Assessing What You Have Built

There is a clever use of terms and concepts in this industry such as describing the organizational structures of independent financial practices as “silos” or “ensembles.” The basic notion is that a silo is a single book of business. The term ensemble is reserved for an actual business with multiple professionals who truly work together as a team, pooling their resources and cash flows, creating a bottom line, and then distributing profits to the owners of that business.

Silos can exist as part of a group, or they can exist as stand-alone offices, but effectively, they each have their own books of business regardless of the employment or compensation approach. Almost every one of the advisors we’ve ever worked with technically falls into the silo category. Even most of the advisors who have been around for 30 years or more and own fast-growing limited liability companies (LLCs) and call themselves ensembles are most often a group of silos. That has been our firsthand experience year after year. In fact, if we restrict our discussion to advisors with a value of $25 million or less, those for whom we have seen the data and that comprise most of the independent industry (at least in terms of a head count), we come across just a handful of true ensembles every year, out of thousands of engagements—that’s it.

Still, these terms have been very useful in that they have focused attention on what you are building, and how you are building it. We couldn’t agree more that correct structuring is critical to building an enduring business model; building the foundation is the prequel to the succession planning process. In his book The Ensemble Practice ( John Wiley & Sons, 2013), Philip Palaveev made this statement: “When you arrive at the conclusion that you want to build an ensemble practice, you will find that hiring professionals with less experience and helping them grow into lead advisors is perhaps the most reliable and most available path to building an institutionalized, valuable, large firm.” And he’s absolutely right.

Let’s build on that point and take stock of what you’ve accomplished to date. What have you built? One of the points we’ve consistently tried to make in this book is that, as an independent owner of what you do, you need different and more appropriate tools to work with than you’ve been given. To help you assess your position and to help you set your goals for the future more accurately and explain them to your stakeholders, we think a simple and intuitive shift in terminology will aid in the process. Consider these time-honored labels and the industry-specific descriptions that follow as guides for determining where you are today, and where you’d like to be five or 10 years from now:

• A job
• A practice
• A business
• A firm

We’ll be the first to admit that these categories, as described in more detail next, will need to evolve and become better defined through actual usage over time, but here’s a good starting point as to how these practical labels seem to break down in our experience:

