There are a lot of details that must be addressed and monitored in order to make a succession plan thrive. For the most part, these are not things that you have to master, but things that you should know about.
A Multiple-Tranche Strategy
Succession planning is more like running a marathon and not at all like run- ning a sprint. The race isn’t won by the swift or the intrepid; it is won by those whose businesses are still growing 20 years from now, while they’re sitting on the shores of Peter Island in the Caribbean watching the palm trees sway in the trade winds. Take that to heart. Slow the process down, and give yourself, your successors, and your clients time to adjust and ben- efi t from the processes that are unfolding. That’s how a succession plan is supposed to work.
The Lifestyle Succession Planning process sets up a pattern of gradual sales of ownership that retain the founder (G-1) in a control position until well after G-2 and G-3, the succession team, have proven themselves capa- ble and dedicated to the task of ownership and leadership and production.
Ownership is purchased (not given away) very gradually even as the busi- ness continues to increase in value over the course of years, maybe even decades. Slow and steady is the rule, provided that G-1 starts the process early enough. Regardless, the fi nancing of the transaction works best when G-2 and G-3 have the opportunity to pay over the long term and to sign promissory notes that may be six fi gures long, but preferably never seven fi gures long; having smaller bites over a longer period of time by multiple successors tends to work best.
Most plans encompass multiple tranches or steps. Think of each tranche as a separate “watertight compartment.” No matter what happens, G-1 is not obligated to sell any more stock to anyone and is not obligated to pro- ceed to Tranche 2. G-2 and G-3, similarly, are not obligated to buy any more ownership and to invest any more of their profi t distributions or take- home pay beyond the initial tranche of ownership. The idea is that everyone stands on one’s own two feet and decides whether, based on the success or failure of the past tranche, to proceed and do it again.
Of course, having a group of successors (i.e., the succession team) tilts the advantage slightly in G-1’s favor, but only slightly, and, in fairness, it offsets the risk of selling internally to one or more successors who typically don’t have any money (or at least not a spare hundred thousand dollars or two). This gradual process, enhanced by the use of drag-along and tag- along rights in the buy-sell agreement, tends to keep everyone motivated and focused on the task at hand and in moving forward with all due speed.
One last point worth mentioning is that, although the Lifestyle Succes- sion Planning process moves forward in a series of tranches, it isn’t like a 16-year-old driver letting out the clutch for the fi rst time. The process tends to unfold more smoothly when everyone is working at the process. When it works to everyone’s satisfaction, it is not at all unusual to roll up Tranche
1 into Tranche 2 and accelerate the process. Conversely, even when, maybe especially when Tranche 1 works faster and better than anyone could have imagined, G-1 has the ability and the power to slow things down and take a year or two off between each tranche before proceeding.
People who think succession planning is about losing control really have no idea how the process works.
It Is All about Growth
Every morning in Africa, a gazelle wakes up. It knows it must run faster than the fastest lion or it will be killed. Every morning a lion wakes up. It knows it must outrun the slowest gazelle or it will starve to death. It doesn’t matter whether you are a lion or a gazelle.
When the sun comes up, you’d better start running!
(African proverb) How do you get the next-generation talent pool to accept and embrace the fact that buying stock or ownership gradually in a growing business (i.e., a business they’re helping to grow) means that each subsequent purchase will be more expensive than the last? The answer is, turn that into good news by connecting those growth rates to both their take-home pay and their ability to buy more stock faster. Here’s how it can work as part of a comprehensive succession plan.
Independent fi nancial services and advisory practices have a decided advantage when it comes to attracting and retaining next-generation talent:
strong, sustainable growth fueled by recurring income sources and predict- able overhead structures. Last year, FP Transitions’ Research and Analytics department conducted a study on growth rates, titled “Independent Finan- cial Service Growth Rate Study.” Following is an excerpt from this study, along with an illustrative chart (Figure 7.1 ).
The macroeconomic exposure of fi nancial services practices to positive growth factors is unique when compared against other mature industries in the United States. Consider this: If an advisor simply maintains his or her client base, and we assume an average market portfolio for every client under management, then the assets under management for that advisor will grow at approximately the rate of market growth, before distributions. According to the Federal Reserve, the average annual return on stocks, Treasury bills, and Treasury bonds for the period from 1962 to 2011 was 10.60 percent, 5.22 percent, and 7.24 percent, respectively (including dividend returns
and coupons on fi xed income securities). For the period 2002–2011, the market returns were 4.93 percent, 5.22 percent, and 7.24 percent for stocks, Treasury bills, and Treasury bonds, respectively.
Our analysis, computed from information we collect directly from our clients, suggests that revenue growth over the 2002–2011 pe- riod was 13 percent, with the middle 50 percent of the distribution growing by between 5 percent and 16 percent annually. Our data for this particular study included practices that ranged in size from
$1 million in assets under advisory/management up to $2 billion in assets. There was no statistical signifi cance when controlled for the size of the underlying practice, business, or fi rm, meaning that the largest practices grew at the same rate as the smallest practices, on average.
