Bert Herzog III doesn't have plans to step aside anytime soon from Executive Wealth Management, the Brighton, Mich.-based advisory firm he founded in 1981. But the 61-year-old already has a plan in place to ensure that his $850-million investment advisory firm that manages money for 2,500 households will continue for decades after he leaves.
In 2016, Mr. Herzog's goal of building a firm that will outlive him moved closer to fruition when he put in motion an internal succession plan that took two years to map out. He sold ownership stakes to four next-gen team members who currently range in age from 33 to 59. The deal reduced Mr. Herzog's equity from 90% to 23.75%, but provided a cash payout to fund his eventual retirement. His remaining shares will be sold when he turns 70 and retires, creating yet another path to ownership for younger, entrepreneurial advisers at the fee-based firm.
"I always wanted to build a legacy and a team that is multigenerational," Mr. Herzog said. "That's always been key to me."
He's not alone. Nearly seven in 10 (69% of) advisers said they prefer to pick and groom successors from within, according to a TD Ameritrade white paper. This internal succession process not only involves advance planning but also transferring ownership of the firm to next-gen advisers and creating other incentives for valued employees to stay and carry on the firm's legacy.
And that's the tricky part. How exactly does an adviser build ownership incentives to attract and retain good employees who in the future will become the foundation for a succession plan that will provide a comfortable way for the owner to cash out of the business?
"Continuity and succession plans are a really vital part of an investment adviser's business plan," said Carolyn Armitage, managing director at investment banking and consulting firm Echelon Partners. "The equity component is very important. Putting in place a long-term incentive plan can be an integral part of keeping employees happy."
Increasingly, promoting a well thought-out succession roadmap and timetable to both employees and clients is viewed as a good way for firms to retain and reward key players.
"The succession plan gives our younger advisers who've been so valuable to our growth the ability to say, 'Hey, we own this,'" Mr. Herzog said.
His firm's plan is also about making sure clients will be in good hands when he's gone.
"What we're transitioning toward is clients not dealing with just Bert Herzog — but dealing with Executive Wealth Management and the team as our advisers mature," Mr. Herzog said.
Selling to in-house advisers provides clients with an added comfort level and continuity of service. It also enables owners to better target successors who fit the firm's culture, investment style and diversity goals.
Steps to take
So, what are the steps to create an incentive/succession plan? Start with a talent assessment, Ms. Armitage said.
"Do you have the right talent within the firm?" she said.
While many first-gen advisers have a do-it-all mentality, it's difficult today to find one person with the skills to run a business, service clients, manage money and serve as rainmaker.
"It could be one person, or you may need three people," Ms. Armitage said.
Next, check to see if the potential successors you've identified are interested in becoming owners, and if they have the risk-taking personality needed to take out a loan to finance their ownership stake.
About one in four next-gen advisers who are offered the opportunity to buy shares in their advisory firm decide not to, said David DeVoe, founder of consulting firm and investment bank DeVoe & Co.
Many firms, he said, wait too long to offer shares, and the valuation climbs so high that the next-gen can't afford it.
"It's too expensive," Mr. DeVoe said.
The final steps are having both sides place a valuation on the firm, put together the path to equity ownership and arrange financing.
Coming up with the right deal terms and timelines for when the balance of power will shift from the first-gen adviser to the next-gen advisers is key, said Vanessa Oligino, director of business performance solutions at TD Ameritrade Institutional.
"It's like a prenuptial agreement," Ms. Oligino said, adding that all parties need to flesh out what goals and financial milestones must be met for the deal to stay on track.
How many owners?
Providing more advisers with an opportunity to become owners is a proactive way to extend a firm's lifespan.
That's the strategy being employed by Mark Feldman, CEO and managing partner at MRA Associates, headquartered in Phoenix. Since he took over as CEO in 2012 and purchased 25% of the firm, the employee-owned investment advisory firm with $3 billion-plus in assets under management has increased its number of partners from three to 11. The youngest partner is 34-years-old.