• A job exists as long as you, the advisor or financial professional, do it. You are independent, and you own what you do, for the most part. It is your “book.” Whether W-2 or 1099, registered rep or investment advisor or insurance professional, it makes no difference—they can all fit equally well under this category. But when you stop and someone else starts, it’s their job to do, not yours, and the cash flow attached to that job belongs in whole or in substantial part to the person doing the job. Of course it is about production; in fact, it is about nothing else. You work under someone else’s roof, you own none of the infrastructure, you have no real obligations to the business other than to produce and get paid while taking care of your clients. The value of a job is tied almost entirely to how much money the producer or advisor takes home every year. There is no need for a succession plan or a continuity plan. You don’t sell a job; you leave it.
• A practice is more than just a job, often involving support staff around the practitioner and basic infrastructure owned by the practitioner (phone system, computers, customer relationship management [CRM] system, a payroll, etc.). But like a job, a practice exists only as long as the practitioner can individually provide the services and expertise. Practices are limited to one generation of ownership, and then someone else takes over—the practice is sold, or the practice is dissolved and the clients find their way to another advisor. Practices have one owner, whether formally in an entity structure or informally in terms of control over the client relationships (a book). The value of a practice typically is limited to about $1 million for a variety of reasons. The focus is entirely on revenue strength; there is little need for enterprise strength at this level. The primary succession plan is attrition, followed in second position by selling to a third party. Continuity agreements are rare, and life insurance is the primary solution, at least for the practitioner; the clients are on their own. There is little or no bottom line, and there doesn’t need to be—no one invests in this model.
  Here’s where the bigger shift occurs. If the engine of production (the means of making money) rests solely or primarily in your hands and you cannot or will not change that dynamic, then you cannot build an enduring business that will outlive you; if that is the case, you own a job or a practice. A business, if that is your goal, is designed to make the founder replaceable at some point, even as the business continues on.
• A business must have certain foundational elements in place: an entity structure, a proper organizational structure, and a compensation structure that give it the ability to attract and retain talent and additional advisors who enable this model to outlive its founder. A business is built to be enduring and transferable from one generation to the next and, as a result, is more likely than not to have an internal succession plan fueled by multiple owners from multiple generations. It operates from a bottom-line approach, and earnings, for the first time, begin to reward ownership and investment in the business. Many businesses still bear the name of the founder, and are working through compensation issues and the effects of revenue-sharing arrangements and are prone to creating competitors rather than collaborators, though they see the problem and are taking steps to try to address the challenges; the leadership is aware. Culture is increasingly important, though many businesses find that they may need to adjust and adapt to a different culture in the future. Continuity agreements are common and take the form of a shareholder agreement or a buy-sell agreement. The value of an independent financial services or advisory business ranges from at least $1 million up to about $10 million. A business gains its momentum and cash flow from revenue strength, and its durability and staying power by developing enterprise strength.
• A firm is an established business, but in addition, it has achieved its value in excess of $10 million, at a minimum, by building a strong foundation of ownership and leadership by recruiting and retaining the very best people in the industry. A firm has multiple generations of ownership with key staff members vying for an opportunity to earn the right to become a partner and invest in the firm. It operates primarily from a bottom-line approach, and earnings are the measure of success, at least as important as production and growth rates. Profit distributions are the variable portion of an owner’s compensation. Continuity agreements are a given, and the firm assumes the natural ability to weather the deaths or early retirements of its current leadership group over time. Collaboration among owners and staff is the rule. A firm emphasizes company-wide coordination of decision making, a group identity, teamwork, and an institutional commitment. The goal isn’t to have the best professionals, but rather to have the best firm. Getting into a firm as a new hire is difficult. New hires not only must have the requisite skill set, but they also must fit into the culture and help it to thrive even as they work hard to support everyone around them.

In this book, from this point forward, when we use terms like practice or business or firm, those terms will be used specifically and within the context of the preceding definitions. We think the independent industry, in terms of a head count, fits into each of these categories approximately as illustrated in Figure 3.1.

Remember that while this is an industry with a relatively high average age, the typical level of production or revenue generation per financial professional or advisor at the major independent broker-dealers, custodians, and insurance companies is less than $200,000 per year—in many cases, much less. These professionals represent an incredible opportunity for business builders and for one-generational practices that need a second generation of talent to work with, mentor, and plan for, or even possibly just to acquire.

It really depends on what your end game strategy is: What do you want your practice to do for you as you grow older? Do you want to build a business that can provide you with a lifetime of income and benefits and purpose? You do have a choice, if you build with the right tools and execute a sound plan with the right goals in mind.

A Building Problem, Not a Planning Problem

Advisors are not planning for succession and failing—they’re not planning at all. And why would they? This is an industry of one-owner jobs and practices that were never intended to grow into enduring businesses (ensembles) or firms (super-ensembles as they are sometimes called). Planning alone cannot fix a structural issue, or worse, a series of structural issues. In fact, planning is not the problem; building is the problem. Once we collectively improve on the assembly methods and the tools, building valuable and enduring businesses will be as natural and normal as, well, providing long-range, multigenerational financial advice.

The wirehouse tools that have been borrowed as building implements by advisors place no value on business building and never had use for equity management in a cash flow only environment. As a result, most advisors and financial professionals don’t even try to set up a formal succession plan—the thought never even occurs to them. If your goal is to progress from a job or a practice to an enduring business, you first have to build an organizational structure that can withstand the test of time. It isn’t that hard to do, but it is best accomplished as part of a comprehensive plan, and ideally, well before designing and implementing your succession plan.

The common starting point for most advisors is a sole proprietorship model—a single advisor compensated on the basis of some form of revenue-split or eat-what-you-kill (EWYK) system, often working under someone else’s umbrella. It resembles Figure 3.2.

