frankly, the internal successors can't meet, but we're still not really comparing apples to apples because the internal successor will go borrow money, deliver cash, a check, and buy-in. They're not going to show up and say, "Hey, you know what, Michael? I want to buy in to the firm here that I'm working at. I'm going to give you a 20% cash down payment, and then I'm going to use some stock in another company." No, they're actually...

Michael: "I'll give you stock in the company that you just sold to me." And you don't want to roll your stock into your stock.

David: But when you see these multiples out there without that context, you think, "Well, shoot, I've got evaluation done, and I'm doing my internal succession plan with my team, and we're talking eight, nine, maybe ten times for a really good firm. I could just hit the easy button here and take this outside investment at 25%, 30% premium, and it sounds a lot easier than mentoring and training and financing." So, I think there are definitely some problems that the PE firms solve for the industry. It does grease the wheels of commerce, but there are definitely some downsides that I have observed. And they're just sort of an incidental issue, but it's having a pretty big impact on internal succession planning.

And it sucks because our industry was really starting to make some strides towards the internal succession planning. It's not the only way to exit the business, don't get me wrong, but I think it's a pretty good plan A because it makes plan B even better. If you end up building your firm to do internal succession, your mentoring, your training, you're building the systems and the processes, you know what? If the successors don't want to buy it or you change your mind, you are still so much more valuable as a result. But then when I start seeing these higher multiples and I think, "Well, there's no point in doing internal succession. A, too much work, and, B, I won't get nearly the same value," it just starts to distract owners, unfortunately.

The Challenge Of Accurately Measuring A Firm’s True Earnings [25:17]

Michael: So, you had mentioned earlier as well that a lot of these deals get struck at some multiple of earnings, but it may be "adjusted earnings." So, can you explain more what that means? And it's literally what gets adjusted? What are the adjustments?

David: Yeah, it's funny because when we talk about ways to build a more valuable business, some of the basic things we'll talk to folks about is just know your P&L. I think it was Peter Drucker who said it, "What's measured improves." Know your P&L, look at your financials every single quarter. You don't need to spend a lot of time on them, but get to know them. Make sure that they're clean and they truly reflect the business as it exists. And a lot of times when you look at these firms, they will be showing abnormally high levels of profitability in many cases, but it's because they haven't been investing back in the business necessarily. They're on the back nine of their career. They're not in growth mode. They're not trying to hire because they're not trying to grow that much anymore.

So then, you get these firms coming in through acquisition saying, "Okay, well, you might be at a 45% margin, but that is not sustainable, scalable. So, we need to adjust the staffing levels, we need to adjust then your insurance premiums and costs, we need to adjust the size of your office because you're going to need more people to scale this thing. You're doing the money management in-house. That's not going to work for us. So, we're going to move it over to how we would manage it and what that cost structure would look like. Your technology sucks. So, we need to switch it over to a more contemporary solution set." And all of a sudden, you go from a firm that the owners were pretty excited about this thing, 45% profitability. And all of a sudden, when the financial folks are done, it's at 15%, 20% profitability, baking in some reasonable owner compensation. So, sure, you're getting 14 times, but it's not 14 times the profits that you were doing the math on.

Michael: So, I guess that's part of what I was wondering or curious about. I feel like the traditional view of understanding the profitability of an independent professional services firm is something the effect of, "Well, you can look at the earnings, but we all know it's a little higher than that because the owner's putting some stuff through the business." And there's this implied assumption of, "Oh, well, if you think that's what the earnings are, wait until you see what they really are once we back out the creative tax strategies that the owner was implementing." Whereas to me, you're telling a story in a very different direction, which is no, no, no, if you're a high margin practice, there's such things being so high margin that the buyer is going to come in and say, "I won't actually give you an EBITDA but multiple on those earnings. I'm going to adjust them, not up to back out your creative uses of cars and boats through the business. I'm going to dial your earnings down because I think I'm going to have to put more cost structure in place to scale the thing that I'm buying from you. So, your earnings are not what you thought they were for the purposes of our earnings multiple."

David: I couldn't have said it better because you're right. When you and I sit down, if we're going to take our respective firms, and I'm going to get my financials ready to give to you or you to me so we can start doing some due diligence talking about a deal...

Michael: Then the car and the boat come back out.

David: Correct.

Michael: I got to polish them earnings up.

David: Which is exactly what happens is the owner, you think, "Okay, well, I see right now what my profitability is, but I know, yeah, that printer and iPad and stuff on there, it gets used for business purposes occasionally, but mostly it's at home with my kids. So, we'll go through and do our adjustments." You think, "Okay, it's even higher now." Well, the problem is for the firm operating...as a general rule of thumb, it's at 40% to 50% profitability, that is generally a firm that's going to get something in the five to six times EBITDA range because it is so high profit that generally, there's some exceptions, but generally, that is a business that it won't be able to maintain that profit margin and still grow in scale and hit these targets that we're expecting. So then, they go through and they do their "normalization." I've just never seen these firms do the normalization and have the profit figure go up. It always seems to go down and by a fair amount sometimes.

At the end of the day, regardless of who the buyer is, it comes down to, "Is the business going to be profitable when I look at this thing as the buyer, net of taxes, debt service, and some expenses to continue to run and operate it?" And I got to tell you, in most cases, if I go buy your business, Michael, and I pay you three times, there's probably ten-year financing, kind of your traditional deal. There's a little bit of meat left on the bone. If we have some growth and the markets are good, then I'll do just fine, but I'm not going to retire early on the acquisition. When you start seeing these deals talked about at four and five and six times top-line revenue, there's no chance. So then, you've got to start figuring out, "Well, how would they make that work? And it's always through the terms.

Michael: That's why I was going to ask you just to come back to that again. So, as you noted, the acquirers doing this serially, they're professionals. They're good at this. They win or they go home. If you think you won, you're probably wrong. It's what the old poker saying like, "If you can't figure out who the sucker at the table is," there you go. So, okay, they’re transacting deals at four to six times revenue, they're not the suckers because they're the professional investors. So, what are we collectively missing about why they're not insane, but doing deals at these valuations? How is this still turning out so profitable for them that they just keep doing it, and apparently, they're hoovering up more private equity to do it because everybody else thinks this is equally awesome in the private equity world? What are we missing about why this math works for them?

