Chapter 5
The First Step—A Continuity Plan
A Dress Rehearsal for Succession Planning
The single biggest threat to an independent practice with one owner or one primary advisor is not the lack of a succession plan; it is the lack of a plan to protect the clients and the owner’s cash flow and value in the event of his or her sudden death or disability (temporary or permanent). In the smaller and more common one-owner, one-generational practice models, a continuity plan must often look outward for its protection and support and to realize its value, usually from a replacement owner. A properly constructed business continuity plan provides for uninterrupted client service and the protection of business value by helping to ensure that the remaining owner(s) has/have the necessary talent, numbers, and funding to continue to run and grow the business while buying out a former owner. In the context of a continuity plan, practices and businesses face very different challenges.
If you’ve built a multigenerational business or are well on the road to doing so, your continuity plan will derive from your succession plan. An internal ownership track, once implemented and in place, is the best continuity plan available, as clients’ needs are addressed by other principals who are invested in the same business; at least in theory, they cannot individually do well unless the business as a whole does well. But that process takes time to design and implement, and, currently, our estimates are that this group comprises only a small fraction of the independent industry. For the vast majority of advisors, it works the other way around: Continuity is the first planning problem to solve because it poses the most immediate and serious threat to a lifetime of work and value and the clients’ well-being. For this reason, and for most independent advisors, continuity planning is best thought of as a dress rehearsal for the succession planning process.
This conclusion, and the continuity planning process in general, is also impacted by an advisor’s age and career length. As previously noted, most advisors wait until at least age 50 before starting the succession planning process, 20 years or more into their careers. Continuity planning cannot or certainly should not wait that long regardless of the size or structure of your enterprise. Unless you’re going to set up a formal succession plan prior to age 50, you need to start the planning process with the continuity aspects front of mind, not with who will be your successor and when and how you’ll retire.
Independent financial services practices are among the most valuable professional services models in the United States. But because those same practices are built primarily around the skill set and personality of an individual advisor, that same value proposition is actually quite fragile; within a business with two or more owners, the value proposition is more durable, but not indestructible. Establishing a continuity plan to protect that value, and the client’s needs, is one of the most important and challenging aspects of being an independent financial services practice owner.
What Exactly Is a Continuity Plan?
A continuity plan is an emergency plan that assures a seamless transfer of control and responsibility in the event of a sudden departure from the practice or business of any of its owners, young or old, and whether by choice or through termination of employment, or death or disability, or even partnership disputes—okay, not always an emergency, but prompted by something relatively sudden and by things we hope don’t happen.
Remember that a succession plan is a professional and written plan designed to build on top of an existing practice or business and to seamlessly and gradually transition ownership and leadership to the next generation. The achievement of these goals, however, assumes that the founder and all the advisors who are part of that plan will live long, healthy, productive lives and that each will remain a part of the same business for the duration; but many times, that just isn’t the case. For that reason, every succession plan needs to incorporate a separate continuity or “what if?” plan—in other words, one plan for the long term, one plan for the short term; you need both levels of planning and in a coordinated fashion.
A continuity plan results in a formal, written continuity agreement. There are many kinds of continuity agreements, and the choice as to which is the best agreement tends to revolve around the number of owners of the practice or business, the type of entity, and what you are attempting to protect against. It further depends on whether the multiple owners own individual books in a practice model or they are shareholders or members of a single business or firm. Even regulatory and compliance issues can significantly impact the choice of plan and continuity partner. Regulators expect that you’ll have a business continuity plan that will protect against a significant business disruption such as a natural disaster or power outages. It’s advisable that you also protect against death or disability of the business owner(s).
For some financial professionals, especially those in a practice model, the first and only solution is to purchase a life insurance policy, a solution that completely ignores the needs and welfare of the client base and any staff members—a practice not only built to die, but planning on it! The secondary solution is a two- or three-page revenue-sharing agreement that we’ll discuss later. Many of the advisors we talk to argue that these approaches are better than nothing, and while that’s certainly true, that isn’t setting the bar very high. In this chapter, we explain some other and probably better approaches for you to consider.