This basic production-based or advisor-driven model is extremely adaptable and simple to establish and operate. If this model is set up with any type of revenue-share or EWYK (short for “eat what you kill”) system, it is all about owning a job. Over time, as the competitive elements begin to outweigh the collaborative attributes, advisors progress from owning a job to owning their own small practice, and it looks more like Figure 3.3.

Unfortunately, these common starting points are often mistaken as building blocks for larger, more sustainable business models; it appears to be as simple as doubling the cash flow by doubling the number of producers. In a wirehouse model or even in an independent broker-dealer, custodian, or insurance company, this is exactly the way it works and has for a long, long time. This results in a very common and predominant business structure in the independent financial services industry illustrated in Figure 3.4.

This structure, for years generically described as a “silo model,” is what we call a “practice,” which is exactly what it is. A practice presents one common business name and structure to the advisor’s clients and to the public, but the nucleus of the model, the corporation or limited liability company (LLC), has little or no value because only expenses are paid through its bank account. The value, or equity, is actually split between two or more advisors, each a separate, isolated production unit or book capable of taking his or her clients with him or her at any time.

From a buyer’s perspective, the practice as a whole, certainly the entity itself, has no value. Adding more and more advisors to this model may increase total cash flow, but it usually does not change the resulting equity value of the founder’s operations. This is the classic one-generational model that most advisors build almost intuitively.

The most valuable and enduring business models now emerging in the independent financial services industry are structured like Figure 3.5. This is a diagram of an independently owned business. It relies on a strong, centralized entity structure (LLC or corporation), which collects all incoming revenue (assigned from the receiving producer/financial advisors), pays out compensation (wages and benefits) for work performed (including production), and pays operating expenses. Controlling these top-line costs results in a bottom line, or profit distributions, and these profits, in turn, provide each equity partner with two essential results: (1) a return on the partner’s investment, and (2) for new owners, the means by which to pay for that continuing investment. These results are why and how next-generation advisors invest in a more valuable business rather than building their own individual books.

So, why would a highly compensated producer who receives, for example, 50 percent of everything he or she brings in want to see a change in the organizational structure toward enterprise strength and away from revenue strength? Quite honestly, he or she may not. You didn’t hire, train, or compensate your best producer to think like a bottom-line investor in your enterprise, and these folks often are paid as much as or more than most owners, with little or no risk of investment. Does that mean you have to jettison highly paid producers in favor of lower-paid, less capable producers? Of course not.

Our experience has been that about 85 percent of next-generation advisors/producers choose to physically and financially invest in being an equity partner in a business or a firm when it is offered. The rest? They already are paid and treated like owners; why sign a promissory note with a payment obligation and take the risk when the benefits of ownership have been freely offered for years? Discouraged? Don’t be—there are ways to solve the problem, but the importance of your organizational structure cannot be overemphasized, or compromised. Here is another way to think about it that many of our clients have found useful and interesting.

A Parable

Consider this parable to better understand the organizational challenges most advisors face when trying to progress from a job to a practice, and ultimately to a business of enduring value over the course of a career:

Picture a bright orange life raft floating on a dark blue, storm-tossed ocean. In this durable, well-built small craft sits an independent financial advisor. Our advisor has a paddle for propulsion, the means by which to move the raft to safer or more prosperous waters. Our advisor has the means to collect and store rainwater for drinking, and fishing tackle to bring in food for survival—the craft literally is floating on a sea of food and fuel to sustain and propel its lone occupant. Our advisor also has a compass for navigation to guide forward progress along a chosen route; or, if preferred, our advisor will just drift as the winds and current dictate. Both result in movement.

Over time, though the sea is vast, there are many financial advisors, and our advisor encounters other life rafts and other peers. Most of the time, they just pass by and coexist, easily and effortlessly competing for the same food supplies without much thought or concern. But in time, when the skies grow dark and the seas inevitably become more challenging and dangerous, behaviors tend to change. Instead of passing by each other, groups of advisors in their bright orange life rafts come together and form a group. Under the right circumstances, they’ll lash their rafts together for safety and support and form a consortium of three or four, each sitting in their separate crafts, but inextricably linked together for the duration of the event.