David: Well, if they're coming in, and just to stick to top-line revenue multiples because it's easy, it's simple, it's very comparable, but if they're doing, let's say, four times, but they're only putting 20% cash down, they're not emptying out the coffers to get these deals done. In fact, they're tying up very little equity, relatively speaking. Now, it's a higher multiple they're paying on the revenue or earnings. It's six of one, half a dozen of another. But the down payments are lower. And so, they can go get a lot more deals done, they can aggregate a lot more practices, they can gain some scales, some efficiencies. Again, we don't need these five practices in Des Moines, for example, having five receptionists, and five office locations, and five people managing the money. So, they can definitely get some scales of economy if they can just aggregate these things fast enough. But again, if you were going to go out as a normal acquirer, peer RIA in the industry, you're going to go borrow the money from an industry lender, "I'm going to deliver to you a duffel bag full of cash," I can only do that so many times, and then people aren't going to give me money anymore.

Michael: Right, because I just I've got too much debt load, I need to pay down my debt a bit with some earnings before I get to go re-up again.

David: But if I could take all that same money and say, "You know what? Instead of paying cash and buying one deal, I could take and do 20% down and then other creative terms for the balance, well, for every one deal I would normally have done, I can do five now." So now, picture that with the power of a PE-backed investor.

Michael: But I guess I'm still just trying to envision like, "Okay, but if I'm overpaying on deals, I can do them faster. I should just grow broke faster." And they don't seem to be, or at least they're not. Nobody seems to have blown up. And the PE firms who ostensibly are very smart about how to make money on money are happy to continue doing these deals. So, I'm still just trying to visualize how does this turn out to be so profitable for them that every PE firm wants to back up wheelbarrows of cash to do this faster at multiples that high.

David: Yeah, again, with the 20%, 30% cash down, and the balance being paid either with your own money effectively, again, you know how earnouts work, it's, "We have to have the growth, and then we're going to use that to pay you that last third." And then the other third coming in equity in the aggregator or PE firm, again, I feel like...

Michael: Which means if this doesn't work out when we write our stock down, your price will retroactively be written down as well.

David: Yeah. Correct. But if it works, it's going to be amazing. But they have to maintain that growth as the PE firm or the PE-backed aggregator for this to all work. So, again, it has some of that multi-level marketing thing where if we can all go and keep helping grow this thing, then the equity I got paid with will have value, and if not, it doesn't. So, basically it's the owner of the firm taking their chips, cashing them, and giving them to somebody else because I think you can grow and be more successful than I could have done on my own, which is where it... I hate it when it undermines the business plan that they had. They were building an amazing business with a great team, all internal. And then they decide, "You know what? This other opportunity seems like it could take the value that I was going to grow and quadruple it in half the time." I don't say there's no shortcuts because occasionally there are shortcuts. But it seems like every time I take a shortcut, it ends up taking me longer.

The Tempting Path For Founders Of Retiring Through Attrition [34:13]

Michael: So, this is kind of where we anchor that at least before you start adding the contingency risks of you actually have to grow to a certain amount after you're gone, and you have to take some of it in stock and hope that actually works out for you when you get to, I guess, the more cash on cash deals, that's a fair label. You're down in a two-and-a-half to three times revenue neighborhood. I guess I'm wondering, is that the baseline for everyone? Is there still a difference between what external deals get done at and what an internal succession gets done at? If I'm a founder, should I be expecting my internal successors to be transacting at a level in that neighborhood?

David: I think that's fair. Whether you're selling internally or externally, there is only so much cash flow in these businesses. So, we can't magically create more. The one advantage I think the external peer-to-peer deal, agnostic of size has over internal succession is you've got that consolidation event. So, you got your practice, Michael. I've got mine. I buy yours. And no, I don't come in and get rid of everybody, but there's definitely some consolidation that happens, margin expansion as a result. And so, because you've got two cash flow streams coming together where internal succession, we're just taking that one and we're trying to start to do more with it, you can get a very similar value from an internal succession plan as you can from an external one, but it's going to take longer. In internal succession planning, I'm not going to sugarcoat it because anybody listening who's doing this or has done it knows, and you know, too, because you've built businesses, internal succession planning, if I tell you, you can get a similar value to an external sale, it's going to be a lot more work. It will take longer, but it can definitely get a similar value, sometimes more, but you're going to have to put in the time and effort.

Michael: What makes it more? How do you get to sometimes more?

David: You know, the benefit, I think, of internal succession planning from a valuation...not value because value can have a lot of different meanings to a lot of different people, but valuation, dollars in your pocket over the course of time, if you start the process early enough, you are proactive, you know what you are working to build towards, you have the end in mind when you start, which it doesn't happen for all of us, but you figure it out eventually, if you can be gradually taking chips off the table over time by virtue of that dollar cost averaging on the way up and then being able to continue to drop profits along the way, while I disproportionately reduce my workload, you can get a very similar, if not greater value, but it can sometimes take 10 or 15 years to do it. And it is a lot of work. We have to be mentoring and training and building a business as opposed to just build the business up to a point where you are ready to retire and then sell it. If you built up something super efficient, fantastic, high five. If it is not super efficient, the next person will make it more efficient, high five.

Michael: Well, because I will admit in that vein, I have heard from a number of advisors over the past few years something to the effect of, "I was working on a succession plan. I did one. It didn't quite work out. I was getting ready to hire another person, do another one, and try to figure this out a second time, and I realized that so many firms call me every day just wanting to buy the whole thing and go away that I have just decided I am going to keep doing it as long as it is fun, and when it is not fun, I am just going to answer one of their phone calls and this will be done. Why would I spend years trying to develop a successor to formulate the exit plan that I could do by just answering the phone any one of the five days of the week that one of these firms calls because we are all just getting continuously bombarded these days?"

And from my industry traditionalist mentality of, "You bring the young person in, and you train them and develop them, and you transition your clients to them over time, and then eventually they take over, and you write off at the sunset," kind of this idealized picture of succession planning, there is something kind of tragic to me about that approach.

David: We have cases we are working on every month where a single-owner firm had some life event. They passed away suddenly, they got ill, permanently disabled, and we have to go sell it. To your point, I hate to put the liquid label on it and commoditize client relationships, but we are able to go place those firms and get very fair values with absolutely no notice. So, it is possible and it is tough to argue with the economics of these deals. But I think your tragic label is not far off because if you made the decision of how you want to exit purely based on financial motives, as an advisor listening, you should just work less each year, retire through attrition, and ride this thing into the ground.

Michael: Well, yeah, that still is the thing that fascinates me the most about the industry as a whole. I watch these industry studies come out year after year of whatever it is, 20% or 30% of advisors have a written succession or exit plan. I am like, "Look, from a client continuity end, I really wish more of us had at least something written to say what happens to my clients if something happens to me, for the clients' sake." But from a pure business economic reality, these things are so profitable. If you hang out with it while it winds down for 10 or 15 years, you probably still net more than you...

