TRANSITION TALK

Financing for Successors

Posted by Christine Sjölin on Feb 21, 2020 10:32:39 AM

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Your principal advisor has invited you to become an owner. Congratulations! The majority of next-generation advisors are energized by the demand for and the opportunity of succession planning, but most founders are stalled leaving successors frustrated. Your challenge as a successor is helping to make the process work for everyone involved. One important way to do that is to recognize the principal owner’s impediments and to help him or her understand the process and how accessible it actually is.

The Primary Obstacle

Like you, most successors—hamstrung by student debt, mid-stride in buying homes, building families, and still growing in their careers and earnings potential—don’t have money to invest in a business. Eager founders (“G1s” or first-generation owners) may seek to remove these obstacles by gifting or granting ownership, but this can taint the relationship as G1 may ultimately feel short-changed by giving away part of the business they built with their own sweat and toil. Beginning a partnership where one side feels cheated isn’t an ideal way to launch a successful, satisfying transition. There has to be a better way. In fact, many founders and successors come together each year with plans that are truly win/win. So where does the money come from? In many cases, the answer is the business itself.

Clearing the Hurdles

For a successor to get this money out of the business, the cash flow must first be properly structured. This means reconfiguring compensation to create profit, controlling expenses to support plan goals, and maximizing revenue growth.

Staff wages make up the largest expense item for a service-focused company. Setting all professionals on a predictable, appropriate salary schedule allows owners to control this expense and plan for growth of the firm. Financial professionals often struggle with this initial step. When you look at how compensation is typically structured, it’s not hard to see why. If you own your own book, you receive 1099 income from the broker-dealer or custodian. As an employee, you receive W2 wages from your firm. If you work for a firm and manage a book of your own, you may receive 1099 income for your share of revenue production and W2 wages for your role in the business. The goal, however, should be for business leaders to structure cash flow to create profit distributions, which owners alone may access.

As an employee, shifting to a fixed salary may mean foregoing some short-term upside, but it also shows your commitment to the business’s long-term growth. As a potential successor, you can bring this up during your review, or as part of a strategic planning meeting. Whether 1099 or W2, if your compensation is based on production, the trade off is worth the predictability.

A fixed, professional salary should be in line with market rates for similarly sized businesses in your region, as well as in keeping with your own personal compensation history so you shouldn’t have to be worried about taking a dramatic pay cut. The first byproduct of restructuring compensation is (or ought to be) enhanced alignment across all professionals—owners and successors a like—with the mission to drive growth to the bottom line.

With the business’s single largest expense channeled into a fixed, predictable spend, the owners can zero in on other costs that may be depleting profitability. Even before you begin discussing ownership with your principal advisor, you can show your interest in the business’s performance by identifying ways to eliminate waste or to make more efficient use of company time and money. If the G1 doesn’t show interest in controlling their P&L or investing in your growth, you will still gain valuable insight and experience, which will serve you in future positions as an employee or business owner.

The most obvious way for you to finance your ownership investment is by growing revenue, but it is important to note that this factor comes last in financing an internal acquisition. Without bringing compensation into alignment and controlling expenses, your investment in top line growth leads to short-term gains at best and long-term disputes over ownership of clients and sweat equity at worst. Principal owners should strike a balance between owner and employee by creating a bonus structure linked to new clients or new revenue. This keeps the compensation model compelling and supports overall business value.

For many growing firms, it’s necessary to develop a system to track the performance metrics that support employee bonuses. In truth, creating a system to track this kind of data is beneficial to any financial practice owner. Like keeping an eye on expenses, tracking your own performance as well as the business’s with measurable business objectives—rather than strictly assets under management—will be a useful skill whether your career advances with your current employer or with a new firm.

Incubating Owners

Once the business has aligned compensation, expenses, and growth, you and your business’s founding owners will have a clearer picture of both the resources and opportunities present to support an internal succession strategy and can proceed toward a formal plan. Succession planning and ownership promises that remain unfulfilled are big reasons why employees vacate their positions and look for work at other firms or in other industries. This is a completely avoidable outcome if the principal owner(s) balance the risks and rewards to both parties by making the first stage of the internal succession an “Incubation Stage.”

The Incubation Stage is a formal, documented transaction that commits both parties to the succession plan but has characteristics that lighten the burden to both buyer and seller. Typically funded using performance-based seller financing, this stage provides you, the successor, an opportunity to invest in the company and experience some of the responsibilities and benefits of ownership (albeit minority ownership). As part of the equity circle, you are incentivized to maximize both profitability and value growth for the business while the founder has a mechanism to realize some of their business value at preferable tax rates. When both sides agree that their partnership is a success, together you can continue with additional tranches of ownership, which can be funded through a variety of sources.

A succession plan that is initiated in this way is better suited to accept third-party lending. The terms of the Incubation Stage allow you to establish equity in the business, which is often a requirement for bank underwriting, and to do so without a lump-sum cash down payment. The steps that make a profit-based note viable—predictable salaries, controlled expenses, and top-line growth—also prepare the business to take on outside financing. A demonstrable history of growth and profitability indicate an investment-worthy business, which banks and private equity will look upon favorably. If the partners choose to accelerate the succession plan using financing, the revised compensation structure is more efficient to satisfy loan payments and sustain future growth.

The Bottom Line

Founders often worry that next-generation advisors don’t have the entrepreneurial acumen they need to get the business off the ground, but successors aren’t building from scratch. The next stage of the business will not—and should not—mirror the last. The strongest owners demonstrate an ownership mentality before they have actual ownership stake. By encouraging the alignment of compensation and expenses you’ll help create the financial structure that supports the vision and future of the business. As a minority owner in a growing firm, you may not have control, but you will have influence, ideas and time; use these assets to invest in the kind of thriving business you want to own.

 

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Topics: Succession Planning, Multi-Generational Ownership, Next Generation, Sustainability, Enterprise

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