A continuity plan, even one that takes the form of a written buy-sell agreement or shareholders’ agreement or is embedded within an operating agreement, is not a succession plan. It can support a succession plan. It can lead to a succession plan, but it is not and never will be a plan for succession—two different things.
Basic Components of a Continuity Plan
The most comprehensive and effective continuity agreements are those between shareholders or partners in a single business. These agreements are quite common to business owners and have a variety of titles depending on the circumstances; they may include a shareholders’ agreement, a buy-sell agreement, a partnership agreement, or an operating agreement. Using these agreements as the standard-bearers for this category of planning, here is a list of the basic elements that should be addressed in a formal continuity agreement:
- Identify and define the triggering events (death, disability, loss of license, termination of employment, etc.).
- Define what disability or disabled means and when it triggers the buyout process.
- Provide for an accurate and industry-specific valuation method for determining fair market value of the exiting owner’s shares or ownership interest; don’t use a multiple of revenue or a basic formula (more on this later).
- Provide for reasonable payment terms, taking into account the possible loss of clients, the need to stabilize and grow the business in the years to come, the need to replace the exiting owner, and the tax impact on the buyer.
- Determine who the buyer will be (the company by redemption, the remaining shareholders on a pro rata basis, a remaining shareholder, or an outside third party) and the order in which they will be selected.
- Provide for the orderly sale of the business (or ownership interest) to a third party in the event no employees or partners elect to step forward.
- Provide for funding through life insurance and lump-sum disability insurance, tying the value of each to the results of a formal valuation as the agreement is executed and regularly thereafter.
- Provide for information to the continuity partner or guardian so that he or she can step in on a moment’s notice and operate computers, ensure payroll is met, talk to the staff as well as the clients, and access the client management software.
These agreements are not of the “one and done” variety; they need to be reviewed and updated on a regular basis, especially if the business is growing fast; if ownership changes in any way (people or shares, by purchase, sale, or grant); if the economy changes significantly; or as value increases by more than $100,000 in any given year. It is not necessary to continually buy more insurance to fund these agreements as the business grows; insurance is often an integral part of the funding solution, but rarely the sole means of a buyout.
Types of Agreements
The type of continuity agreement that is appropriate for your situation depends largely on what you own at the time the agreement is executed. If you own a practice, the common solution is a revenue-sharing agreement. If you own a business, or are in the process of building one, your choices and level of continuity protection are greatly increased.
Revenue-Sharing Agreements
Now, having started with the best continuity planning solution (formal partners in a single, enduring business), let’s discuss the most popular solution, recalling that 95 percent of independent financial service professionals are one-owner practices. Continuity planning is especially challenging for the single-owner practice.
The most common continuity solution for a single-owner practice derives from the most commonly used compensation structure—a revenue-sharing arrangement. Independent broker-dealers and custodians routinely hand out short-form contracts (two or three pages in length is typical) to their advisors at no charge, as a substitute for a formal or more comprehensive continuity plan in the event of a disaster. These continuity agreements, often called something like an “Agreement for Assignment of Accounts,” allow a seller and a buyer or continuity partner to agree on terms of sale in the event of an advisor’s death, permanent disability, or retirement.
Let’s be honest. There really is no continuity; there is a replacement advisor within the same broker-dealer or custodial network, who will end up taking over the practice with virtually no risk, and paying only 60 to 70 cents on the dollar, and doing things his/her way almost without regard for what you promised your clients. These are great deals for a buyer—there is nothing to lose. For the seller, these work if you place no significant value on what you’ve built and don’t really need the money that might come from the agreement. For the broker-dealer or custodian, it’s the only way to practically (and efficiently) exert any control over the client base and help ensure they stay within the network. Equity is not the issue.