David: You do. I've done the math. You can do the math in your head. You don't even need a spreadsheet to do it. Unfortunately, if your clients were sitting in the room with you watching this happen, you would be, in many cases, not your listeners, of course, but other podcast listeners who are advisors, they would be mortified that their clients knew that they were prospecting half the time. And by prospecting, I obviously mean golfing. And we see it industry-wide. We've got a good marketing team here, I think, and they'll send out newsletters and emails to different folks. I got to tell you, it doesn't matter what day of the week, what week of the year, what month of the year. If we send out 1,000 messages to folks, at any given time, a third of those will bounce back with out-of-office replies. So, unfortunately, retirement through attrition is the leading exit strategy for an industry full of professional planners, and it kills me. It hurts my heart.

Michael: And the irony in me is just it often really is actually the most financially remunerative path. There's a point where you get a certain size and team members that that gets more challenging. But for a solo practice, like a founder-centric practice, just the math works remarkably well. And it's only better if you get to the point where you then eventually say, "I don't really want to keep doing this with the clients I've got left. I've had a change in health and circumstances." And then you take a call from any one of the buyers that wants to aggregate you, and you will get a terminal value for whatever was left that you had not attritioned down. And it still has value because of this strange liquidity in the advisor marketplace. I mean, I don't think of it as belittling to clients. I view it as the opposite, which is just there's a lot of firms that are very eager to expand their client bases and would be happy to serve your clients well if you are willing to help transition that relationship to them.

David: Yeah, I've seen folks recently in the last couple of years start to take a little bit more proactive approach to that same retirement through attrition mentality. But instead of purely retiring by working less and responding to clients more slowly or not at all, instead, they end up doing partial book sales where, "All right, I know I've already cut down to three, three and a half days per week. I need to pare my book down to make sure I could still take care of the household that I have." And so, they'll sell the “C” and “D” clients. And when I talk about this at conferences, a lot of times, Michael, people will come back afterwards. They don't usually say during the presentation, fortunately. They'll say, "I'd love the idea academically, but who wants to buy my C and D clients?" To which I reply, "A Ph.D. They're all over the industry. We're looking for somebody who's poor, hungry, and driven." There are so many folks out there. They can't knock on doors all day long, like they need clients.

Michael: There's a lot of younger, newer advisors that would really love that opportunity. Don't you remember what it was like when you were getting started? If someone would have given you an opportunity...we talk about it, some regularity here, like, "Your C clients are someone else's A-gem clients." They're probably a little earlier in their career than you are. Your C clients are someone else's A clients. They're really going to serve them well. They really are excited to serve that client well because it's a really good client for them at their stage of business and size.

David: Which is why I love talking about succession planning because when you can talk about this subject matter, generally, even the folks who are actively retiring through attrition, while they're listening to me at the conference, they're not doing it on purpose. They took Fridays off because you know what? "I'm 60. A, I've earned it. B, I'm not in growth mode anymore. I'll just maintain my book. I cannot be here on Fridays. Fridays aren't that busy anyway." Well, it's nice to have a three-day weekend. I love it. It's fantastic. But you know what's better than a three-day weekend? A four-day weekend. Mondays suck anyway. Let's take Mondays off. Again, I've earned it. I'm now 62. Well, unfortunately...

Michael: Spent 30 years building the goodwill of that business like, "Yes, I've earned it."

David: Granted now it's recurring, but the first 10, 15 years of this, I wasn't in business 15 years. I was in business one year 15 times because it was commission-based. And so, they take Mondays off, and just like the upcoming holiday, you know what happens if you take Monday off, it turns Tuesday into a Monday. So, they take half days on Tuesdays to ease into the work week, which now consists of Wednesday and Thursday. And so, they hear us at these conferences and talking about these succession strategies. In their mind, they're thinking, "Okay, there's PE. I'm not big enough for that. I'm just not really interested in it, but I'm not ready to retire either. So, I'll just retire through attrition, kind of by default." And then they hear some of these strategies about, "Well, you could do a merger. You don't have to be huge to do a merger. You could do a partial book sale. Sell your C and D clients." Those, to your point, C and D clients now become somebody else's A clients. They can uncover some hidden gold in there, take great care of the clients. They're auditioning for your B clients when you're ready to cut back a little more. There's a lot of other ways to exit than just pulling the ripcord, taking the check, and exiting stage left.

A Step-By-Step Approach To Enacting A Gradual Internal Succession [44:36]

Michael: So, take us now in the other direction for a moment. So, it really wasn't my intention coming into discussion. I feel like we've beat up succession planning for a while because financially, it may be a better deal to attrition out. And if you just don't feel like it, you can pick up the phone and your business is remarkably liquid. So, who chooses to pursue succession planning paths? Are there patterns, are there archetypes that you see of where is this a good fit or who is this a good fit for? What advisors get excited to go down this path?

David: And it's so funny because I would tell you, Michael, it's probably the vast majority of your listeners, advisors, who they've gotten past the point of that lifestyle practice, not past as in they've reached some new zenith of their career. It's just a different fork in the road. You can enjoy having a fantastically efficient, simple lifestyle business. Or they decide to put their foot on the gas, "We're going to grow this thing, and we're going to hire some people, and we get past that point where it feels like the adult daycare, we've got some good, smart people on the team." That's the vast majority of folks who I'm talking to at these conferences and industry events and attend the webinars. And they have good team members, whether it's two or three of them or 25 of them, doesn't matter. They want to see...legacy sounds a little too kitschy, but they want to see their legacy, their team continue to succeed as they slow down and exit stage left.

Anybody who has good team members that cares about the team that they've built because they've been investing years in training them, creating little mini-mes effectively, they want to see that thing continue to succeed in their absence. But then to your point, they get distracted occasionally with the PE conversation or the letter they got from their peer that you could just pull the ripcord today and I'll write you a check. Well, yeah. But if you can do internal succession planning, you can exit gradually on your terms, you can help promote the next generation if that's important to you. There's a lot of other really fun, intrinsic things that I see play out with internal succession.

Michael: So, in that vein, I guess then help us reframe this all together. So, if I'm the founder and I do want to do an internal succession plan, I've spent a lot of time supporting and developing this team, I want to see them succeed, I'm very invested into the team as much as my clients that we serve, I would like to see this legacy continue and not have it disrupted by a giant idea that's going to rip the name off the door the moment the paperwork's signed, so I want to do this succession legacy thing, how do I pursue this and not feel financially disadvantaged because I'm not taking the phone calls with the big numbers?

