My fi rst foray into the world of the independent fi nancial services profes- sional occurred more than two decades ago as a securities regulator. While employed by the Oregon Securities Division, I discovered and investigated one of the largest fi nancial fraud cases in the state’s history. But on my fi rst day at work I was handed a copy of the Oregon Revised Statutes (ORS)
and the Oregon Administrative Rules and told to write up a set of proposed rules for transitioning an independent practice. The Internet was still a thing of the future, so I learned the old‐fashioned way: I picked up a copy of the Investment Advisers Act of 1940, ORS Chapter 59 on securities regulation, and the Securities Exchange Act of 1934, and I read the material, page by page; then I started asking questions.
Of my more experienced colleagues, I asked: “Can independent advi- sors sell their practices when they’re ready to retire?” and the answer was:
“Of course not; there is nothing to sell.” I then asked, “So what is the point of writing up rules for transitioning their client base?” The answer was in the ballpark of: “Just follow the rules the wirehouses use—that’s how every- one does it. There is no discernible difference between the two models.” And that answer has stuck with me ever since—just do what the wirehouses do.
Of course, that answer and its logic were wrong, but it permeates the culture of advisors to this day.
We have the opportunity to talk to thousands of independent owners and their staff members every year, and almost everyone still has some tie back to the wirehouse side of this industry. Some of you started your careers there and learned the ropes before jumping to the independent side. Others learned from a boss, a parent, or other mentors who received their training from one of the large, captive models. The wirehouse industry provides the foundation and education for most of today’s independent fi nancial profes- sionals and advisors. To be sure, there were many, many good lessons to be learned and brought over to the independent space—but there were also some lessons and tools that simply do not apply to those who own their own business.
Over the past 20 years or so, independent ownership is the story in the fi nancial services industry. But independence has an Achilles’ heel—the prac- tices die off with no one to succeed the founder. Too many practices aren’t even capable of generating a successor because of how they are assembled.
The culprit is the use of wirehouse, employee‐based compensation and reward systems that make production and sales achievements the pinnacle of a career. Not to say for a minute that these venerable institutions don’t do a lot of great things for their clients and this industry, but there is simply no need for these folks to learn how to build an enduring and transferable business—that is not a necessary task under the wirehouse model.
In the independent space, building a business would seem to be the pinnacle of most careers, and it will be just as soon as independent professionals discover the most powerful and lucrative tool they have:
equity. Equity is the value of the business separate and apart from the cash fl ow and compensation paid for work performed. It isn’t that equity is struggling to get a foothold (it’s not), but in this young industry,
70 percent of the professionals make less than $200,000 a year, and the immediate value they care about is cash fl ow; with little or no infrastructure, nothing they do even remotely looks or feels like any kind of business, and it isn’t.
The problem, however, isn’t limited to small practices or new start‐ups.
The independent professionals and advisors we work with that have annual production or gross revenues of greater than $5 million, even $10 million, almost all use some form of revenue‐sharing arrangements or an eat‐what‐
you‐kill system that rewards sales and production tied to the top line, not the bottom line. “Fracture lines” are built into the practice model as individual books or practices are built in an environment that starts out collaboratively but most often ends up creating competitors. And advisors do this over and over again as if it were the most normal and natural thing in the world—
which it is on the captive side, but Dorothy, you’re not in Kansas anymore.
It is time to dispense with obsolete practices and incorrect building tools and to recognize that the world of the independent advisor is different from being in a wirehouse. Building an enduring and valuable business should be the goal of every independent professional with annual production or gross revenues of $500,000 or more. It is time to stop “owning a job” and get to work, building effi ciently and effectively with the proper tools and for gen- erations to come. Some of the biggest challenges you’ll face in doing so lie in discarding what you’ve been taught is normal and right.
The Persistence of a Job Mentality
Correctly structuring compensation at the ownership level is a critical ele- ment to building a valuable and enduring business. Ownership‐level com- pensation cannot be determined by a chart or a survey or even benchmarking data; at this level, the common mistake is to focus on the question of how muchan owner should be paid, instead of how an owner should be paid.
Independent advisors start this part of the planning process by seeking answers to the wrong question.
