How Financial Advisors Can Equitize Their Employees 

There are multiple paths to equitization in a financial advisory practice — here are some considerations.

Christopher Toumajian
Christopher Toumajian

As financial advisors grow their business or plan for succession, retaining talent is key. Equitizing employees can be a big driver in this effort. If you decide to provide a path to equitization, there are meaningful ways to structure these pathways without a material impact to dilution.

If you’re looking at succession planning and creating a pathway to monetize your business, equity consideration for financial advisors and other key employees can be crucial to a smooth transition for all interested parties (seller, employees, buyer and, most important, clients). Whether you are in growth or succession mode, consulting with legal and tax specialists is highly recommended in creating a structure.

What are the different compensation structures firms can consider, and what are the pros and cons of each?

Depending on your legal entity structure (C corporation, S corporation, LLC, etc.), you may have unique options available to you. We’ll discuss some of the options available to an LLC here, as it’s one of the more common structures for RIA firms.

In an LLC taxed as a partnership, for example, there are two types of equity units that can be offered: Capital interest and profit interest.

A capital interest member has a claim to partnership assets. Capital interest units can be granted or sold by the firm to the employee. A sale of capital interest units can accomplish several goals including:

• Raising equity capital for the firm
• Immediate participation in the profit/loss of the firm, as well as distributions for the member.

Profit interest units are a type of LTIP, or long-term incentive plan. A profits interest member has no claim to partnership assets. With profit interest unit grants, an employee can become a partner of the firm without making any capital contribution. These units vest over time (typically five to seven years) and the profit interest member participates in the delta between the threshold value and sale price in the event of a liquidation or sale.

Tax and Other Operational Consequences of Equitization

There are several tax consequences to consider for both the firm and the employee when offering an equity pathway. For example, capital interest members will be taxed on their pro-rata share of earnings in the LLC. Profit interest members, while not incurring any tax when receiving their units (depending on certain personal tax elections being made) also benefit from long-term capital gains tax treatment in the event of a liquidation or sale.

As partners, profit interest member will receive their pro-rata share of earnings as well. The income tax consequences can be meaningful, as profit interest members do not generally participate in distributions. Compensation for partners becomes “guaranteed payments” and these partners are now subject to self-employment taxes and could have limits on benefits participation.

There are also operational consequences to consider, for both the firm and the employee. While capital interest units would presumably have voting rights, does the firm want to offer the same rights to profit interest members? Does the employee who is offered a purchase of capital interest units have the capital to contribute? If not, does the firm plan to provide financing? If so, on what terms?  Is the firm prepared to handle the additional administration in terms of payroll, tax preparation, maintaining the cap table, and so on?

What are signs that suggest a particular structure isn’t working — and is it possible to shift gears if something isn’t working?

Feedback from partners would likely be the clearest sign that a particular structure is not working. Shifting gears can be a complicated endeavor and difficult to unwind. Careful consideration should be given before choosing an equitization path for employees.

Alternative equity or equity-like options (such as phantom units) could also be explored if the chosen strategy does not appear to be successful. As part of a succession plan or exit strategy sale, consider passing the responsibility of equitization onto the buyer for your key advisors as part of the deal terms.

Are there any particular things to watch out for if the younger advisor is a family member?

While equitizing fellow family members is a common practice, it’s important to maintain consistent policies. For example, using the same vesting period for profit units or using the same valuation methodology for capital interest units. Failure to do so could result in resentment from other employees and fellow partners.

Another Alternative Out There: Strategic Sale of Business

Many RIAs got into business as a means to provide fiduciary advice, which meant leaving large firms. But now there are quite a few independent buyers that can facilitate a structured succession that would equitize your employees even if they aren’t looking to take over the business.

Putting the Equitization Plan into Action

Whether you’re in growth or succession mode, putting a plan into action that keeps key contributors engaged in the business can set you up for the next phase of your firm. This allows you to put your financial plan into place.

Christopher Toumajian, CPA is the Chief Financial Officer at EP Wealth Advisors



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