A Buyers Take on Succession Planning in The Financial Services Industry

---

In an environment where the ratio of buyers to sellers of financial advisory firms is nearly 50 to 1, it’s hardly an opportune time for me, the buyer, to be laying out my demands.  But with the current discussion regarding business succession planning being dictated by third party consultants and active sellers, I feel it is time to stand up for my fellow buyers and throw my two cents into the mix.

Buying a firm is something I have considered for quite a while.  In an increasingly competitive environment, it seems that size and scalability will become progressively important as the financial services industry evolves.  For size, scalability, and many other reasons, I am continually optimistic about the opportunity to acquire.

But for me, it’s not about throwing a blind offer at every willing seller.  It’s more than merely adding to my assets under management so I can pound my chest over an artificial scoreboard.  It’s about finding a seller, a firm, a team, and a transaction that enhances my firm’s position in an increasingly competitive world.

My hope today is to shed light on the thoughts of one willing, qualified, and able buyer.  This isn’t intended to be a complete list of all my technical considerations; it is intended to bring a third voice into the maturing discussion, that of the buyer.

Firm and Philosophy Matter…. A Lot

Finding a firm that shares a similar financial planning and investment management philosophy is critical.  It's more than that; it’s non-negotiable.  If we don’t agree here, it doesn’t make sense to move forward.  I like doing business with clients I like and who like me.  My best clients share in a mutual commitment to the financial planning process and value my expertise.  It will be difficult to successfully merge a client base and work force that operate functionally different practices.  The divisive environment is a risk that I am not willing to assume.

Our business models must agree.  Firm philosophy is essential.  Firm philosophy doesn’t mean we should operate identically, but it does mean our practices can merge seamlessly.  My goal is to find a firm that leverages our independent strengths and creates a unit that is stronger together than separate.

Leveraging our strengths can happen one of several ways.

1. We operate parallel practices. We have similar client bases in terms of net worth, age, and issues.  We implement similar investment and planning philosophies, and our firms would benefit mutually by leveraging best practices and economies of scale.
2. We operate different practices, but I am looking to expand into your market or leverage a particular area of expertise. You may have a niche practice in the targeted market I am seeking to enter.  A few examples may be a firm that focuses on employer sponsored retirement plans, business owners, doctors, or corporate executives.  The concept of evolving a practice from a generalist into specialist is a transition we are likely to see.  A strategic merger into your niche market may be a calculated strategy for business development.

I can go further and say there are many practices I won’t consider.  A firm too heavily focused on transactions or insurance, or 70-year-old sole practitioner who hasn’t met with his clients personally in years isn’t for me.  But this is ok.  With so many buyers in the market, I am sure these firms will find someone willing to open their checkbook.

The Details Matter Too

It’s quite possible that you’ve never shared your books and records with anyone.  You never needed too.  As a potential buyer, you should fully expect to share your books with me; I want to see what’s under the hood.  This is a big transaction, and I need to understand what’s involved.

You should expect me to ask questions regarding total revenue and where its derived from.  I want to dig into your clients and understand their demographics and fee structures.  A 45 year old client with a similar revenue stream to a 70 year old client might be more valuable. Only by completing this analysis can I be sure your business is a good fit for me.

It’s equally important I understand your business expenses. Do you have a key employee or office location that are non-negotiable, meaning they are coming as part of the deal.  What other expenses do you have related to E/O, overrides, office admin, rent, marketing, etc.

I want to know softer information such as how often you communicate with your clients and using what medium.  Do you meet with clients via the phone, email, or skype?  Do you meet once a year or once a month?  Do you have a specialized process that clients expect moving forward?

I’ll be asking your more questions about your business than you’ve ever had to share.  While this seems uncomfortable and direct, you should appreciate the due diligence.  The thoroughness is representative of how I operate my business, and what your clients can expect moving forward.  A systematic analysis should provide you added comfort that a deal will create a highly predictable merger leading to a greater likelihood of a success, a greater retention of clients, and a greater total earnout paid.

In the End Price Matters, But Terms Matter More

I believe we are seeking an agreement where the seller feels adequately compensated for their time, efforts, and liabilities associated with building a business.  In order to accomplish this, we must provide the seller a net annual cash flow that is sufficient to encourage them to sell the firm.  The buyer is seeking to create a positive cash flow in the long term to substantiate their investment of time, money, and expertise.

Sounds easy, right?

Unfortunately, it’s not. 1.9 times recurring revenue, 6x EBITA; I am sure you have seen the models. The existing discussion focuses too much energy on multiples of revenue as the deciding factor in coming to agreeable terms.  Depending on whom you listen to and what day of the week it is, there is an abundance of valuation approaches for a financial advisory business.  Companies like FP Transitions and Gladstone have made a business out of valuations.

And while I’ll concede it’s important to both the seller and the buyer to obtain a professional valuation, it’s more important that the seller and buyer come to agreeable terms. It’s the terms that matter.  The terms dictate how much money the seller receives after taxes and how soon they receive it.  Isn’t the total money received after taxes the number that matters?