David: And I would say the clients that we have or clients we have that don't feel that way are usually those that have gotten to a point where they have done a couple of gradual internal sales to their internal team, they've been mentoring and training, and they're now down to maybe 20% or 30% ownership in the firm they founded. And they'll probably stay that way in many cases until the day they die, or at least until their health begins to wane. Those are the ones that see the light at the end of the tunnel. They say, "Okay, you know what? I've been able to sell the first 20% tranche at fair value a decade ago, and then we doubled in size five years later, and I sold another 20%. And my remaining 60% was worth more than when I started selling equity." So, they keep having this growth inside the firm, and they don't feel like Sisyphus pushing the rock up the hill all by themselves. Now, they've got some other people pushing the rock up the hill. And occasionally, I can take a day off from pushing the rock up the hill. And then a couple of days off, those are the ones that sit back and look at it and say, "I couldn't imagine responding to any of those aggregator letters that I get in the mail, given where I'm at now in my career and how much value and I've been able to get out of this thing, both literal and figurative value.

Michael: So, can you walk me through that further, though? You kind of set this up as, "I've been doing some partial sales to my team. I'm now down to 20% to 30%." But for those who have not gone down this road at all, so how does this work? How did I sell the first 70% to 80%?

David: Well, it's a lot more fun. Michael, just go to the last chapter of the book and start there. But we'll go back to chapter one. So, I would say, "Where do these things begin?" Honestly, from a succession perspective, assuming they've got people at the firm, and it makes sense to start thinking about internal succession because it does take some bodies, at least one other person besides yourself, small detail, right? I think the jumping-off point would be probably the formalization of things like your job descriptions. And if you've got job descriptions from a couple of positions you've hired for over the last couple of years, lay the job descriptions out on the table, get them an order of how much you're paying people. All of a sudden, it starts to look like you maybe have a career track, kind of. So, formalize the job descriptions, the career track and the pay bands, that's, believe it or not, kind of step one.

Step two is then making sure that the compensation systems inside your organization are designed for a team. We see a lot of folks who they want to do internal succession, they want to train and promote and build an integrated ensemble team. I know you can't see air quotes, but they were there. But their compensation models are still sort of that old-school revenue-based payout on a grid. And your job, Michael, is to go get clients and then serve those clients and maybe even manage the money. Well, that doesn't really support a team. So, we've got to shift to more of a team-based compensation model, and then we get to a point where, "Okay, we've got a great team, we've got a career track. We can now start to have the conversation of, 'Well, when you've been here for five or ten years,'" wouldn't be uncommon.

Then we're going to introduce phantom equity or synthetic equity, a more specific term for things like stock appreciation rights, liquidation rights plan. It's phantom, it's synthetic equity, but it's beginning to head down a path towards partnership in the organization. And then we can start layering in, "Okay, you know what? If you've been here for ten years, you've got your CFP, you're taking care of a certain level of clientele," not everybody, but those would be your qualifications to have a conversation about actually being able to buy into the firm. And then they'll do their first, usually either a 1% to 5% sale, depending on the size of the firm, that is company-financed. That's sort of how they'll prime the pump. "We'll do the financing internally. We'll control it." Yes, said another way, that is them buying in, let's say 5%. And then they get 5% of the profits, which they then turn on and give back to you to pay for the equity.

It feels like you're recycling your profits, but you are. You're doing it intentionally, or we do maybe a little bit larger purchase, something north of $300,000 as a value. And we'll go get industry financing. The banks love financing these deals. They'll finance a 1% to 5% or 10% buy-in for the next-gen advisors. And they do it because number one, they want to finance the rest of those purchases, obviously, but also the collateral for that small amount that was purchased is usually the entire firm. So, the banks like the transactions, we can get things going internally by selling small, maybe 1% to 10%. That's your first bite at the apple. We grow for two or three more years, you get some of that debt paid down using the profits you're receiving, and you show up and you buy another tranche of ownership. And we have some additional profitability coming from the first purchase plus the second purchase. We start to pick up momentum pretty quickly.

Now, to be fair, from a cold start, if we had done no sales, we've just been working together, mentoring and training, it's probably going to take seven to ten years of doing those kinds of transactions to be able to have the owner get down to a minority stake. But through those multiple sales and acquisitions happening, usually in two to three, maybe three to four-year increments, gaps in between, we're able to capture a fair amount of the growth and upside as the founder while still making sure that the profit that the next-gen advisor receives is sufficient to cover the note payment to the bank or back to the company. I'll pause there.

Michael: So, my takeaway to the framing of this is just this traditional frame that we've got for succession planning, which is, "I reach the day that I'm willing to exit, and then you go get the bank financing and buy me out because I use seller finance, but now you can bank finance it." That's not a good mental model out of the gates. The better mental model is, "We're going to spend seven to ten years as one or more successors buy a couple percent at a time in tranches every few years." And I guess if you start compounding growth, you can buy incrementally larger pieces over time. So, we're going to do this in two to four tranches over the span of a decade to get to the point where maybe one or more successors own enough that I even dip to the minority stake as the founder. And then I may still have a tail from there where the firm is still growing, and I'm still getting some of the appreciation, but the successors are now eventually buying out the rest of my stake.

David: Yeah, exactly right. It's more of an emphasis on the planning part of succession planning, to your point, as opposed to a singular transaction. There's nothing wrong with the singular transaction on the surface. If you're selling to a peer, for example, again, if you and I own separate RIAs, I'm going to work until I'm ready to not work, and then I respond to your letter or your email and I sell to you, that works because you know how to run a business, you can get the loan. It's not as scary for you as a fellow founder. You know how to serve clients, you know how to manage money. You know how to do everything pretty well. So, buying my business and then me exiting over a 12 to 18-month period isn't crazy.

But when you think about it, for me to do that same thing internally, even if I've been focusing on actively mentoring and training, putting you in the driver's seat while I'm still in the car as the founder, it's still you're flipping the switch. It's very analog. "Okay, well, I own 100% of it, and I'm going to sell it to you, and you who have never owned a money business, we're going to flip that same switch and turn you into an entrepreneur, and you're going to go get a loan for a million dollars, $2 million." That is scary. It's frankly why the number one lead source for our listings when we list businesses that need to find a buyer, they're failed succession plans. It's not that the succession plan really failed. It's more that the advisor founder failed the plan. They got to the exit door, and they pulled the rip cord and the next generation just wasn't ready, at least not that fast.

Michael: And so, you get successors that didn't want to buy the whole big thing, but they'll buy a smaller thing that you listed separately?

David: Yeah. Basically, we have these happen literally all the time where folks will call us and oftentimes we didn't work on them, but there's even some clients we helped do their succession plan with their one internal team member. But the next generation looks at this thing, and they just decide, "You know what? I appreciate the opportunity, Michael, to buy the business. I'm just not there yet." And you've got the founder saying, "Well, you are. I've mentored and trained you. I know you're capable of doing this." And they're just not there emotionally, even though you can show them the spreadsheets. And so, I hate to have that analogy, but a lot of times doing succession planning, it's a little bit like boiling the frog. We got to turn the heat up real slow so they don't jump out. And before they know it, we cooked them. But we've got them to a point where it's pretty hard to say no to buying 1% to 5% when you can show me it pays for itself. It's a reasonable dollar amount. Well, okay. The next deal is a little bit bigger. I did the first one. It paid for itself. It worked. So, the proof is in the pudding. We just have to approach these things, succession planning, as a series of events. Frankly, almost as a mindset, it's not a singular transaction. It can be, but that's a sale. That's not succession planning to me. It's easier, though. That's for sure.