During this time together, our financial advisors can explore various opportunities. Synergies may develop from the group, as the paddles are placed in the hands of the strongest advisors whose task it will be to propel the group to safety. The advisor best qualified to lead and navigate will take the compass and direct the group with a single vision and set of coordinated actions. And the advisor best suited to “hunting and gathering” will be charged with collecting water for drinking and food in order to sustain the efforts of his or her crewmates—each doing what he or she does best, contributing to the success of the group. But it is just as likely that each independent advisor continues to function as a separate unit, each eating what he or she kills and each reserving the right to cut the ropes and paddle off at any time and in a direction of his or her own choosing.

One of the biggest mistakes that financial advisors continue to make is to view this group of life rafts as the pinnacle of business growth and organization, or even as the goal—as it is in most practice management circles. The mistake is to think of this loose assembly of individuals and producers as a ship when in fact it is nothing more than a flotilla, quick and easy to assemble, and equally quick and easy to disassemble. The wirehouse model and even the independent broker-dealer and office of supervisory jurisdiction (OSJ) models we currently have are poor blueprints for building a valuable and enduring advisory business.

Later in this book, we’ll talk about onboarding advisors with existing books and evaluating them as possible equity partners, and we’ll differentiate their contributions in terms of what they impact: cash flow or equity value, or both. Here is another useful way to think about these kinds of issues. Your business is the ship, and the advisor with a small book is in a life raft. In year one of the onboarding process, allow the life raft to tie up next to your ship, and to enjoy the shelter and safety and convenience your larger and more stable vessel has to offer. Over time, if the onboarding process goes well, the advisor may leave his or her life raft and find a permanent place on your ship, or, if the process does not go well, the advisor can get back into his or her life raft and paddle away. That’s what life rafts are built to do. Keep that in mind when you allow them to come alongside your ship and enjoy the efforts of your labors.

Building Your Ship

As we continue to evolve and fine-tune the more appropriate categories of building a job, a practice, a business, or a firm, let’s apply the lessons to be learned from the preceding parable. What are the practical differences between a practice and a business?

Building a ship is not for everyone, but more than 1 percent of the industry needs to do so—that is, needs to build enduring businesses. Think of it this way. If you own a job or a practice, you still need a continuity partner; you still need someone, someday, to step in and take over for you and to take care of your clients and their children and grandchildren, someone to pay fair market value and help you realize the value of one of your most valuable assets. Who better to do that job than the ship on the horizon? If you don’t want to build your own ship, then steer toward someone else’s when the skies become dark and the seas start to get rough; stay close to the ships out there. They can help in many ways and for generations to come.

Rethinking Your Compensation System

In this industry, we are firmly convinced that the early generations are building life rafts by accident; it is what advisors with a wirehouse background or training think they’re supposed to be doing, and honestly, they do it quite well. It is what advisors are told to do—that, and the simple replication of the models immediately available and obvious to every practice owner: independent broker-dealers, custodians, OSJs, branch managers, and the like. As you know, or as you’re quickly learning, independent models are unique and they require special attention and special tools and assembly methods during the foundational building process.

Simply stated, revenue sharing is a terrible compensation system for advisors who want to build a business. Revenue sharing or commission splitting or any kind of EWYK system has a seriously detrimental effect on where the value, or equity, is centered—either in the enterprise or business itself (which can endure) or in the individual producer or advisor (which is unlikely to survive beyond the advisor’s career). When compensation is tied exclusively to the top line, to gross revenue or total production, there is zero reason to aspire to ownership; there is no need to even hazard a glance at the bottom-line profits when you’re paid off of the top line. This is a great deal for nonowner revenue producers; they take little or no risk, working only the hours necessary to produce revenue, and they get paid like an owner. But that is not how to build a business.

