Editor’s note: DJ Hunt is a longtime columnist with Rethinking65. To read more of his articles, click here.
DJ Hunt
One of the most discussed topics in the financial planning profession today is the lack of up-and-coming talent to replace the aging advisors and founders in the RIA space. So, not surprisingly, another hot topic is succession planning.
The private equity-backed deals — with big checks based on big multiples — are making headlines, but they carry drawbacks for both the founders of a firm and the aforementioned limited number of next-generation advisors.
In these private-equity deals, the founders are likely to retain some equity in the acquiring firm, but the younger advisors and support staff are largely left out and just become employees of the new firm. This next generation of would-be owners, collectively known as G2, face a big decision: stay put at the roll-up firm and possibly never having the opportunity to move into leadership positions or gain equity in the enterprise they’re helping to build — or leave to start their own practice.
What’s Often Overlooked for Legacy Financial Advisory Firms
A common reason selling founders give for choosing the private equity route is leveraging scaled resources for better growth. What is not mentioned enough in the discussion is that “scaling resources” very likely translates into laying off the acquired firm’s non-client-facing staff. In most succession deals involving a private equity roll-up, the purchased firm ceases to exist as a separate entity. The sign on the door is changed as soon as the deal closes, and much of the support staff are now redundant.
But for many founders, legacy is more important than squeezing the last possible dollar out of their firms. They don’t want to see everything they’ve built disappear with the stroke of a check. This is where internal succession comes into play — selling the firm to current employees.
For internal succession to work, multiple things must align. But two big hurdles must be cleared for an internal succession plan to even be possible: The founders must plan ahead and the G2 group must want to run the firm. Here’s a closer look at both hurdles.
Planning Ahead for Founding Financial Advisors Is Critical
If the founders have an interest in internal succession, they need to begin the implementation as soon as possible. Maybe even much sooner than they would expect, or G2 won’t be able to secure funding for the purchase.
Few advisors in their 30s and 40s have the ability to plunk down a six- or even seven-figure buy-in amount out of their own pocket. So, some type of financing is almost always required. If the deal is structured properly, the profit distributions the G2 owners receive on their newly acquired shares will, at a minimum, cover the loan payments. That way the new buyers don’t have to come to the table with a huge cash outlay upfront.
But it can’t work if the founders wait too long to begin selling.
If a founder wakes up sometime in his or her 60s and decides to start investigating an internal succession plan, the math for the G2s is daunting. The amount of money needed to take a founder all the way out in a handful of years is too large for one or two G2s to finance on their own. Of course, this all depends on the size of the firm. But a mid-sized RIA with a high-seven, or low-eight figure valuation could require up to 10 G2 partners to buy out a single founder. When this is the case, waiting too long to start means they’ve likely missed their opportunity for internal succession.
‘Small Bites’
The key is for the founders to start selling small pieces of the business early, even a couple of decades prior to their own retirement. This allows the G2 group to take multiple small bites of the apple as the years go by. As older loans are paid off, the newly unencumbered profit distributions can go to paying down subsequent loans or be used to cushion erratic payouts caused by market downturns.
This rolling buy-in structure allows founders to maintain majority ownership and control while G2 assumes an increasingly larger stake in the firm and more executive responsibilities as the years go by. So, by the time the founders are ready to sell their final shares and fully step away, G2 is either already largely running the show or is primed to step into the most senior roles.
G2 Leadership is Essential for Financial Advisors
Another potential hang-up to an internal succession plan is if the G2 buyers aren’t interested in running the firm or are ill-prepared to do so. Many excellent financial planners spent their career solely focused on a specific area and don’t develop an executive skillset or receive preparation on taking over leadership duties.
The founders who built their firms into what they are today wore many hats along the way. In addition to attracting clients and growing the business, they were also able to find, train and retain great employees for the jobs required to run a healthy and growing advisory firm. Some of these employees now in the G2 position haven’t had the same variety of responsibilities as the founders.
For instance, a great advisor has spent her 15-year career solely focused on being a rock star for her clients. As a G2 owner, perhaps she’s now faced with taking on some HR-management duties and finds it’s not a comfortable fit. Or maybe an operations manager asked to help with a marketing plan realizes that’s not their cup of tea. Perhaps the rainmaker who loves nothing but networking and landing big new clients is suddenly tasked with compliance work that is a thorn in their side.
When this happens, even if the internal succession plan is underway and G2 has begun to buy into the firm, a future management crisis could unfold if founders are unable to step away from the executive functions their successors are unprepared for — or don’t even want. This is even more likely in smaller firms, where there may only be two or three G2 successors. Mid-size and larger firms likely have a deeper bench of G2 talent that could potentially combine varied interests and skills to put together a solid leadership team.
The Value of Time
In a properly planned internal succession, the G2 group will continue to play to their strengths while also having the runway to develop and grow out of their comfort zones. They’ll be able to expand their skill base, rather than having new responsibilities thrust upon them too quickly. This is another big reason why founders, in general, need to plan further ahead than they currently are.
The growth process for G2 could take longer than a founder in their 60s would like, especially if they haven’t already begun the process. Often, these founders sell to the roll-up firms — not because they really want to “scale growth,” but because they are left with no choice. They didn’t plan far enough ahead and now it’s their only option to monetize and retire on the timeline they envision.
What’s Working for Financial Advisors
As a G2 owner myself, I’m a beneficiary of the planning our firm’s founders did more than a decade ago. Our ownership group has grown from three founders to now seven owners, with more to come over the next several years.
Our founders, who’ve sold small equity stakes over the years to G2 advisors, remain at the helm of the firm. But the current group of G2 owners all sit on the executive committee and are gaining invaluable experience into how the founders approach the business. In turn, the founders receive the insights of the next generation and the G2 group is empowered to take on leadership roles and give input on all decisions. Several years will pass before the G2 generation fully controls our business, and we will be well prepared to take the lead.
As our founders continue to sell shares to an expanding group of G2 owners, there will come a point when they don’t immediately add new owners to the leadership team. This is healthy, as younger buyers will have “skin in the game” via an equity stake in the firm they are helping to build while maturing in their careers and getting ready to step into senior roles when their time comes.
Maybe this is an unintended benefit to internal succession — ensuring that the next generation of advisors is as ready as they can be to carry the torch. The firms that do this well will be the places future generations of advisors want to be.
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.