Regardless of the broker-dealer or custodian, the forms are pretty much all the same. Most include provisions such that the advisor who takes over the client accounts or relationships (typically called the “assignee”) will pay to the disabled advisor or to the deceased advisor’s estate (the “assignor”) X percent of the revenues earned for Y years. The assignee is not obligated to make any payments on client accounts not serviced by the assignee, who has the unilateral ability to decide for himself or herself which accounts to service and which ones to let go. There is no down payment to help motivate the assignee to service most of the accounts, or to service them well. Should anything happen to the assignee, or if the assignee changes to a different broker-dealer, the agreement usually contains an immediate termination clause.
The arrangement typically applies only to management fees and insurance renewal commissions, or trails (the sales commission–based portion of the practice is given a value of zero even if there is a historical track record of repeatable and consistent sales commissions), and provides that the designated percentage of those revenue streams be paid out by the broker-dealer or custodian to the retiring advisor or to his or her surviving spouse, estate, or other designated beneficiary. Taxes are commonly ignored, and that usually means that instead of long-term capital gains, the seller receives the proceeds at ordinary income tax rates. Most contain no provisions for settling a dispute or verifying the income received by the buyer.
The truth is that these agreements mirror the way most practices are assembled and built, so it is only natural to use a similar tool to take them apart and bring them to an end. This is part of the cycle of building a practice designed to die from the outset. If that is acceptable to you, and to your broker-dealer or custodian, then use these forms and don’t look back.
Here’s the bottom line: For a one-owner practice with less than about $200,000 in gross revenue at its peak, revenue-sharing arrangements are the best solution. They’re quick, cheap, and capable of delivering about 60 to 70 cents on the dollar, depending on the circumstances and the economy. But for every advisor above that level, and as an industry, we have to do better than this and we can. “Better than nothing” can never be allowed to be the standard for an independent advisor. Would you ever provide that answer to your clients when they inevitably ask the question: “What happens to me if something happens to you?”
A Guardian Agreement
A continuity plan should always address and define triggering events such as death, disability, or termination of employment, but the plan also needs to consider the very real possibility of a temporary change in operating control or the delivery of services. This situation might occur when an advisor is injured in an auto accident and he or she is unable to work for five to six months, but then returns to the practice or business. The guardian agreement was a concept that we first introduced to this industry in 2008, but honestly, we’ve never been able to make it work effectively for 95 percent or more of this industry.
As designed, a guardian agreement allows another advisor, or guardian, to manage the practice temporarily in the event of an advisor’s disability. The guardian is appropriately compensated for the services he or she provides until the disabled advisor is able to return to work, or until the practice can be sold to a third party. On rare occasions, this role is filled by another advisor unaffiliated with the disabled or deceased advisor’s practice; sometimes this role is filled by a key employee, son, or daughter, or, more commonly, by a minority shareholder who simply isn’t in a position to buy and run the practice permanently or by a larger shareholder who is.
This is a very real problem to solve for, especially for advisors in their 50s, 60s, or 70s, of which there are more than a few. But for one-owner independent practices it is quite difficult to provide any meaningful, compliant, and practical coverage on a temporary basis by an outside party, even another advisor with the same broker-dealer or custodian and operating in the same office. Theoretically, at least, a guardian agreement provides a solution. As a practical matter, the better solution is to recognize this shortcoming in the practice model and to immediately set out to build a practice or a business with an entity structure and at least one other equity partner (even just a 5 percent owner, for example)—in which case, the role of guardian falls to a partner through the use of a buy-sell or shareholders’ agreement as outlined next. Your temporary fill-in is an owner of your business and will have access to the necessary information and authority with the clients and the broker-dealer or custodian, to make good and timely decisions.
In sum, a guardian agreement is best utilized as part of a more comprehensive plan and by partners in a single business. As a financial professional in charge of managing and directing investments to last for at least your clients’ lifetimes and usually beyond, you have a duty as an independent owner to build a business to do what you’re promising or certainly implying that you’ll do. Let’s look next at how a professional continuity plan is structured for a financial services or advisory business and how it is integrated into the succession planning process.