Here is an example from a group we recently worked with:

Mark and Katie Dickson, husband and wife, operated a fee-based business in Boston, Massachusetts. The value of their 23-year-old business was determined to be $2.5 million, enough to fuel dreams of a comfortable retirement. Mark and Katie were well-educated and experienced owners and collectively held the credentials of CFP, MBA, and CPA, and Katie was an OSJ as well. They were each 50 percent owners of an LLC taxed as an S corporation. Mark was 58 when we met him; Katie was 54. Mark and Katie had two key employees, Karl and Christina, and together, they wanted to design and implement a 20-year succession plan that would allow Mark and Katie to gradually retire on the job starting in their mid-60s.

The business was flourishing in most respects. In addition to substantial business value, Dickson Financial Partners, LLC, enjoyed a strong annual revenue growth rate of 14 percent (an average over the preceding five years), and spent only 38 percent of its revenue on overhead, not including owners’ compensation. Payroll, occupancy costs, advertising, and information technology (IT) expenditures all benchmarked favorably against their level of competition. They performed annual valuations and tracked the growth of their equity value carefully.

Karl (age 39) and Christina (age 35) had no clients when they were hired by the business some years before. They were paid on a revenue-sharing arrangement and encouraged to “build their own books,” and build they did. Whether with Mark and Katie’s donated smaller clients or clients they found on their own, Karl and Christina managed to each build substantial recurring revenue–based books without ever having to invest or risk their own money in building an office or the infrastructure to support their production goals. And they didn’t really have to worry about much other than production, which contributed to the high, sustained growth rate of the enterprise. Mark and Katie took care of everything from staffing to the phone systems to the IT issues, all in exchange for 50 percent of the revenue Karl and Christina produced. What Mark and Katie didn’t pay attention to until too late was the equity value of the separate books.

Very recently, Mark and Katie were delighted to welcome Karl and Christina into the ownership circle and offered them each a discounted and seller-financed opportunity to become partners in the business, cumulatively buying 25 percent of their ownership in Tranche 1 of the plan. Karl and Christina were honored to be asked, but then responded with a series of unsettling questions:

• “Why would we buy our own books?”
• “How much stock are you granting to each of us in exchange for the books we’ve built?”
• “Why would we want to become minority owners and at-will employees when we already own and control our own books and income streams?”

Based solely on the production numbers, Karl and Christina would be 28.3 percent and 15.6 percent owners, respectively. Legally, they owned 0 percent of Dickson Financial Partners, LLC, but they were able to negotiate from a position of strength. They didn’t want to leave and set up their own practices, and in the end they didn’t have to. The deal got done and Karl and Christina ended up with 25 percent of the ownership of Dickson Financial Partners (worth $625,000), and a salary increase.

In the end, Mark and Katie realized that they had nearly made a $1.1 million mistake and created two potential competitors rather than two potential partners. Almost 45 percent of their cash flow could have walked away. Instead of selling a 25 percent stake in their business, they exchanged ownership for control over books they watched and enabled to be built.

Mark and Katie had managed over the years to retain 100 percent of the ownership and control of their LLC, but they failed to realize that they were slowly and certainly transferring away over a million dollars of that equity by saving money and using a simple revenue-sharing approach.

Balancing Revenue Strength and Enterprise Strength

Creating substantial and enduring value in a professional services business over the course of a career is a multifaceted challenge that will demand adjustments or improvements to a number of primary value drivers and support mechanisms. In addition to the more obvious elements of cash flow and incoming revenue, equity growth and management strategies also depend heavily on certain foundational elements such as the entity structure, the organizational structure, compensation methods and profit distributions, ownership tracks, and talent management initiatives—elements that speak to the strength and ability of an enterprise to grow and retain value over time.

By our estimate, 95 percent of advisors focus primarily or exclusively on revenue strength elements (the function of owning a job or a practice). The analysis of revenue strength covers an array of benchmarks, but focuses on the areas of revenue production, cash flow quality, pricing competitiveness, and efficiency.

