Best Practices For Internal Succession Planning Of Financial Advisory Firms

A Review Of The Internal Succession Issues To Consider In Pursuing “Success And Succession”

Independent advisory firms are born from the desire of a founder to do things his/her own way, combined with the sheer willpower, perseverance, and “grit” to build from scratch a business that can execute the founder’s vision. In the early years, the founder has little choice but to do ‘everything’ in the business – as there’s nobody else to do it – and even as the business grows, it’s hard to let go of that “nobody else is going to do it so I have to” habit. The firm is “founder-centric” in the truest sense.

Yet as pointed out in the recently released new book “Success and Succession” (by Eric Hehman, Jay Hummel, and Tim Kochis, due out in the fall of 2015), it’s this exact “do everything to execute the business vision” attitude and independent spirit that becomes one of the significant blocking points of a successful transition to an internal successor – for the simple reason that ultimately, a successor who takes over an advisory firm has his/her own vision of what that business can now become, and may have a different way of executing that vision, especially given the depth and infrastructure of the advisory firm at that point.

In other words, one of the key points made in “Success and Succession” is that while the advisory firm founder may feel like he/she is a “painter” who has creatively painted a business out of nothing, a successor who is buying the business is not trying to buy the founder's painting to hang on the wall, but one to which he/she can add some brushstrokes to make it their own. Accordingly, one of the fastest ways to ruin a succession plan is for a founder to insist that the successor can’t do anything to change the painting being sold. In other words, ultimately a successor doesn’t want to just execute the original founder’s vision, but to transition the business to make his/her own mark as well.

Of course, the transition away from being a “founder-centric” firm is difficult. In the real world, it quickly becomes not only an issue of just transitioning the actual operation and management of the business, but the emotional issues that arise when the founder’s own identity is so intertwined with the firm that stepping away from the business is like losing one’s own sense of self. And of course, for a business that has built significant enterprise value, the succession transition has significant financial ramifications for both the founder and the successor as well.

In recent years, much has been written of the challenge of succession planning from the perspective of the advisory firm founder and the consultants who work with them, but what makes “Success and Succession” unique is that its authors include two individuals (Hehman and Hummel) who have gone down the path of succession as internal successors (including one who went literally from the firm's first unpaid intern to the successor CEO!). Accordingly, the book brings the unique perspective that ultimately, a successful succession plan is high stakes for both the founder and the successor, which means both have much at risk if the plan fails, both have much to gain if it succeeds… and it’s that connection of shared risk that actually creates the bond necessary to push through the inevitable operational, financial, and emotional conflicts that arise to achieve a succession success.

Operational Issues Transitioning Away From A Founder-Centric Advisory Firm

While there are many operational issues to manage in the process of executing an internal succession plan, the biggest one to tackle is the transition away from being a “founder-centric” advisory firm in the first place.

The starting point of creating a firm that can outlive its founder is to transition client relationship responsibilities; after all, if the founder is going to exit the business, and the business wants to sustain, it needs a way to sustain the client relationships without the founder’s ongoing involvement! And as the authors point out, transitioning clients is not merely a matter of who does the client work, but who ‘runs’ the client meeting, controls the agenda with the client, and ultimately where people even sit in the meeting. If the client is going to perceive the ‘new’ advisor as their primary advisor going forward, that person eventually needs to control the meeting, and figuratively (or even literally) sit at the head of the table. Though at the same time, successors need to be cognizant that it can be very difficult for the founder to sit “second chair” after driving the business and the client relationships for so many years!

Notably, though, moving away from being founder-centric is not just about transitioning clients to a successor advisor (although that matters, too); as the “Success and Succession” authors put it, “a client succession plan without a management succession plan is not a real succession plan.”

In fact, as other succession planning experts like David Grau have noted, the authors also advise that a succession transition of management will itself take time – potentially even more time than the transition of ownership/equity itself. In other words, ideally the successor should begin to take on greater responsibility in the years leading up to the ownership transition, rather than trying to shift power and responsibility all at once, where the paperwork is signed on a Friday afternoon and suddenly the successor shows up as the new CEO for the first time on Monday morning.

