Commonly overlooked nuances of forgivable notes

While consulting with advisers in transition, I frequently talk with those who need transition money in order to make a broker-dealer change. While capital is appealing, it typically comes tied to details that can dramatically affect the attractiveness of the deal, as was the case for an adviser I recently spoke to.

Jon was fed up with the empty promises made by his broker-dealer. He was tired of the firm’s not following through on things agreed to during the recruiting process. Jon had decided he was done, and there was nothing left to do but find a new broker-dealer. His story was nothing I haven’t heard before. But picking up and moving to a new broker-dealer is sometimes easier said than done.

When Jon moved to his current broker-dealer, he got transition money in the form of a seven-year forgivable note that had production hurdles tied to each year’s forgiveness. Jon thought the note wasn’t going to be much of a hindrance, as he has been with the broker-dealer for six years and only missed his production hurdle in one of the six years. After explaining some of the nuances baked into forgivable notes, I encouraged Jon to find out how much of his note was not yet forgiven. The calculation shocked me as much as it shocked him. He still owed his broker-dealer close to three-quarters of what he originally received. Again, this is after being there for six years.

Jon was confused about how he could owe them such a large portion. In an effort to clarify, I broke down what happened. The following are contract nuances that are often overlooked but can dramatically affect the likelihood of having a note fully forgiven.

1) Length of the note — Broker-dealers differ dramatically in the length of time you must stay with them in order to have a note forgiven. I have seen notes range anywhere from three to nine years.

2) Forgiveness schedule — Possibly even more important than the length of the note is the forgiveness schedule. In most cases, the schedule is equally weighted each year you meet the requirements. For example, if the note is seven years old and you hit the production requirement in year one, then one-seventh of the note is forgiven. Sometimes, though, notes can be unequally weighted. If this is the case, typically most of the forgiveness will be toward the end of the note, as was the case with Jon. For example, if in year one you hit your goal, you may actually only be forgiven a very small percentage of the overall amount. To complicate this matter even further, tax implications are often overlooked as the note is forgiven. For example, if you receive a forgivable loan for $250,000 and 25% of the note is forgiven in year seven, then you will have additional taxable income of $62,500 that year.

3) Production hurdles — Most forgivable notes are tied to production hurdles that must be met in order for the years to be forgiven. Typically, production hurdles will start somewhere around 80% of an adviser’s trailing-12 gross dealer concession and then will quickly ratchet up each year thereafter. By mid-note, the hurdle typically surpasses 100% of the original trailing-12 gross dealer concession. This is another nuance that penalized Jon, as most notes read that if you do not hit your production numbers in any given year, two things can happen: The broker-dealer can call a portion of the note, or it can extend the note an additional year. The second option may sound more appealing, but it’s important to remember that some notes include an interest penalty when a year isn’t forgiven. This hurt Jon, as his note actually accrued interest in the year he didn’t hit his production requirement.

Like Jon, many advisers look to a new broker-dealer to assist in the costs associated with a broker-dealer transition. While the amount of capital that is being offered is an important factor, it may be more essential to consider and negotiate the details that define how a note is forgiven.

Jodie Papike is the executive vice president of Cross-Search, a third-party, independent broker-dealer recruiting firm that connects advisers with broker-dealers.