Valuing The Initial Tranches Of An Internal Sale [56:37]

Michael: So, how early do you start introducing tranches to make this work?

David: I would say as soon as you have somebody on the team who, when you look at them, their skills, and how hard it would be to replace them, that's a good time to contemplate getting them into some kind of ownership position. Maybe it's a phantom equity plan to start with, keep it simple, try it on for size since you've never had a partner before, but consider some type of equity sharing at least ten years before you'd want to exit stage left. Give yourself time. Now, I'll tell you, the ancillary benefit to building a business as opposed to a practice or a book of business, if you end up getting to a point where, "You know what? I'm tired of it, I want to retire, I had a health event or my spouse had a health event and I just need to sell it," when you are working to build an internal succession plan and it doesn't end up working out, you are generally still so much more valuable as a result because as an outside firm looking to acquire, do I want to buy the retiring advisor's job where I've got to make sure I've got somebody here in-house who can take over that book and we've got to get to know the clients, or would I rather buy a business that it's mostly turnkey, it can mostly take care of itself with its existing staff? I'll pay more for the one that's pretty turnkey. So, even failed succession plans when they have to look externally, generally get more value.

Michael: So then, how does this get valued? When I'm ready to start doing my first 1% or 3% or 5% tranche, am I doing this at market rates and I'm getting valuation or I'm setting some number along the lines of what we were talking about earlier? Is there discounting that I'm supposed to do because this is a minority stake that's not very marketable as a minority stake and all the ways that valuation discounts can sometimes get applied? How does the valuation get set when you're starting to do these tranches?

David: Now, full disclosure, you're asking a barber if you need a haircut.

Michael: Fair enough.

David: We help folks with these valuations. But even if you call one of our peers, competitors, I would still give you the same answer. It's important if we were going to start doing succession planning, and I'm ten years out from my hypothetical retirement date. It's not on the Outlook calendar, but it's penciled in at home with my spouse thinking, "2035 will be the year. I'll probably plan to retire thereabouts." If we're going to start that process now, for example, I should have been starting to do valuations, formal valuations with a firm who knows what they're doing a couple years before I would contemplate doing any kind of sale event because I want to know before I show up to that conversation, I want to know what the value is. Not only do I want to know what it is when I get my first valuation, number one, I'm probably not going to have the best financials for my first valuation. Gathering the data is going to take a lot of work. It may not be perfectly accurate. I'm sure all of our clients get us stuff that is. But on occasion, I don't think it is. There's some rounding error in there.

So, the first valuation is not going to be probably the most tight data going in, but it'll be directionally accurate. But we can now identify the value drivers, the value detractors for this organization. We can start to look at the financials. What were the pluses and minuses effectively? I've got a year or two before I'm going to contemplate doing anything with my internal team. I can start to make some adjustments, work with a consultant or coach. I can make sure that when I do finally show up for that first sale that I have a business that somebody would want to invest in because as it turns out, succession planning and that first sale event, it's quite literally somebody choosing to invest in the business.

And then with these things being so often bank-financed, well, guess what the bank wants to see? They want to see the financials of the company that this person or this team is buying into. I don't want to have to send over my financials with a long 400-word essay explaining why these numbers may not be exactly what they seem on the surface. So, I think doing the valuations ahead of time, a couple years in advance, is a really powerful tool to just take the surprise out, and then you just generally start to get in a pretty consistent cadence when you have other shareholders on the team, big or small, where we kind of want to track and know our stock price. So, they get in a very regular cadence of doing these valuations with us or somebody else because it's the most holistic measure of how the firm is doing.

Michael: So, I'm still trying to visualize, though, just where these numbers get struck. And if you start applying discounts for small tranches relative to what you do, if I just came in and said, "Okay, I'm ready to be the successor. I got a bank deal for the whole thing, and you're going to sell me 100% and move on," so, relative to multiples that we were talking about earlier, where do multiples get set? Do discounts get applied, or how do they get applied in this context?

David: Good question. Again, part of why I love listening to your podcast is you always keep peeling the onion back another layer. So, yeah, to your point, we're going to talk internal succession. And for those first couple tranches, I'm buying in. And I don't care if it's 1% to 5% or 10% to 20%. The first one or two, or first few are going to be a minority stakeholder. So, to your point, the conversation will always come up. They're not always applied, but there's going to be some conversation around a minority discount, which is...you know, but for the audience, bifurcating it, it is a discount for lack of marketability, it is a discount for lack of control, both of which apply to some degree when you've got 49% or less, certainly 1%. So, there is a minority discount.

So, we get the valuation. That will be fair market value. That's the value of the organization that I could go get from somebody. But I'm selling you 5%, 10%. That isn't, to your point, just 10% of the number that's on that valuation. That's a starting place. But then again, as the buyer, whether I ask for it as the successor, which can be awkward, don't get me wrong, a lot of times we'll blame it on our CPA or our attorney that told me to ask you about this, founder, boss. There should be some kind of minority discount for the stake that I'm buying. So, yes, very often you will see a 10% to 30%. It's pretty consistent. You'll hear from CPAs or even our valuation team, 10% to 40% is kind of the general range.

For internal succession, it tends to be on the lower part of that band, probably 10% to 30%. Where it doesn't end up always applying, even though it probably still technically should, is a lot of those first purchases that we're seeing to start the succession plan out, they're seller or company-financed. Well, if I'm going to let you buy in, for example, Michael, and buy 5% of the firm, and I'm financing, i.e., you get to use my profits to pay me back with, you don't also get to have a minority discount on top of me giving you special terms for financing. So, it's kind of an either/or deal. So, minority discount makes sense. Great to talk about.

Michael: So, if you want me to seller finance you, I'm not necessarily going to give you discounts as well. If you want to go get bank financing, then I may apply some discounts because you're now taking this risk on with the bank.

