Editor’s note: DJ Hunt is a longtime columnist with Rethinking65. Read more of his articles here.
In my previous column, I laid out the do’s and don’ts of internal succession planning. In this companion piece, I’ll discuss some of the ways that G2 buyers can get the financing needed to buy into advisory practices where they are already working to hone their skills and build their books of business.
Seller Financing
The most frictionless financing method is seller financing. In this scenario, the founder takes payments, rather than a lump sum, from the G2 buyer. This method doesn’t require the buyer to provide their own capital at the outset, they don’t have to qualify for a loan, and the terms can be structured in any way the buyer and seller agree upon.
The general idea here is that the buyer now owns a portion of the business, but most (if not all) of the profit distributions associated with their ownership percentage will stay with the selling founder for the agreed upon term. This is the safest method for the buyer because if the business hits a rough patch, the buyer is not on the hook to a bank and may be able to negotiate a longer payout term with the selling founder.
On the other hand, seller financing is the riskiest strategy for the founder. The founder gets no cash up front and continues to rely on the business succeeding in order to withdraw their equity. Seller financing is a good option in a situation when a founder gets an early start on internal succession and sells a small percentage to a younger G2. In short, the founder’s risk is lowered proportionately by the amount of up-front cash they can receive.
Traditional Commercial Bank Financing
Because seller financing results in heightened risk for the seller, the most common way to fund an internal succession is traditional bank financing. Several banks now have RIA-specific lending divisions that cater to our industry. With this strategy, the seller gets all their cash up front — a much less risky move for them.
Of course, borrowing money from a bank is a riskier proposition for the buyer. Banks aren’t often loaning 100% of the purchase price to an individual (more on this below). Therefore, the buyer is required to bring some of their own money to the table, in addition to committing to make regular payments to a bank. A major business interruption –— like a market crash — could lower the buyer’s profit distributions, but that loan payment is not going away.
Banksrequire up-front capital of up to 30% from the buyer, which means that G2 advisors buying into mid- and large-size firms with higher valuations may not qualify for standard bank financing. These folks must turn to Small Business Administration loans to fund their purchase.
There are many ins and outs to SBA financing; the biggest thing to consider is that they don’t allow for “earn-outs.” This means the selling advisor must sell 100% of their shares. They can stay on as an employee or a 1099 consultant but can’t have a remaining ownership stake.
The Blended Strategy: A Happy Medium
A funding strategy that is gaining popularity blends the benefits of owner financing for the buyer and bank financing for the seller. The advisor firm itself, not the individual buyer, borrows the money from the bank and the buyer signs a note payable to the firm.
The firm likely has stronger financials than the G2 buyers, so the financing is easier to obtain. And because there is less risk to the bank, the loan terms can be more favorable — including 100% financing. This allows the G2 buyers to avoid having to provide any of their own capital, and the selling founders receive their equity in a lump sum.
With this strategy, both the buyers and the sellers (as owners of the firm) sign the bank note with personal guarantees. There is a bit of a string attached to the sellers: They guarantee the loan that is being used to buy them out, but their guarantee period could be significantly less than that of the buyers.
An Example
A founder sells a 5% stake in the firm to a G2 successor. The firm, as its own entity, borrows the entire purchase price, and the founder pockets the proceeds on day one. The terms are a 10-year note with interest-only payments the first year.
This interest-only year allows the buyer to build a “war chest” to cushion potential future business slowdowns. In addition, the seller’s personal guarantee drops off after year three, so they are clear of further obligation for the note. Like seller financing, this strategy works best when the seller intends to remain at the firm for at least a few years past the transaction date.
Additional Considerations
Advisory firms often bring in third-party valuation firms or business brokers that specialize in financial advisory transactions to help the buy-in run as smoothly as it can. These folks can do everything from valuing the business to providing the necessary legal documents to introducing bankers. The terms are always negotiable between buyers and sellers, and financing terms are based on the strength of the business and guarantor’s financials.
At larger firms, multiple founders may sell to multiple G2 buyers in the same transaction. If the total number of shares offered is matched with the correct amount of G2 demand, the deal works just like one founder selling to one buyer. One caveat is the buyers (as owners of the firm) personally guarantee each another’s loan amount. So, choose your partners carefully and make sure you have ironclad membership and operating agreements!
Don’t Forget About Taxes
The tax ramifications for each scenario should be considered as well. In seller financing, the seller’s capital gain is realized over the entire term, not all in the year of sale. With both types of bank financing, the seller’s entire capital gain is realized in the year of sale.
As for the buyer, in all scenarios shared above, the profit distributions on their new shares are considered taxable income. However, most or all of this income goes to pay off the seller or the bank, meaning the buyer is liable for taxes on income they never see. This is something that must be planned for.
Whether approaching a transaction as a buyer or a seller, it goes without saying that having competent tax counsel on your team will make sure you aren’t signing up for any nasty surprises.
At the end of the day, each firm will have sellers and buyers with different sets of circumstances. Therefore, in addition to the above strategies, there could also be any combination of seller and bank financing. Ultimately, firm founders and G2 advisors intent on an internal succession plan can find a, funding solution for every situation.
DJ Hunt, CFP, is a fee-only financial advisor with Moisand Fitzgerald Tamayo, LLC. in Melbourne, Florida. His clients include working professionals, business owners and retirees. DJ can be reached at dj@moisandfitzgerald.com.