Specifically, the terms of the agreement that adjust the purchase price are the tax treatment of the purchase price, the down payment, and the earn-out/employment contract.  It is possible to create a model that puts the buyer and the seller in substantially equal places, regardless of actual purchase price, by altering purchase terms accordingly.  To say it another way, I can easily (relatively) make a 2.4 multiple of revenue purchase price equal a 1.9 multiple when totaling after tax revenue to the seller.

Let's take a look.

Capital Transaction

Will the seller receive payments subject to ordinary income and self-employment tax, or will they be treated as a tax-favored capital transaction?  As a seller, you want a capital transaction.  It will allow you to claim the entire purchase price (over basis) as a long term capital again (assuming they’ve been in business over one year).  The tax strategy can increase the total after-tax dollars the seller receives by 25% or more, assuming the same purchase price.  Same purchase price, less income tax owed, equals more money in the seller’s pocket. All else being equal; the decision to elect a capital transaction should lower the overall purchase price.

As a buyer, the decision of ordinary income or capital transactions has the opposite impact.  When a buyer pays the seller as ordinary income, he can deduct 100% of the annual amount paid a business expense (creating a revenue neutral scenario).  When the buyout is treated as a capital transaction, the buyer must amortize the purchase price over 15 years while continuing to make payments over the agreed buyout terms (typically 3-7 years).  During the buyout period the buyer is paying out more than what he can deduct.  This means paying tax on money that is actually an expense, and a less advantageous cash flow position.

It’s worth noting two positives associated with capital transactions for the buyer.  Upon completion of the earn-out, the buyer will benefit from several years of a deductible expense beyond completing required payments to the seller.  The extended amortization schedule will create a positive cash flow effect during those years.  It’s equally important to note that as a capital transaction, the buyer is creating basis in the business.)

Down Payment

A higher percentage paid up-front means a smaller overall purchase payment. As a seller, you likely want your hands on as much of the money up front as possible.  But as the down payment represents a larger portion of the purchase price, my risk as the buyer increases.  It makes sense that by assuming more risk, I need a higher IRR to substantiate the risk. As the percentage of down payment increases, the amount the seller has at risk decreases (the more money you receive up-front, the less you have on the line).  With less at risk to the seller, will his enthusiasm in the business remain the same?  Will he be as actively engaged in the profit, loss, growth, and retention of clients?  My suspicion is not so much.

Earn Out and Employment Agreement

I want the seller engaged in the future success of the business.  I want the seller engaged in the process.  I want the seller excited about transition, and I want the seller to want to continue to grow the business.

In order to do that, I want a portion of your income tied to the success and/or failure of future business (including market performance). Having an earn-out and employment contract can make this work by being subject to the value of the retained business, adjusted for growth and loss from client activities and market performance.  This concept addresses a mutual (albeit for different reasons) concern of the buyer and seller.  Simply stated, the seller is concerned the market is going to go up right after the sale, and the buyer is worried the market will go down.  Either way, someone may be leaving money on the table.

I have the upmost respect for first-generation business owners and sellers who have built not only their practice, but have also built the profession.  I want you on my team, and I want you to share your story, both internally and externally.   An employment agreement can also help transition you, the seller, from employment into retirement, over the course of several years.  But most importantly, this can be done at your speed.

Where do we go from here?

The singular question that you, as a seller, need to answer is: do you want to sell?  Or don’t you?

I recognize the complexity linked to this decision.  You’ve built a valuable business that has not only helped others to accumulate, distribute and transfer wealth, but also allowed you to do the same.   Your business is likely a significant part of your personal nest egg.

More importantly, your business is part of your identity, your friendships, and your social network.  Your business is not only what you do; it’s often who you are. But at some point (whether, by design or other less desirable factors such as death or disability), you can’t do it on your own.

When this realization occurs, and you are ready to discuss business transition, it is important to know your priorities.  Is it most important to chase a misguided estimate such as the highest multiple or stay engaged by signing an employment agreement?  Maybe a larger payment up-front is preferred?  Understanding what is most important to the seller is important for me to know as the buyer.  Your priorities will help dictate my offering terms.

At the end of it, I am interested in transparency and fair dealing.  I want you engaged, excited, and passionate about the transition.  My goal is to create a transaction that pays you adequately for the business you’ve developed, encourages you to stay engaged, and allows you to participate in the growth.  I am looking for terms that provide adequate cash flow in both the short- and long-term to compensate for my time, my expertise, and my risk.

You owe it to your clients.  Take control of your business succession plan by engaging with a like-minded firm that has an intergenerational succession plan established.   Do what you can to avoid a forced transaction due to death or disability.  The sellers who arrive at this conclusion proactively are the sellers I want to talk to.  These are the sellers who are truly putting their clients first.

---

Daniel Zajac Compliance Disclosures:
None of the information in this document should be considered tax or legal advice.  You should consult your legal or tax advisor for information concerning your individual situation.

Advisory services offered through Capital Analysts, Inc. or Lincoln Investment, Registered Investment Advisors. Securities offered through Lincoln Investment, Broker Dealer, Member FINRA/SIPC. www.lincolninvestment.com

SimoneZajac Wealth Management Group, LLC and the above firms are independent, non-affiliated entities.