The fact that the timing of management transition may be separate from the timing of ownership transition also illustrates another key point in the successful execution of a succession plan – that in the end, ownership and management are actually separate parts of the business. While making such a distinction is generally a moot point in the early days of an advisory firm, when the founder is the owner and manager (and likely almost every other role as well!), as the firm grows such a separation of ownership and management becomes essential.

After all, it’s almost impossible for an advisory firm to be “run by committee” as the number of (successor) owners increases. And more generally, for a successor to really be willing to “buy in” (both mentally and eventually financially), it’s crucial that the successor feel empowered to chart his/her own future course for the business, even if the full equity ownership transition has not yet occurred.

Is Buying Into An Advisory Firm Financially Riskier Than Starting One?

Starting an advisory firm from scratch can create a huge “income gap” for founders, with years of taking little or nothing out of the business and making “no” money – a very significant challenge, and a material financial risk to launching an advisory firm. Fortunately, the sale value of successfully building a firm goes a long way to compensate for this risk!

By contrast, it may seem like a successor buying into an advisory firm has a much easier and “less risky” proposition, given that the business is ‘already’ built and already has revenue and clients. Yet the reality, as the authors note, is that in facilitating a succession plan, the successor takes on a unique risk that the founder never faced: an enormous pile of debt used to finance the purchase of the business, which is also a debt for which the buyer often has to pledge virtually all personal assets as recourse!

In other words, while the founder of an advisory firm might have taken the risk of starting from scratch and failing and going years without any clients, revenue, or income, in pursuit of building a firm worth hundreds of thousands or even millions of dollars, it’s crucial to recognize that the successor faces the ‘unique’ and significant risk of taking on hundreds of thousands or millions of dollars of debt to buy that firm! In fact, one might reasonably argue that the successor is actually engaging in an even riskier path than the original founder, especially if the firm does not have sufficient profit margins to weather difficult times, and/or cannot retain its clients and maintain its growth momentum! If the founder failed, he/she could simply move on to another endeavor; if a successor fails, the debt is still due, and an advisory firm has few assets to cover that debt outside of the (hopefully!) recurring revenue of the clients!

Of course, a successor can at least partially self-manage this risk by not buying as much of the firm in the first place. Yet the challenge is that any ‘upwardly mobile’ ambitious young successor probably isn’t going to be excited about "just" owning 1% of an advisory firm either (at least not given the size of most advisory firms in practice today). If the current advisory firm is where the successor is going to hang his/her hat for the long run – potentially the rest of his/her entire career – then the size of the stake needs to be meaningful enough to support an entire career, notwithstanding the amount of risk that must be incurred to make it happen.

In addition, it’s also crucial to recognize that for a purchase to be appealing to a successor, the business needs to have growth and upside potential from the point of purchase. In other words, while a founder may be quite happy and content to simply continue taking healthy profit distributions from a sizable advisory firm, most internal successors are not like private equity firms, content to simply buy access to a share of those profit-distribution cash flows for however long they may last. Instead, just as the founder created and built a business that increased in value over time, so too does a successor want to buy into a business that will grow and increase in value over time, to justify the sheer amount of risk inherent in taking on so much debt to buy the firm in the first place.

In other words, for most successors, it’s not enough to ‘just’ buy a share of a $500k or $2M or $10M+ value business that pays out healthy profit dividends to its owners. For a 30-something year old buying in, it’s about what the firm may be worth decades from now; it’s about growing the value of the $2M firm to be something that is worth $10M, or the $10M firm into something worth $50M, to create the long-term upside that compensates for the risk (just as the founder took the risk of building from zero and is enjoying the benefit of what’s been created in the process).

This distinction is important because it sets up a classic ‘conflict’ for an advisory firm around its financial management, especially for any time periods when both the founder and successor generations co-own equity in the business. Founding owners may prefer to just draw on their "dividends" and profit distributions, but successors are more likely to want to reinvest some/most/all the profits into the business to grow the equity value for the future - just as the founder did at a similar age in the early years, when the founder wasn’t taking much of any money out of the business either! Which means that while a successor may be willing to pay the founding owner for his/her share to fund the founder’s retirement, it’s far less appealing for the successor to use the ongoing profits to fund the founder’s ongoing retirement lifestyle while the founder remains tied to the business.