David: Exactly. And when we shift gears and start talking about bank financing, then they don't tend to be 1% to 5% purchases. Depending on the size firm, it wouldn't be uncommon that the successor or successor team would do...if we're using external financing, I might buy 24%, 25% the first time. Get that paid down, go 5 or 6 years, I'll buy the next 24%, 25%. So now, I'm up to 49% as an individual or the group. And then the founder will keep the 51% stake until they're ready to really take their foot off the gas and hand over control. And those deals, again, because they're larger, the bank will finance it, but the math still works. I get a larger percentage of the profits, and I've got a larger loan, but these things generally still cash flow. And it's been one of the really nice things, I would say, Michael, from the industry lenders coming in, is they brought some sense of normalcy to the industry and the buyers and sellers because I can't just say, "Well, I want ten times my earnings." Well, banks can come in, and they're going to order an appraisal. And if the stake you're selling doesn't appraise, they're not going to lend on it. So, it's been an interesting way to get everybody to come back to reality.

How Founders Can Maximize Their Firm’s Valuation [1:04:53]

Michael: So then, in terms of the valuation itself, I guess, before we apply discounts, are we typically valuing on revenue here? Are we actually valuing on earnings? Because it sounds like the bank's looking at earnings for perhaps reasonable repayment of our debt purposes. So, are you typically striking internal succession deals on revenue or on earnings?

David: Internal succession should always be focused on earnings. Again, when we talk about buying in, the way that I'm going to service this debt is from the profitability that I will hopefully be receiving. And we've seen that over the years as the industry has just evolved around the topic of value and valuation. For so long, everything was focused on revenue multiples, revenue-based valuations, market valuations, which are fine. They have their place. Their place is not on internal succession planning. Internal succession is all about the profits that this machine that I'm buying into can produce. And to your point, banks will for sure go there, regardless of how you guys got to your number, they're focused on profitability.

Michael: So, what are typical earnings multiples in this context?

David: Minority discounting aside, earnings multiples, EBITDA multiples in particular, we're generally seeing something right around nine times earnings is where most firms doing buying and selling succession planning internally, they're generally around that nine times number. You'll see some that will get to 12 times. But again, when there are 12 times, you're getting that higher multiple because you've been reinvesting in the business, you've got marketing, you're properly staffed, you got good technology. That's a really nice way of saying you have lower margins, but you're more scalable. So, you get a higher multiple, higher value at the end of the day. So, safely, you're probably looking at something between 6 and 12, but yet 9 has been the average last year, the year before. It's pretty steady.

Michael: Can you talk a little more, just like what shapes you to be towards the upper end of the range or the lower end of the range if you're going to come off that number? Are there some big factors that tend to move that materially?

David: The softball on that one is going to be growth. If we have consistent, demonstrable growth, if we have a well-trained team, or we're properly staffed, we don't have five advisors on the team, all of which are serving 300 households and working 60 hours per week, well, sure, you're driving a ton of profits out, but you have no room for any additional growth. So, they have growth and they have the ability to sustain and maintain the service related to that growth. Those are kind of key parts.

Michael: And what is like viable growth in this context? Is there some growth rate you have to get to before the market really says like, "Okay, this is actually good enough that you get a better multiple for this?"

David: Probably north of 10% or 12%. Then you start to maybe get a pat on the back. Anything less than that, and to your point, it's positive. But we have a lot of advisors who are selling, doing succession planning, and they're pretty happy when they do their valuation. And they turn in their data, and they show you they've been growing by 5% per year for the last five or six years. And again, you wouldn't tell them this, but you and I both know when you look at that and you think, "Okay, well, I factor out market appreciation..."

Michael: That's pretty much market average if your clients are conservatively invested…

David: And to be fair, for the advisors who you're having these conversations with and they're selling, they're 60, 65. So, you and I both know, plus or minus how old the book of business is, there's some RMDs, there's some clients who pass away. It happens. But, yeah, I think as soon as you get into the north of 10% or 12%, and again, you have the ability to maintain the service on those clients while you're growing with the existing staff, you can start to see a little bit higher premiums. And again, we need technology inside the firm. And we can't just go out and upgrade everyone to the newest iPhone. That's not what I'm talking about. We need the CRM system and the workflows, the efficiencies, outsourcing where we can. Those are firms that ultimately, if they did have the conversation about private equity, there would be a lot less normalization having to take place.

Michael: So, I guess my other question kind of related to that, we started talking about these multiples of earnings. As you said earlier, in external deals, there's often a lot of adjustments that happen to earnings. As the owner, I back out all of my creative tax deductions. As the buyer, you start layering in investments that should have been made that weren't made, that we're going to adjust in. So, when I'm a 1% to 5% owner, I don't necessarily get to dictate those kinds of adjustments, or maybe I do. I guess that's what I'm wondering. If I'm the successor, do I basically have to take the owner's earnings statement at face value? Do I get to adjust these? Is that a negotiating point? Like, "Okay, I'll give you ten instead of nine, but I'm going to adjust your earnings down." So, how do you arrive at the magical earnings number when the person who's selling to me has a remarkable amount of control about what that number looks like?

David: Yeah, and you're not wrong. From the person buying in perspective, that it is a little scary because I'm buying in and I'm relying on the profits I'm going to be receiving now as an owner to be able to service this note. It's one thing if it's company-financed. "You loaned it to me, and I'm paying you back with your money. We're going to make sure that works. We'll figure it out." But you and I both know how banks are. If times are good, they will say, "Pay me." If times are not so good, the answer remains the same, "Pay me." So, when you're looking at the ability of the owner to kind of manipulate the financials, there have been two solutions we've seen that seem to have worked and are working pretty well. For the longest time when we do internal succession in those first couple of sales, we would use a version of a promissory note between the successor buying in and the company. We call it a stretch note. There's other names for it. But basically, instead of having a promissory note to buy into your firm, Michael, where I sign it, I have an amortization schedule, a principal and interest, we know how those things work, well, those are kind of scary because if you do decide to make some other investments in the firm, run more through the business and there's not enough profits for me to cover the note, that's not great.

Michael: Your founder reinvestment is tanked by note payment in year two or three.

David: Yeah. And it is hard to go from one owner to two plus because before as the founder, it was just my other checking account. There was no one to hold me accountable besides my CPA at the end of the year. And they'll market it as an owner distribution. They'll figure it out. Now, I have somebody else to be accountable to. It's kind of like getting married and having to share your bank account because it is very much an economic marriage of sorts. So, the traditional promissory note hadn't worked really well. So, we shifted to a stretch note where what we end up signing for the first transaction or two is I will promise to pay you back, Michael, 90% or whatever the number is we agree to. Let's say 90% of the after-tax proceeds I receive in distributions, that's what my payment will be on this note. And so, if we do well, we have lots of profits coming out, I'm required to plow them almost all back in. And so, we get this thing paid off faster. If the markets are terrible in 2025, we do an acquisition. We don't distribute much in the way of profits. It's just going to take a little longer to get this thing paid down. So, that's one way to future-proof the first, second purchase buying in and make sure the next-gen sees this will work.