Buy-Sell Agreements
For businesses or firms set up as an entity (corporation or limited liability company [LLC]) with two or more owners, the choice of continuity partner is fairly clear—a fellow owner or owners will be the best choice. If a shareholders’ agreement or an operating agreement has been entered into, the choice is a matter of contractual obligation. In that a shareholders’ agreement refers to a corporation and an operating agreement refers to an LLC, we’ll use the more generic term of a buy-sell agreement to refer to a continuity planning agreement for multiple owners of a corporation, a partnership, or an LLC.
A buy-sell agreement is a legal document that specifies how a privately held company or its owners will redistribute ownership in the event that one of the owners dies, becomes disabled, retires, or otherwise leaves the business. The agreement is a contractual covenant by each owner (and the company) to redeem or purchase the stake of any owner who departs, with the goal of providing payment of value to that individual or to his or her estate, and to ensure that the business enterprise survives. A buy-sell agreement also helps to reduce the complications of having a surviving spouse (or a son or daughter) or Uncle Charley suddenly appear at the ownership table in the event their loved one dies or becomes disabled.
Note: Before proceeding, it is important to point out that the use of an entity structure does not always create a clear and immediate solution, as many advisors build individual books, using the entity only to share expenses and create some cost savings. The central entity typically has little or no value in this setting and is all but disregarded for continuity and valuation purposes. Partners in these types of arrangements tend to have their own specialties with different revenue models and client demographics than the seller’s. Think of a practice model with one partner who is an active portfolio manager, one who is a passive portfolio manager, one who sells insurance products, and one who does hourly or flat fee financial planning work. This dynamic makes it difficult for any of them to buy one of the others’ practices or books. Continuity solutions still exist for this model, but are more limited and tend to shift toward the guardian agreement format and/or a fast sale to an experienced local buyer with a very similar revenue model, or even a revenue-sharing arrangement if the book is small enough.
In the case of a privately held, independent financial services business, the primary goal of a buy-sell agreement is to avoid conflict and confusion by keeping ownership and control in the hands of those individuals who will be responsible for managing the operations of the business. In other words, the goal of such an agreement is successful business continuity under less than optimum conditions. As such, the buy-sell agreement is the fallback plan or safety net and is an integral part of a well-designed and longer-range succession plan. While buy-sell agreements are common in most businesses across the spectrum, the continuation of a highly regulated business means this document takes on even greater importance.
A buy-sell agreement also establishes a valuation mechanism and agreed-upon payment terms to facilitate the ownership transfer. This process is actually a “double-edged sword,” though, since the valuation approach and payment terms the owners must agree to in advance of the transfer event will determine what any one of the owners or his or her estate might receive upon death or disability; it is also the value that the remaining owner(s) would have to pay for another’s shares or ownership interest.
A buy-sell agreement creates a protocol for deciding who will be the buyer of an existing owner’s interest. In general, the starting place is stock (or ownership) redemption, followed by the ability to implement a cross-purchase arrangement. If redemption by the company is not the choice by the remaining shareholders upon a triggering event, the second choice is usually the purchase of the exiting owner’s interest by all the remaining shareholders on a pro rata basis; this helps to maintain the status quo in a multiple-owner business or firm. If ownership is not redeemed or purchased by the remaining shareholders on a pro rata basis, the next level is usually the purchase by any one of the remaining shareholders. And finally, if none of the previous levels work out, the final level of value realization is to sell the interest to a third party—not practical, but necessary in some instances.
A buy-sell agreement is not a crisis document, or at least it is not intended to be figured out in the midst of a crisis. Rather, it should be a well-planned agreement, executed in advance, shared with the owners’ spouses and stakeholders (CPA, attorney, etc.), and revisited annually. It is designed to help shareholders or business partners deal with unpredictable business situations in the best way possible. At the very least, it provides some framework for when the parties can’t agree on buyout terms.
Funding Your Continuity Plan
The default arrangement for a buyout triggered by death or disability is seller financing over an extended period of time (five to 10 years). In other words, the buyer, whether it be the company through redemption or one or more individuals (i.e., the remaining shareholders or partners) through a cross-purchase arrangement, executes a promissory note and makes payments to the seller or to the estate of the deceased or disabled partner. Do not use an earn-out arrangement for this type of situation and this length of financing.