Broadening ownership ranks, Mr. Feldman said, was part of the firm's internal succession plan, as well as a tool to retain top performers.
"The talented young team members of today will be the future generation of partners," Mr. Feldman said.
The criteria he used to identify next-gen partners included leadership qualities, the ability to grow the business, high-quality interactions with clients and staff, and specialized expertise.
There are several ways to turn next-gen advisers and employees into owners. The most common is when the current owner approaches a valuable employee and offers him or her a piece of the business. The next-gen adviser typically has to come up with a 20% down payment; the balance is usually financed by a loan furnished by the selling firm, a bank or other third-party lender.
Valuing the firm accurately is the last step in transferring ownership to next-gen advisers. To get the price right, sellers and buyers should refrain from using rule-of-thumb, ballpark valuations, such as basing a deal on a multiple of revenue or cash flow, Mr. DeVoe said.
"Multiples are the wrong way to value a firm," he said. "Doing so is using math a 10-year-old child can do in their head to value a multimillion dollar business."
Instead, it's vital to analyze the firm's future profit and growth potential, cash flow, management depth and processes rather than looking at a firm's books in the rear-view mirror. Just focusing on revenue, for example, doesn't tell you how fast the firm is growing, how much of the top line is being generated by one star adviser, or identify unseen risks. Two firms might have identical revenue streams but one might be growing twice as fast and getting sizable revenue generation and other types of contributions from a "team" of employees.
"A buyer is willing to pay more for a high-growth company, and even more for a company that demonstrates a model for continued high growth," Mr. DeVoe said. "It's one thing to grow because of 'charisma.' But a more valuable business is one that can demonstrate that they've created a comprehensive, integrated, successful marketing machine. Similarly, a company that has all sorts of risks, such as no nonsolicit agreements, is dependent on a key person, or has a few large, concentrated clients, will receive a lower valuation. And rightly so."
RIA firms with $1 billion-plus in AUM are currently being valued between 6.5 and 9.5 times cash flow, Mr. DeVoe said. That compares with a valuation of 4.3 to 6.3 times cash flow for $100 million firms, and 5.5 to 7.5 times cash flow for firms with AUM of $500 million.
Many industry consultants recommend that all parties get their own independent valuation and finalize the closing price after negotiations. Others recommend hiring a reputable, independent consulting firm to do a single comprehensive analysis and come up with a valuation that all parties can trust and feel comfortable with.
To help make the deal more affordable, RIAs sometimes discount the value of the shares purchased by an internal successor, Ms. Oligino said. RIAs also divert funds from employee bonuses and dividends earned on the purchased stock to help successors pay back their loans.
Some firms share equity via employee stock ownership plans, or ESOPs. Others grant equity as part of a profit-sharing plan or overall compensation, or when performance metrics are met.
One industry trend that calls for more comprehensive succession planning is the move away from founder-driven firms and book-of-business setups and toward larger enterprises run by a handful of high-level managers specializing in key areas, such as compliance, investment research and strategy, asset management, and business operations.
That's the direction Brouwer & Janachowski, a wealth management firm in Mill Valley, Calif., has moved in since co-founder Kurt Brouwer retired a few years ago. The firm, which has $1.7 billion in AUM, put its written succession plan into action and bought out Mr. Brouwer's 50% ownership stake.
"This type of enterprise is one that can live beyond its founder and grow," said Stephen Janachowski, 62, the firm's other co-founder, president and CEO. "It requires more advanced succession planning. I have five next-gen advisers now that own a piece of the business. And my plan is to broaden ownership."
Mr. Janachowski said he plans to work at least another 10 years and will eventually sell off his ownership stake to next-gen advisers.
"I want them to feel they have a vested interest in the company," he said. "I want to win their hearts and minds. I want them to feel and act like an owner rather than view it as just a job."