Michael: And so, the idea here now is, "Now, I'm out of the bank financing world, and I'm back into seller, finance firm, finance to structure this note that says the payment of the note is 90% of whatever the after-tax proceeds were." It's almost like a revenue-based note. It's a profit-based note at that point. So, I'm buffered as the buyer in a bear market. As the seller, you just get your money faster if we're growing.

David: Yep. So, that works really well, just for the first transaction or two to demonstrate to the successor that this works. Like, "Don't be afraid. It will pay for itself." Then we can shift to some other financing structure, usually with a bank thereafter. The other alternative is we do the first purchase and it's bank-financed. Well, the bank requires collateral usually to be certainly the stock that was acquired, but also that the founder, the company is the co-guarantor. Well, as it turns out, if the company is the co-guarantor, they're probably going to make sure there's enough profits to cover the note payment. So, banks turn out, they're pretty darn smart. And so, with that requirement to be the co-guarantor, kind of like mom and dad on your first car, it also helps make sure that this will get paid for. There will be profits distributed to cover the note, but we will figure something out.

Michael: I feel like that's how we handle earnings after the deal closes. So, I guess I'm just trying to visualize or understand further like how do we get to an agreement about what the earnings number is when we say it's nine times earnings or whatever multiple people we pick?

David: Right. Yeah. Leading up to doing the purchase, that is, it is a conversation that happens. If your financials as the founder maybe aren't as tight as they should be, it can be an awkward conversation because obviously, when I buy into a firm as the successor, this is our time to negotiate, make sure we get to a fair deal where we're both equally happy or both equally unhappy. That's same outcome, generally speaking. Well, yeah, but the hour before we sat down at the table and had this conversation, we were very much in a owner-employee relationship. And so now, I come in and play hardball with my boss, not a wise decision. You may rescind my ability to buy in.

So, it's a fine line that they have to walk. And again, it's part of why doing the valuation ahead of time can be helpful because the founder in a vacuum by themselves can get the valuation back and see, "Well, what the heck? SRG [Succession Resource Group] must be misinformed because my value came back so much lower than what I see out there in the industry." "Well, it's not that we're misinformed, maybe occasionally, but generally speaking, no, here's why. We go through the financials. Here's where your earnings should be. Here's what you probably should be reinvesting the business relative to your peers that you aren't." So, when they have those conversations ahead of time, that makes it a heck of a lot easier because otherwise, you're right. When I go to buy in, especially if it's a single owner firm I'm buying into, the financials can be…not a hot mess, but they just seem like they maybe aren't as accurate as they should be if I'm going to be giving you money and relying on your accounting.

Michael: So, the third-party valuation essentially becomes the neutral arbiter to pick a number in the good old-fashioned negotiating. If we both don't entirely like the number, that probably means a fair midpoint between us if we're both unhappy.

David: Which is why it's nice to do it earlier than when you're doing the transaction because when you get the valuation and you find out all these things that you just didn't know because you hadn't done a valuation before and you can explain a lot of it away, well, yeah, you can. But at the end of the day, your financials are your financials, and you've got to give them to a bank, and you've got to give them to the valuation expert and your successor. Nobody wants to hear all those explanations and do the normalization. So, it's good to do that stuff ahead of time if we can. And again, we're talking about internal succession. Usually, the first purchase is when we're having these awkward conversations, to your point, around the financials and the multiple, but it's a lot more awkward. A lot of the conversations that we see take place, there wasn't a valuation done by a neutral third party arm's length. It's the owner who has read lots of articles. They're very well-informed. They've got lots of small business owner clients telling the successor the value that they want. And you've got generally pretty smart successors going back home and doing some math and looking at the spreadsheet and talking to the lender saying, "I don't think this works." That's where, again, an outside third party, whether it's the lender, valuation firm, somebody can help ground things back in reality. And by reality, the financials on the acquisition.

How Succession Resource Group Supports Advisory Firms [1:17:08]

Michael: So now, help us understand... I'm taking one step further back. So, what exactly do you do? What does SRG, the business do?

David: Yeah, good question. It's changed just like the advisor space. We've kind of grown up with it. I mean, 20 years ago, I was really just doing mergers and acquisitions, pure M&A work, buying and selling business brokerage. And we always use the term M&A. It was mostly A, acquisitions. There weren't a ton of mergers happening. Today, we see a lot of mergers happening. So, historically, it was just a lot of pure business brokerage work. Now, at SRG, we still do the succession planning, and we'll help folks. Folks who are at the exit door, we can help them sell. We can list the business if we need to to find an outside buyer, get a higher value if that's what the owner is desirous of. Do a lot of internal succession planning work, which is a lot of fun for us because, again, we know where these things can get to if folks start the process early enough. And they’ve built some really amazing businesses and great teams. And so, that's almost some of the most rewarding work that we do because you get to see the next generation taking over, the current generation who's been working hard to build this thing, slow it down and enjoy life. It's really fun to watch.

But we've had the opportunity now doing it long enough to not just sit at the exit door and wait to see what our clients show up with that we can back up now and say, "Hey, you know what, Michael? Let us help you get your entity structure set up so that when you're ready to do succession planning, you don't just show up with an S-Corp, or an LLC, or an LLC taxes and S corp. Let's try to be intentional about this and future-proof it. Let's get your compensation plan done correctly." So, we have the ability to help them with the valuation, do that on an annual basis. We do a lot of that work as many of the firms like ours do. But then it's what do you do with that information? It's like doing client segmentation. Well, the segmentation is not really that valuable. It's what you do with the information. So, we get a chance to help them build their succession plans, set up the entities so that that's a little bit more easy to do, get their employment contracts buttoned up, which will build more value in the business, non-competes, all that fun stuff, create compensation plans, again, that help support a true team, which then makes our job that much easier with succession planning later. So, while we don't do practice management, we do focus on all things that impact the value of that organization, but we only do it for independent financial advisors. So, we tell folks we know a lot about a little.

Michael: Right. So, as you reflect on this journey, building the business and going down this path, what surprised you the most about building a business, helping advisors through succession?

David: The thing that surprised me most, I would say probably how much time and money, profit, however you want to label it, how much time and money you have to be willing to invest to create a business versus a really flexible job. When I launched Succession Resource Group, I could have just kept it a lean, mean lifestyle business. Had a support staff and kept it pretty easy, pretty flexible. But that would have very much been a job. To your earlier analogy, when I stopped showing up for a couple of days or a year, then there's not much there. But to actually build a business that can serve clients, grow in scale, you know just looking at it on the surface, well, that's going to take time. And, of course, you're going to have to reinvest back in the business. I had no idea how much time and how much money, profits that you could otherwise have taken out of a cash cow and really enjoyed spending with your family. Instead, you make the business part of your family, and you put a lot of your time and money back into that. I had absolutely no idea. And if you'd have frankly told me on the front end, I don't know that I would have done it. But here we are and it's been a lot of fun, it's been a wild ride. But it's a lot when you stand back and look at it.

