The compensation conundrum

Since most wealth management firms are privately owned, their founders/owners exercise a great deal of flexibility in how they pay themselves.

Some take a salary, as financial advisers working in a firm model do. Some turn down base pay, opting to take quarterly or annual profit distributions as an alternative. Others choose a combination of the two.

As original founders are replaced with next-gen owners, however, leaders are increasingly becoming more disciplined. Because of this, the independent wealth management industry has become more structured and professionally managed, meaning there is an increased focus on building vibrant, growth-oriented and sustainable businesses – as opposed to lifestyle practices, which typically have shorter shelf lives.

As a result, firms are more circumspect not just about the types of compensation founders/owners receive but how that compensation is reflected in year-end statements. To be clear, firms can build value irrespective of how a founder/owner is paid, but a good valuation expert can ensure that value is calculated correctly.

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The distribution trap

Consider the example of a founder/owner who eschews a salary, preferring instead to collect quarterly or year-end distributions based on profitability. This approach is widespread at lifestyle practices throughout the industry.

When this happens, though, it sometimes fails to recognize their contributions as an adviser and CEO, which is a problem because when the firm does its accounting, the overall payroll obligations would be lower than other, similarly sized businesses. That, in turn, artificially boosts the firm's profitability, making it seem as if the firm is more valuable than it really is.

In these instances, therefore, firms should determine what a fair salary for that position would be and plug it into their profit-and-loss statements each year as an expense. Coming up with the appropriate figure requires considering several variables, including the executive's experience level, functions performed, the size of the firm, its geographic location and the services the firm provides.

The lavish salary

Meanwhile, when a founder/owner takes a salary that is above the norm, the reverse happens: The P/L value of the firm could be considered misleadingly low. Granted, in many instances it may be easy to defend a founder/owner receiving outsize compensation, based on the value they bring to the organization.

At the same time, prospective buyers do not need to commit as much to a replacement’s salary. For this reason, it’s necessary to benchmark the executive's compensation against industry peers and apply the difference as additional earnings based on the same criteria noted above.

The lesson here is that valuation experts consider firms through the lens of earnings multiples, not revenue multiples, in contrast to the way advisers operating in an office of supervisory jurisdiction and hybrid model have traditionally put a price tag on their books of business.

Founders/owners have the right to compensate themselves any way they wish. It’s just more important now to standardize their compensation in a way that yields a clear picture of what their firm is really worth.

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Carolyn Armitage is a managing director with Echelon Partners, which provides M&A advisory, valuation, consulting and investment banking services to RIAs.