The cost of independence

Christopher Bray founded Ariel Capital Advisors nearly two years ago, naming the Florida-based advisory firm after his 4-year-old daughter. Now he is being sued by Ariel Investments, a $10 billion Chicago-based mutual fund company, for allegedly infringing on its trademark. Mr. Bray, whose firm has about $225 million in assets under management, doesn't want to change his company's name and is fighting the fund company in court. But that is coming at a cost, both in legal expenses and time that could be better spent growing his young business. “I had a zillion worries when I started the firm, including possible litigation with former partners and fear my clients wouldn't come with me,” Mr. Bray said. “But I never imagined this.” Each year, thousands of advisers like Mr. Bray strike out on their own, leaving established firms to go independent. While many of these advisers try to estimate their expenses and revenue in advance, it is not an exact science. Some find that they underestimated costs and didn't account for unforeseen expenses such as those Mr. Bray has encountered. In fact, the ongoing costs of operating a business are one of the top concerns that advisers have about switching to the independent model, according to a survey by Cerulli Associates earlier this year. Typical areas that give these new business owners trouble are technology and compliance, the price of office space and the expense of hiring a staff. Projections on the revenue side can also miss the mark. Experts say some advisers don't account for how long it takes to ramp up revenue, even if they have been in the business for a considerable amount of time. “For the first six months of an RIA, revenue is not completely online,” said John Furey, principal and founder of consultant Advisor Growth Strategies. “I don't want to sugarcoat it; it's always the case.” A registered investment adviser's largest direct expense is paying professional salaries and other compensation, including their own. The total costs associated with people, including pay, benefits and training, typically make up about 75% of an RIA's costs, according to the 2015 InvestmentNews Adviser Compensation and Staffing report. “No one really appreciates the personnel costs of running a business,” said Nathan Paulson, founder of 6-year-old Paulson Wealth Management in Wheaton, Ill. “And as you add staff and grow, that just multiplies.” Since opening his firm in 2009, Mr. Paulson said, his health insurance premiums have doubled.

STAFF COMPENSATION

Advisory firms typically spend about 11% of their revenue compensating staff, and another 2% on payroll taxes, the InvestmentNews data show. The cost of providing staff with benefits equals about 2% of revenue for a solo firm and upwards of 4% for firms with multiple professionals. Office space is also expensive. Solo-adviser firms spend about 5% of revenue on maintaining offices, an expense that declines to about 3% of revenue as firms grow to at least $5 million in revenue, according to the InvestmentNews data. Technology costs, such as software, hardware and office equipment, typically are about 3% of an adviser's revenue. But technology can also take up a lot of time. Joseph Jay, who founded his own firm in 2012 and recently created a new RIA to accommodate a partner, said he invested in cloud technology that will allow the business to run more efficiently, and pays monthly to use Salesforce for its customer relationship management system and ExactTarget for email marketing. In addition to eating up revenue, the technology component also consumes a great deal of time, especially finding tools that integrate easily with each other, said Mr. Jay, co-owner of Midwestern Financial Group in Iowa City, Iowa. “We are trying to be mobile and secure and making sure solutions are encrypted,” he said. In addition to all the costs associated with running a small business, advisers bear additional expenses because they work in the highly regulated environment of financial securities, said Marc Cohen, chief compliance officer for MarketCounsel. Advisory firms with at least several hundred million dollars in revenue typically have a person at the firm who spends about half of his or her time working on compliance, as well as hiring outside regulatory consultants to help identify compliance needs and handle some of the administrative burden of federal and state securities rules. Compliance costs vary based on the size of the advisory firm, the financial models being used, the type of investments used in portfolios and the number of locations, said Mr. Cohen, who speaks with a couple of dozen prospective breakaway advisers every week.

REGULATORY COSTS

Art Haws, co-founder of Tennessee-based RIA HawsGoodwin Financial, said the expenses his firm incurred related to meeting the nation's regulatory requirements added up to thousands of dollars more than he predicted when he started his firm in November 2012. HawsGoodwin still employs a compliance consultant and an outside lawyer on an ongoing basis to make sure all required disclosures and document updates are up to snuff, Mr. Haws said. While advisers crossing over to the independent model worry about expenses, Cerulli's survey shows their No. 1 concern has to do with the revenue side of the business: fear of losing clients during a transition. Clients who decline to follow their adviser through a move typically are unhappy with investment performance, don't think the adviser was a good fit for them or believe they weren't getting the service they deserved, Mr. Furey said. However, advisers typically retain a large amount of the assets they manage for clients when they move firms because the relationship usually is with the adviser, not the institution. Clients mostly want to make sure an adviser's new business is legitimate, Mr. Paulson said.

NOT BERNIE MADOFF

When he opened his RIA in 2009, clients asked him how they could be sure he wasn't “a Bernie Madoff.” He responded by explaining that he was using outside vendors as the firm's custodian, clearing broker and reporting agent, providing clients with information from three sources in addition to his office. Advisers who moved in the past three years saw about 72% of the assets they managed follow them to their new firm, according to a Cerulli Associates report from October. Advisers leave about 9% of assets at their former firm, consciously pruning clients who won't be ideal for their new business. But the revenue assets generate does not arrive the day the new RIA opens for business. Revenue grows as client assets trickle into the new firm during the transition period. One of the costliest mistakes new RIAs make is to take on too many fixed expenses before they have realized the revenue of the new business, said Bob Oros, executive vice president and head of the RIA segment for Fidelity Clearing & Custody at Fidelity Investments. That can include leasing office space that's grander than what they need or buying expensive technology that might not be priced well for a small business, he said. “It's a dangerous strategy to build it too big, just saying they will come,” Mr. Oros said.