Buy-sell agreements are often triggered on short notice, which practically results in a very small down payment; frankly, it is hard to maintain a high level of liquidity in a small business in anticipation of an event you hope won’t ever happen within the context of a pass-through entity structure. The most common structures just aren’t built to save or sit on a lot of extra cash. A nominal down payment, in turn, will place a heavier load on the cash flow stream of the business or individual buyer for many years to come, often on an after-tax basis, and occasionally during the course of a recessionary event, or upon the loss of one or more large clients (which can, and often does, follow a triggering event).
For all these reasons, the buyout process can be significantly aided by proper funding mechanisms such as life insurance or lump-sum disability insurance. For buyouts triggered by death, a life insurance policy held by the buyer (many times this is the business itself) on each of the owners can be an effective option for funding either a down payment or the entire purchase price. Lump-sum disability insurance is also an option for buyouts triggered by disability, but the policy is generally aimed at providing a significant down payment (relying on the acquired cash flow to pay the balance). Without adequate funding, you may be solving one serious problem while simultaneously creating a different and equally serious problem.
Adequately funding a buy-sell agreement requires a high level of advanced planning and professional guidance. Insurance funding strategies depend on whether the buyer will be the entity or one or more of the remaining individual shareholders or partners, and what type of entity you have (C corporation, S corporation, or LLC taxed as one of three different models). To obtain the correct answers, you’ll need to consider the challenges from legal, tax, regulatory, and cash flow perspectives, and then make decisions based on the talent level left behind to mind the store and handle the obligations. And once you’ve figured it out, the answers tend to change over time as the business grows and the ownership changes.
Funding also requires an accurate determination of value. Obtain a formal valuation before you set up your continuity plan so that all of the owners can agree on the process and each can live with the results should the agreement be suddenly triggered and under trying circumstances. Do not use a multiple of revenue to accomplish this task; depending on the circumstances of the buyout, as well as the economic climate, you may lock in a payment obligation that is unsustainable and will threaten the business’s ability to survive. In this case, simple is not better.
Bank financing is also a solution to consider. It is still difficult and impractical to obtain bank financing from a local institution for the purposes we’re talking about here, especially in the context of a highly regulated, intangible, professional services model, but significant progress continues to be made on this front. With proper cash flow modeling, a strong foundational structure, proper valuation techniques, and adequate payment terms, bank financing is a viable solution should your buy-sell agreement be triggered.
Continuity Plan Dos and Don’ts
Regardless of the type of continuity agreement you use, here are some pointers that you should consider to ensure that your continuity plan and agreement not only address but also fulfill your intentions and those of your business partners when it is time for a shareholder or member to leave or when disaster strikes.
- DO NOT use a multiple of value or any static formula or a fixed dollar amount (stated value) to determine the value of the business or any owner’s share of the business in a continuity plan. When you do this, you are locking in a number that you must pay in the years to come based on the trailing 12 months revenue (or earnings) at the time of the triggering event. For example, what if there was a large one-time annuity sale in the past 12 months that spiked revenue? If you use the trailing 12 months to determine value in the future, then you capture that revenue spike, even though it may not be sustainable moving forward.
Remember what happened in October 2008? Using the trailing 12 months as the determinant of value would have meant that the surviving owners would have had to tackle a number without the revenue streams that supported its calculation. The same thing can happen when a partner who, by way of example, is subject to a regulatory event and causes harm to the company, then suffers a severe heart attack, is disabled, and then has his or her value locked in place just before the revenues take a severe hit. Bad news, but it happens. - DO NOT guess at the payment terms contracted for in a buy-sell agreement, or simply plug in a number that seems about right. We recommend using a spreadsheet format to calculate the after-tax effects of buying out an exiting partner that also take into account the business’s overhead structure, growth rates, cost to replace the lost talent, interest rates, and so on. Remember, one of the goals of a buy-sell agreement is to ensure that the company survives the buyout process. Take the time to do the math.