Most independent financial services professionals and advisors understand how to build revenue strength (increasing the number of good clients and retaining those relationships); the challenge in making it to the enduring business level lies in building enterprise strength. Enterprise strength is a term we use to refer to a financial services business’s legal and organizational structure (including its compensation systems)—in other words, its infrastructure. Are the necessary people, tools, and resources in place to build and support an enduring and transferable business over time? Can the business survive and prosper after its founder’s retirement, death, or disability? Is it one valuable and enduring enterprise or many smaller, individual books that are just as likely to become competitors as collaborators?

Increasing both of these business components may seem like a sensible approach to increasing business equity, but the process becomes more problematic in achieving the end result over time. For example, increasing the number of clients and retaining those relationships as a business’s leadership ages may require a substantial investment in staffing, training, and operational capacity, while pursuing a strategy of significantly increasing the revenue generated per client may require a change in culture, deliverables, skill sets, and operational systems. In either case, any increase in revenue that is accomplished by emphasizing one strategy or the other does not directly correlate to an equal or proportional increase in the equity value of a financial services business, nor its ability to sustain the rate of growth and to realize that value upon transition.

As a quick aside, ever wonder why there is such strong buyer demand for practices (today’s buyer-to-seller ratio is 50 to 1)? Imagine if you were selling your home and had that kind of demand, in just the first 10 days! There may well be a number of good reasons, but consider this: The average buyer tends to be two to three times the size of the average seller. Big is buying small, and the motivation seems quite logical. Practices (see the previous definition) have an inherent limit on value because of how they’re constructed. The highest value we’ve seen in the past several years, expressed as a multiple of gross recurring revenue, is just short of 3.0 times trailing 12 months revenue. The average multiple of fees or trails, as depicted in Figure 3.6, is 2.36 times trailing 12 months revenue. But businesses are more valuable; when sold internally, they tend to generate a much greater return, something in the neighborhood of 6.0 times trailing 12 months revenue based on the starting point of the plan, not including wages and benefits for the duration of the plan. Every dollar of revenue acquired from a practice and placed into a business with a balance of revenue strength and enterprise strength becomes worth far more.

Enterprise strength is not an elusive or difficult goal to obtain, if you know what you’re doing, but it is not a building step many practice owners concentrate on. That’s unfortunate, and that needs to change if your goal is to build a business of enduring and transferable value. Continue to focus on the concept of building a foundation for success before you begin the succession planning process. The three areas to focus on are your organizational structure, your compensation structure, and your entity structure. Having covered the first two earlier in this chapter, let’s focus on the final and most straightforward of these three foundational elements: entity structure.

Selecting the Right Entity Structure

Based on a steady stream of data from over 1,000 valuations per year, we know that eighty percent of advisors with values of $1 million or more are set up as an entity (S corporations or LLCs are the most popular models among advisors); above $5 million in value, close to 100 percent of advisors are structured as or make use of an entity. This is not a coincidence, as size and structure are directly related. Businesses require more than one person to run or administer them, and entities can accommodate that fact better than sole proprietorships or even teams. If you want to build a valuable and enduring business, set up a formal entity; that is step one in the implementation process and is a step best taken well in advance of designing and implementing your succession plan.

A sole proprietorship, or a corporation or an LLC with just one owner, will come to an end with the retirement, disability, or death of its owner; it is built to die. A corporation or an LLC with multiple generations of ownership serving multigenerational client bases, on the other hand, has the ability with proper planning and staffing to last well beyond any one advisor’s career or lifetime, and to create an enduring business with significant transferable value. This business value or equity, in turn, can support a variety of sophisticated succession plans for the founding owner and key staff members.