In fact, the authors even suggest that some advisory firms may want to look to arrangements that include “mandatory” retirement dates, or age triggers where equity must be sold. As they note, “advisory businesses [as service businesses] are meant to be owned by those actually currently working in the business” and the existence of absentee owners who just want to draw on dividend distributions can create a significant conflict with ongoing owners who are still trying to build for their own future. At a minimum, successors and founders need to recognize the importance of creating a “distributions vs reinvestment” policy for the firm, seeking to strike a balance between the goals and desires of each generation given their respective stages of life.

Ultimately, this dichotomy also re-emphasizes the importance of separating ownership from management of the firm, as owners may have different goals at different times, and vesting responsibility in management to run the business as a business helps to ensure that the business is operated in a manner that sustains the business.

The Emotional Challenges Of Executing An Internal Succession Plan

Notwithstanding the operational and financial challenges, the “Success and Succession” authors note that in the end, it’s the emotional issues of the successor and founder that can create the biggest challenges when executing a succession plan – a perspective strongly supported in a recent white paper by industry commentator Mark Hurley of Fiduciary Network as well.

From the founder’s perspective, the problem is that in a founder-centric business – so common with most independent advisory firms – the founder’s own personal identity is wrapped up in the business, to the point that selling and exiting the business can feel like a loss of self. Not unlike the retiring client who finds themselves feeling lost due to the disconnect from work, its sense of purpose, and its social support system, so too can founders struggle greatly with the transition out of the business.

Except as the owner of the business, the emotional challenges of the transition can manifest as roadblocks to the succession plan itself. In fact, the authors note that often disputes about the terms of a succession agreement are less about the terms themselves, than as a substitute for some emotional challenge the owner is facing. In other cases, progress on a succession plan may grind to a halt altogether – again, often a result of the founder having fears or doubts, and deciding subconsciously that it’s easier to do nothing than face the challenge.

Of course, Hehman and Hummel note that the stress and emotional nature of executing a succession plan is not unique to the founder. The successor can be emotional too, feeling the stress of taking on significant debt to purchase a business where the outcome is still uncertain, vested with the responsibility of providing for staff as well. Not to mention the personal social turmoil of transitioning from a work peer to “the boss” of the firm. Yet a succession plan where both parties are emotional is even more challenging, even when everyone has the best of intentions; as the authors note, “Internal successions only get accomplished when there is an abundance of fairness. Emotions run high and can cause all parties to define fairness differently.”

It is here perhaps that the authors offer some of their best advice – in fact, what may seem like minor or offhand comments about tips and strategies to manage emotional issues may actually have a greater impact on successfully navigating a succession plan than anything else in the book. For instance, Hehman and Hummel suggest that it’s crucial for successors to find mentors outside the firm, to help them keep perspective as the emotional stresses of getting a deal done will take an inevitable toll. In addition, successors should encourage the founder to get outside counsel as well – ideally, a financial planner of their own (i.e., to be the founder-financial-planner's financial planner!), to help the founder understand “how much is enough” for their own financial needs in negotiating a deal. Otherwise, the successor is often put in the position of making this point, leading to a conflicted position where the successor is trying to help the founder clarify his/her own financial plan and how the business sale fits in, even while trying to negotiate for themselves on the other side of the deal. And in recognizing the importance of ‘legacy’ for most founders, the authors also point out the value of helping the firm owner establish that legacy, which could be anything from establishing a scholarship in his/her name, to naming a conference room after the founder, or something similarly important/relevant to the founder.

In the end, the reality is that as the collective first generation of financial planners (the Baby Boomers) begin to retire, we will witness the first en masse series of succession planning transitions. Hehman and Hummel have the “good fortune” of having been at the front end of that wave, and along with Tim Kochis (as an exiting founder of a highly successful advisory firm) have written a book dense with the insights, advice, and pure wisdom that come from living the reality of a succession plan. Which means simply put, “Success and Succession” (just released this week!) is a must read for any successor looking to be on the receiving end of a succession plan, in a world where there are still far too few "primers" on succession planning… and along with David Grau's "Succession Planning for Financial Advisors" would probably be a good idea for every founder looking to sell a business to read for some perspective, too!

So what do you think? Have you ever been through an internal succession plan, or are you considering one? Do the comments of Hehman, Hummel, and Kochis ring true to you? If you've been through an internal succession yourself, what else would you add to the discussion?