Michael: So, what was the low point for you on this journey?

David: Yeah, you've got your ups and downs. But if I had to label low points, frankly, I'd say losing good team members. That's probably the one that just it's a real kick in the nuts. It hurts. It's no fun. When I started the business and hired staff and trained them, I thought of it like, "This is your business family." I've come to learn as we've grown, you don't generally fire family. You can. Been there, done that. But when it comes to a business, at least ours, I would say we're more closely aligned to...we're an all-star team. And you've got all-stars on the team, you're very good at curating that talent and helping mentor and train it. And so, it really sucks when somebody moves on. But it happens.

And I would say...my team knows this. We give them letters of recommendation, recommendations on LinkedIn while they're here. I want to keep everybody, obviously, but I want anybody who moves on to move on to do bigger and better things even when they do choose to leave, but still sucks. And the only other one I'd say it's just occasionally, you lose sight of why you're doing what you're doing. I have those momentary lapses. It happens. And not once every decade, it happens on occasion throughout the year. And then it just starts to feel repetitive and a little bit of a grind. And you just have to get back to, as cliche as it sound, sort of that mission, vision values, like, "Why do we do what we do? What impact are we having?" And that can renew you. But when I lose sight of that, that can be a real low point throughout any year.

Michael: So, what else do you know now you wish you could go back and tell you 15, 20 years ago as you were early on into succession planning with advisors?

David: You can't start the process too early. Again, having grown up in the business and grown up with M&A when we first started out, like you talked about, it was just purely transactions. When you're ready to retire, you listed and sold your business, you found a buyer, and you exited stage left. After a 12-month transition period, if we were lucky, to see where we're at now, boy, it would have been nice to just know these businesses have value. There will be a next generation of talent that will come up, they will be mentored and trained, and start with the end in mind. And instead, so many of us, myself included, tackled the things that were in front of us. You focus on the basics, the blocking, and tackling. But if I could have been a little bit more forward-looking, which I try to do now, but in the moment, it feels speculative until it then happens. So, it would be nice just to frankly have faith in the industry and know that even now when you see reports about advisor headcount down or the Cerulli study with 100,000 advisors, trillion dollars in assets exiting, we'll be okay. Everything will get back to normal, things move in cycles. And so, just having that little bit longer term mindset and being in it for the long-term.

Michael: Well, I am struck by just how long-term it quickly gets if you start working backwards to say, "If my plan is to exit in my early 60s, and I need 10, 15 years to do the deals and all the tranches, I almost have to get the first slice done no later than 50. And if I need five-plus years of developing some talent to get there, if I'm hoping to exit in my early 60s, and I'm not already starting the process in my early 40s, I may be behind." It feels a little intimidating. I have to admit, as I say that out loud.

David: Now that you've just did, basically, you're saying, "Well, I should start thinking about selling parts of my firm and doing succession planning when I'm in my mid-40s. I'm in growth mode."

Michael: I just feel like I'm hitting my stride.

David: Right. I don't want to give up any equity right now. I'm growing by 15%, 20% every year. Let's give it a couple more years. I need to capture some of that value that I've missed out on for so long, putting money, blood, sweat, and tears into this business. I get it, man. It's tough. And I sit here listening. I think I'm 40...I was born in '80s, what? 44? Should be pretty easy math, will be 45 this year. To think about selling off parts of the firm now just seems absolutely crazy to me. But at the end of the day, if you've been focusing on building good talent and you want to be able to put your next generation in a good position to succeed, you someday don't wait too long. I get it, but don't wait too long.

David’s Advice For Prospective Successors To Start The Conversation [1:25:27]

Michael: Yeah. So then, what advice would you give to the perspective successors trying to open the door and do this? For all the discussion around succession from the founder, and the number one thing I hear from successors on the other end is, "We're on the seventh year of the five-year succession plan, but he says he's really going to start it this year. And I'm still waiting." So, what advice would you give to the successors that really are actually eager to buy in maybe not 100% of the thing in a single year in a giant bank transaction. But if I want to get succession planning started and I'm having trouble because the founder can't quite seem to get there, even though we've been talking about it, what advice do you give to successors that are trying to figure out how to get this going?

David: I would say the first piece, and I say this to a lot of folks and don't necessarily probably always like to hear it, but for the successor, no, you're not ready. For the founder, know that they will never be ready. And also, as the founder, when you started your firm, you weren't ready. None of us are ready until we do it. So, make sure if you're going to be doing succession planning, I don't care where you're at in your career, and if the succession buy-in events five or ten years off, you're never going to be ready until you do it. You'll figure it out if you've got good people. For the actual successor, be a sponge and work your rear off. And I'll try to keep it peachy, but work your rear off. They say, "Work smart, not hard." Do both. At the very least, just work hard because there'd be a lot of folks that, especially in this industry, because of the recurring revenue, they just don't work as hard as many folks probably should.

So, for the next generation, work hard, be a sponge, two ears, one mouth. Do more listening than you do talking, which frankly, again, is part of why I'd love to see the succession planning happening. Because if you got two ears, one mouth, and you got a good team of successors under you and they're listening, there's a lot that they can learn. And when advisors list their practice and sell with us and they retire, or they sell to a peer and they exit in 12 or 18 months, they can still get a good value. But I know it doesn't affect them directly. But you think about it from an industry perspective, Michael, just the brain drain on the industry, if folks don't do this kind of proactive succession planning with their teams, how much knowledge they take out of the business about the industry, the investment strategy, the products, the clients, and the families? It takes a lot of time to get all that intellectual capital out of a founder's head that's been accumulating that stuff for 20 or 30 years.

What Success Means To David [1:28:03]

Michael: So, as we wrap up, this is a podcast about success. And just one of the themes that comes up is literally that word success means very different things to different people. And so, you, to me, ironically, have built a successful business around succession planning. The business is in a wonderful place. How do you define success for yourself at this point?

David: I would say initially creating something that can exist independent of me. Again, we might eat my own cooking, ascribe to our own philosophies. So, certainly, creating something that can exist without me would be a key attribute of how I would define success. Also, that provides a positive impact on the industry. Obviously, we work on mergers and acquisitions and valuations in the financial services industry. But I don't care if I was in real estate or some other profession, software. I want to be able to create something that can exist independent of me. Maybe you call that leaving a legacy. I won't go that far yet. I'm only in my 40s. But also, it has an impact on the industry. And frankly, the last one checkbox would be enjoying what I'm doing.

Michael: Enjoying what I'm doing. I love it. Well, thank you so much, David, for joining us on the "Financial Advisor Success" podcast.