In this industry, we see the following structures used most frequently in the independent space:

• S corporation
• Limited liability company (LLC) taxed as a disregarded entity
• LLC taxed as a partnership
• LLC taxed as an S corporation

We come across some C corporations (occasionally as an LLC tax election) and a few general partnerships, but not in significant numbers. C corporations tend to be the entity of choice for older and larger firms (more than 20 years old and above $20 million in value—the 20:20 Club), but not so much for the practice models. We also set up and work with teaming arrangements that don’t involve the use of a formal entity (usually due to compliance issues within the broker-dealer or insurance company). For the most part, S corporations and LLCs are the predominant choices by advisors.

One of the keys to building an investor-worthy business, or at least one of the more straightforward routes, is the use of a tax conduit, because it helps to channel money to the bottom line, a function that solves a number of important building and compensation issues. C corporations can work, too, but most advisors we talk to with this entity structure channel all of the cash flow out as compensation to avoid double taxation, providing no return on investment to next-generation advisors.

For those of you who reside in the realm of the sole proprietor model on the advice of your tax or legal counsel, understand that the benefits of proper entity structuring reach far beyond liability and tax issues. Establishing an entity structure and using it correctly can provide an excellent continuity solution as well as additional long-term strategic planning opportunities. Utilizing an entity structure along with ongoing, annual valuations to monitor equity can help retain and propel the next generation of advisory talent, which in turn can perpetuate your business while providing you with an income stream for the rest of your life. These common goals are almost impossible to achieve through a sole proprietorship.

One of the major advantages for owners who operate as an entity is the ability to transfer or sell small, incremental ownership interests to next-generation staff members, and create two or more owners of one financial services business. For example, a founding owner can set up an internal ownership track and gradually sell 5 percent, 10 percent, or 25 percent of the business to one or more key employees, paid for over many years in a series of tranches while retaining control, a process that is part of FP Transitions’ “Lifestyle Succession Plan,” explained below. The ability to create multiple owners in one enterprise, as you’re learning, is the perfect antidote to the revenue-sharing, individual book-building approach that has created an industry of one-generational practices.

Note: Even though an entity cannot be paid securities revenues under Financial Industry Regulatory Authority (FINRA) rules, almost all independent broker-dealers permit advisors to contribute their earned revenues into a corporate bank account that pays expenses, including salaries. To be on the safe side, all owners should be properly licensed in order to participate in these structures and to receive profit distributions. Fee-only Registered Investment Advisers (RIAs) are a different matter, and are typically a little easier to work with in this regard. If you’re FINRA licensed and you’re not sure, check with your compliance department beforehand.

Remodeling Your Cash Flow

In order to build an enduring business—something that can outlive you while providing a lifetime of benefits and income through your succession plan—an independently owned practice needs to be repowered with next-generation talent. In fact, as the value, cash flow, and complexity of the business grows, most succession plans involve not just one next-generation advisor, but a succession team with owners filling specific roles in the enterprise. As a founder, don’t be afraid of this change. Embrace it, because it cannot unfold and it cannot be successful without your help; you’re the cornerstone and will be for a long time to come.

To assemble this team, the founding owner has to be able to draw younger, talented advisors into the ownership circle and help them answer a couple of important questions: (1) “What am I investing in, and why?” and (2) “Where does the money come from to enable me to buy into the business and, one day, to buy out the founder or senior partners?” Proper cash flow modeling is the key to helping next-generation advisors invest their money and careers in the business in which they work, because it helps to create a bottom line or profit distribution in an LLC or an S corporation. Profit distributions, actual profit distribution checks issued several times a year to all owners, serve as the practical answers to those questions. Creating those distributions is one of the key steps in transforming your practice into a durable business.

In this book, we’ll assume that all current and prospective owners are actively involved in the business, and are properly licensed or registered to provide services or sell products that generate revenue and help the business pay its bills and grow. In other words, succession planning in this industry tends to be about active ownership, not passive ownership. With these basic assumptions in place, the following is an explanation of how to create a bottom line or profits that attract and reward active, next-generation advisors.