The compensation system most commonly utilized by independent fi nancial professionals in this industry is some form of a revenue‐sharing or commission‐splitting arrangement. Revenue sharing is an easy and seemingly low‐risk payment system to implement—certainly, on the sur- face, easier than hiring a bookkeeper and setting up a payroll service to generate a W‐2 wage and withholding system. But the risk and true cost of a revenue‐sharing arrangement become increasingly apparent the more successful the younger advisor becomes; any value other than the share of revenue typically belongs to the individual advisor responsible for build- ing the book.
Instead of building businesses that evolve and improve from one gener- ation to the next, advisors in this industry build one-generational practices, and subsequently rebuild them from scratch with each new generation of owners largely because of these eat‐what‐you‐kill compensation systems.
For that reason, jobs and practices that last for just one generation of own- ership are plentiful; multigenerational businesses and fi rms are rare. The goal of a practice owner is one of production, and production equates more directly with cash fl ow than it does with equity.
In the independent sector, if your goal is to build a valuable and enduring business, then your focus should be on a team of advisors working together, compensated for contributing to and supporting a single enterprise, rather than building individual books and subsequently leaving with the clients and related cash fl ow they generate when the time is right.
Revenue Sharing: Heads They Win, Tails You Lose
Let’s examine this premise. You hire a 32‐year‐old advisor (we’ll call him Bob) with a newly minted certifi ed fi nancial planner (CFP) designation and a small book that may or may not follow him, but he is fully licensed (or registered as an IAR) and ready to go. You agree to a small base salary for one year, credited toward the payout structure, which is a 50/50 revenue‐
sharing arrangement. Bob turns out to be a complete and total failure. He couldn’t sell a space heater to an Eskimo or create a fi nancial plan that looks out past the end of the week. You let him go. You saved the costs and com- plexities of setting up a payroll, and you didn’t pay for what you didn’t get;
but did you win? What exactly did you gain in this arrangement?
The best argument is that you cut your losses and on that point we’ll con- cede. You defi nitely did that. But you lost a year or more in the effort, you’re a little older and thinking about slowing down yourself, and now you have to start over with a new hire. So let’s rewrite history and explore this from a different angle.
Bob instead turns out to be one of the best professionals you could have hoped for. He comes in early, he stays late, your clients love him, and most of his clients followed him. He produces $250,000 in gross revenue (or gross dealer concession [GDC] under Financial Industry Regulatory Authority [FINRA] rules) by the end of his second year, and all indications are that he’ll double that by the time he has fi ve years in with you. What exactly have you gained in this scenario?
Well, you get 50 percent of everything Bob produces, so that’s $125,000 a year by the end of year two. That’s a good thing. Bob takes the same amount of money home as his reward, a good payday for him as well. Of course, Bob hasn’t had to spend any money on desks or chairs, a computer
or a customer relationship management (CRM) system, a phone system, the offi ce space, or a computer network or the staff to make all these aspects of a business come to life, but you did. So you take your half and you pay the rent, the staff, the light bill, and other expenses, and then you take home what’s left. You own half the cash fl ow, halved again after expenses, but what about the equity—the value of the book?
After year fi ve, Bob does indeed reach his goal and now produces almost
$500,000 in top‐line revenue per year. About 70 percent of this revenue is recurring. You decide to make Bob a partner in your business and offer him the opportunity to buy in, but Bob astutely asks, “What about my book? Do you want to buy what I’ve built or exchange it for an equivalent amount of stock?”
Those are really good questions, and we hear them almost every day. You own part of the cash fl ow, while Bob owns all the equity. Bob controls the assets, and those assets (the client relationships) are portable. They may not all follow Bob as he walks across the street and hangs out his own shingle, but they could, and therein lies the strength of Bob’s negotiating position.
This example illustrates the concept that, as independent advisors, there are two kinds of value: cash fl ow and equity. This is a critical distinction that separates an independent practice from a captive or wirehouse practice.