Clearly this is a positive refl ection on the fi nancial services indus- try as a whole—advisors are not simply limited to the long-term growth of the markets. Independent advisors can add assets and clients to their practices, increase death benefi ts as part of the plan- ning process, and create a multigenerational asset platform to de- fray the negative revenue effect of clients and assets that are in the distribution phase of their life cycle.
In a typical succession plan, the next generation builds on top of an established business and, as a team of owners, they work together to build a stronger and deeper organization. The reward is illustrated both in the
FIGURE 7.1 Growth Rates of Financial Practices from 2002 to 2011
1%
0%
5%
0% 10%
−5% 15%
−10% 20%
−15% 25%
−20%
−25% 30%
−30%
2%
3%
4%
5%
6%
Percentage of Practices
Average Annual Growth Rates
improving multiple of gross revenue or earnings and in the total realized equity value by the founder. The fi nal results tend toward a value, expressed as a multiple of gross revenue, of about six times the starting point, not including a reasonable salary for the owner for the duration. In addition, founders benefi t from a reduced workload in the second half of the plan and a built-in continuity plan to protect business value as the practice is transformed into a multigenerational business.
The presence of one or more internal successors is intended to support and accelerate growth even as the founding owner gradually retires on the job.
This is in stark contrast to the single-owner model where production tends to decline rapidly as the founding owner works less and less as the founder nears retirement. Growth is imperative if you’re building something that can outlive you. You cannot attract next-generation talent to support your model if you aren’t growing. The ship either is under power or it is adrift.
Finally, never lose sight of one simple fact: Growth is the reason next- generation advisors invest their money, time, and careers into the process of building an enduring business, and building on top of your existing practice model. Growth provides the return on investment and the means by which ownership is paid for. Succession planning is all about sustainable, long- term growth, and that is why this is one of the steps you need to understand and build around on the path forward.
Proper Application of Minority Discounts
Minority and marketability discounts are adjustments to the fair market value of stock because the minority interest owner(s) cannot direct or control the business operations and because the minority interest lacks marketability.
G-2 and G-3 owners will invariably become minority owners. In fact, it is highly likely that, by Tranche 3, your business may never again have a single, majority shareholder. This is part of the shift from the “strong man”
approach where one person does it all to the collaborative environment where no one person can excel unless the business as a whole does well.
Understand that as a business owner, it is entirely your decision whether to offer a minority discount. If you do offer a discount, it is also acceptable to never, ever offer another one regardless of whether your next-generation staff members are purchasing another minority ownership interest. If you’re an S corporation, mind that “one class of stock” rule and be consistent in applying discounts from one shareholder to the next. Most of the succession plans we set up employ only one minority discount, that in Tranche 1, and then never again.
A minority interest is noncontrolling ownership, usually defi ned as less than 50 percent of a company’s voting shares. A minority discount, at least
in the case of an amicable buy-in situation, is a reduction in the price of stock from its fair market value because the minority interest owner(s) can- not direct or control the business operations, and because of lack of market- ability and therefore liquidity of the shares.
A minority discount applied to a noncontrolling ownership interest in a small business refl ects the notion that a partial ownership interest may be worth less than its pro rata (proportional) share of the total business. For example, ownership of a 25 percent share in the business may be worth less than 25 percent of the entire business’s value. This is so because this 25 percent ownership share may be limited as to control over critical aspects of the business, including:
■ Electing the company’s directors and appointing its offi cers
■ Declaring and distributing profi ts (dividends or profi t distributions)
■ Entering into contractual relationships with customers and suppliers
■ Raising debt or equity capital
■ Hiring and dismissing employees or offi cers
■ Selling the business or acquiring other operations
In practical terms, the applicable range of discounts is generally between 10 percent and 40 percent, though it is imperative that every owner and investor confer with his or her CPA/accountant as to what is reasonable and appropriate in each situation. The amount of the minority discount is not set or specifi cally established by law. It depends on a number of factors and is adjusted for any given situation, rather than being applied as a universal standard. Note that it is appropriate to calculate separate discounts for lack of control and lack of marketability, but the cumulative total should be within the range of 10 percent to 40 percent (see Figure 7.2 ). A discount, if offered, should be applied fairly and evenly. For example, if a 10 percent interest in the business is being sold to two members of a succession team at or at about the same time, the same valuation method and the same level of discounting (if any) should apply to each sale.
That said, here’s the practical side of this argument. Consider that in most internal sales of independent fi nancial services and advisory businesses,
FIGURE 7.2 Application of Minority Discounts to Sale of Stock MARKET VALUE
LACK OF CONTROL, LIQUIDITY, AND MARKETABILITY