Let’s start with how cash flows through an independent advisor’s S corporation (or an LLC taxed as an S corporation). Basically, there are two ways to get money out of an independent practice or business—wages and profit distributions. But there are three ways to build wealth from the same model: (1) wages (S corporations or LLCs taxed as an S corporation can and should pay W-2 wages to their shareholders), which include bonuses; (2) profit distributions; and (3) equity value.

The addition of equity or business value to the equation is essential and part of the business-building process, because the growth of equity has the lowest tax rate of the three wealth-building tools, and we’re not talking about long-term capital gains rates. Think instead about the tax on the growth of equity in your business or, for comparative purposes, your home; you don’t pay taxes on the growth of equity until the equity is realized. As a growth tool, as a building tool, equity is what separates an independent business from a wirehouse model. It bears repeating: If your broker-dealer or custodian’s practice management team cannot help you address the equity component, then they’re treating you like a practice and not a business. They’re thinking small; are you?

Referencing Figure 3.7, consider the process step-by-step from an owner’s perspective.

Production Model versus Business Model

So, if building a business with a bottom line makes it more sustainable and more valuable and sets up a strong succession plan, why don’t more owners employ this method? The answer lies in the fact that most practice owners tend to focus their efforts almost entirely on production without thinking about the trade-off in terms of equity and enterprise strength. In this section, we compare the production model and the business model works, side-by-side, and show you the math.

A typical arrangement is illustrated in Figure 3.8; assume a fee-based practice with annual gross revenue of $1 million. The producers in this model, including the owner/founder, are paid on a 50 percent revenue-sharing arrangement; in other words, everyone receives 50 percent of every dollar of revenue they produce. After paying the overhead (staff compensation, lease costs, benefits, utilities, marketing, technology, management, etc.), there is little or no meaningful profit.

Most independent practices and businesses operate as pass-through tax conduits (sole proprietorships, S corporations, and LLCs taxed as a disregarded entity, partnership, or S corporation), so actual owners may not consider lack of profits an issue. If the goal is simply to generate a good living and to have maximum individual control over the engine of production, there is nothing wrong with this approach. But consider what this same model looks like five years later (Figure 3.9) when there is little or no meaningful profit compared to the business model in Figure 3.10.

Assuming a 7 percent annual top-line growth rate for the five-year period, the production model has grown at the same rate as the business model. Both have the same top-line revenue, and both owners make about the same amount of money. So what’s the difference? Equity. The business model is worth in the neighborhood of $3 million; the production model is unsalable as a business because the nonowners control their own books and it is highly unlikely that all producers will sell in unison. In fairness, the production model is built for producer enrichment, not owner’s equity—but with the business model, you have the same production and the advantage of equity value.

In the business model, the function of controlling and gradually flattening the compensation line with a salary/bonus structure, as we illustrated in the preceding section, results in a bottom line. The profits, in turn, are reserved for those who legally own and who financially invest in the business—advisors who buy stock from the founder. Because the business model now has two or more owners who focus on the bottom line (and for good reason since it impacts their take-home pay), expenses tend to be better controlled as well. The margin between revenue growth and expense growth tends to improve, and that further improves the bottom line over time.

The profits generated in the business model are distributed approximately quarterly to the owners in the business. If minority owners want to increase their profit distributions, they will have to think like an owner: (1) grow the top-line revenue (production is still job number one), (2) reduce overhead costs, and/or (3) buy more stock. All of a sudden, the implicit value of ownership has increased without lessening the business’s rate of growth. Granted, the compensation systems we examine a thousand times a year are more varied and a little more elaborate than we’re illustrating here, but the common denominators in almost every case are some type of EWYK system and a one-owner practice model focused almost exclusively on production.

In sum, remodeling your cash flows means that things are going to be different. You will have to learn to use your financial data more effectively, and that function will make you a better owner and advisor, especially to your business clients. Once these systems and processes are in place, however, most owners find that the cash flow structure is not more complicated—it is more sophisticated. It will increase business formalities, which is to be expected as a business becomes investor-worthy. From the founder’s perspective, flexibility (in terms of his/her personal salary and distributions) is gradually exchanged for predictability and reliability, even longevity.