CASH FLOW
EQUITY VALUE
INDEPENDENT OWNERSHIP
The point is that setting up a revenue‐sharing arrangement or any form of an eat‐what‐you‐kill payment structure is a losing proposition for the founder or actual owner, unless you own your own independent broker‐
dealer or custodian, a wirehouse, or an offi ce of supervisory jurisdiction (OSJ); don’t emulate these models for any other reason. Remember that most of those models are worth far less, per dollar of revenue generated, than your own enterprise. If the next‐generation advisor fails, you lose. If the next‐generation advisor succeeds, you have to buy what he or she has built and pay for it with the stock or ownership interests of your own business,
or risk creating a competitor, and you lose again. Is cash fl ow alone, after expenses, worth that cost?
Think about this from the eyes of the next generation. When younger advisors are hired into a practice with no future of its own, a practice that is tied to the life or the career of its single owner, the very natural tendency is for them to build their own practices or books. Said differently, if there is no single enterprise to invest in, they start building their own practices and that is exactly what is happening in this industry. Acknowledging that is the fi rst step toward building a business of your own that works for you.
Fracture Lines!
Revenue‐sharing arrangements and other eat‐what‐you‐kill compensation structures seriously undermine the effort to build a valuable and enduring business. Practices with more than one producer or advisor are being built with fracture lines from day one. Consider the diagram in Figure 2.3 . In this example, Advisor A, who is 62 years old, is the 100 percent owner of an S corporation. He hires and mentors Advisor B, who is 42 years old, and years later, Advisor C, who is 36 years old. Advisor A provides his younger associ- ates the bottom half of his client base and all new client referrals that are below his minimums or who are just not a good personal fi t. This fee‐based practice has a value of just over $1,000,000.
Four years later, when Advisor A is nearing retirement and is faced with a sudden and serious health condition, he decides to sell the business and
FIGURE 2.3 Fracture Lines
LLC / Corporation
clients clients clients
ADVISOR B
42 years old Production = $140,000/yr
ADVISOR C
36 years old Production = $100,000/yr ADVISOR A
62 years old Production = $300,000/yr 100% owner, S corporation
turns to Advisor B. Advisor B is interested in being the buyer, but doesn’t want to pay for his own book, and certainly won’t pay anything for Advisor C’s book. When Advisor A looks outside the fi rm, a third‐party buyer mate- rializes and offers $1.6 million for the practice, but there’s a catch. Advisors B and C must sign noncompete, nonsolicitation, and no service agreements, and/or formal employment agreements with restrictive covenants so that the buyer knows they won’t interfere with or impede the buyer’s ability to control and retain the acquired client base—except that they won’t cooper- ate. And why would they?
All of a sudden, Advisors B and C’s zero ownership positions are worth something—quite a lot, actually, as the junior advisors now have veto power over the value of their own books, cumulatively about $500,000 to $600,000 in value. The mistake most founders make is that they ask us to value the combined cash fl ows and think that they own and control 100 percent of the equity. How could they control 100 percent of the equity value when they or their practices don’t control 100 percent of the asset base? This isn’t one business; it is three separate practices. The fracture lines were built in from the fi rst day Advisor A hired each junior advisor and paid him using the industry standard revenue‐sharing arrangement.
This common example provides the junior, nonshareholder advisors with control over the assets (the client relationships) even though they haven’t invested anything into building their own businesses: no lease of offi ce space, no phone system or computer network, no employee payroll.
All these things are provided through a revenue‐sharing arrangement from Advisor A, who was willing to accept cash fl ow in exchange for the control and value of the assets in each junior advisor’s book. This is not an anomaly; this is why there are so few sustainable businesses in this industry.
The junior advisors, in turn, enjoy cash fl ow with minimal investment and risk—what we describe as “owning a job.” But what happens if Advisor B or Advisor C gets hit by the proverbial bus as he steps off the curb at the end of a hard day? He owns nothing that is transferable. His family receives little or no value even with the typical revenue‐sharing continuity agree- ment, and, with no infrastructure, the relationships he controls are gone in a heartbeat.
These built‐in fracture lines take a single practice with multiple advisors and create multiple books that, cumulatively, are unsalable and therefore end up somewhere between worthless and worth less (than they should be).
Creating a competitor is never the goal, but unfortunately creating an equity partner and investor, at least for 99 percent of advisors, hasn’t been one of the goals, either. It’s time to change that, and as an independent owner, you have the perfect tool for the job—equity.