- DO value your business and review your buy-sell agreement once each year. Log the annual event right now on your Outlook calendar or customer relationship management (CRM) system for the next 10 years. A routine review of the agreement can help business owners ensure that their document takes into account changes in personal circumstances or changes in the business itself, and provides for evolution of the plan and the business valuation mechanism. That way, the agreement will be ready to do the job when you need it most.
- DO focus on and understand the definition of disability in your continuity agreement. Many business owners simply trust the standard attorney boilerplate language to define when an owner is disabled and must be bought out or must sell. The reality of most disability cases is not the sudden and completely debilitating, nearly fatal auto accident; instead, it is often something more subtle, some health issue that starts and stops for uneven intervals over many years, or it is the disability or medical condition of an advisor’s spouse or child that significantly alters the advisor’s involvement and effectiveness on the job. Study the definition in your agreement carefully and make it fit the circumstances of your industry, your business, and your life.
- DO make sure that your agreement addresses what happens in the event of the involuntary departure of one of the partners or shareholders. In instances like these, the treatment of the departing shareholder may depend on the circumstances surrounding the departure. An owner who is asked to leave as a result of a difference in goals and objectives may be viewed very differently than a person who leaves because of performance issues or, even worse, regulatory violations. Draft these considerations as early as possible, while everyone is getting along well and these issues are still merely theoretical.
- DO watch out for the situation where there are two or more senior owners of similar age. An internal buyout arrangement can require as many as seven to 10 years or more to pay off from operational cash flow after taxes and after replacing the exiting advisor owner. This makes the process impractical for a single remaining owner in his or her late 50s or early 60s. One commonly used solution is to set up an internal ownership track that provides an opportunity for the next generation to step in on a continuity basis and purchase the exiting owner’s shares or interest, perhaps on a non-pro rata basis.
- DO take the time to learn your options and best strategies, especially if you’re a single-owner, one-generational practice model. Signing a revenue-sharing–based continuity agreement might seem easy, but if you end up receiving 30 cents on the dollar, there is very little you can do about it. Consider instead the Practice Emergency Program (PEP), a unique option offered by FP Transitions. Advisors who have not identified a suitable buyer for a continuity agreement or a buy-sell agreement can enroll in PEP and authorize FP Transitions to sell the advisor’s business on the open market upon the advisor’s death or disability to the best-qualified successor. With a 50:1 buyer-to-seller ratio, it is quite likely that you’ll come closer to realizing the value of what you’ve built than using a revenue-sharing arrangement.
- DO NOT settle for a continuity plan that is only better than nothing unless that is how you feel about your clients and what you’ve spent your career doing. When you get above $200,000 to $250,000 in gross revenue or gross dealer concession (GDC), do the job right. In this day and age, half of a million dollars in value, at long-term capital gains rates, deserves your time and attention.
While none of us wants to believe that our association with our business partners or shareholders may someday come to an end, as it relates to a continuity agreement, it is always good to remember that, one way or another, you will part ways. It is important to plan for such events well in advance. On that note, the fact that partnerships end is not a good reason to avoid having a partner; it is a great reason to plan ahead and build something stronger than any one individual.
A Powerful Acquisition Tool
When practice owners decide to list and sell their practices on the FP Transitions’ listing system, the typical response is about a 50-to-1 buyer-to-seller ratio. From a buyer’s perspective, those are long odds indeed. But there is a way to reduce those odds significantly, and literally take the seller off the market years beforehand. Successful and repeat buyers, those who acquire a practice every year, often use an additional approach—they become a continuity partner.
The tools to succeed are simple. Value your business, structure it correctly, and then set up your own continuity plan. Once you’ve figured out how to do these basic things for yourself, do the same for others who are in your area but smaller than you in terms of value and cash flow. An enduring business model can and should become the continuity partner for five or six other smaller practices in the same geographic area and within the same broker-dealer or custodial network. The arrangement is straightforward. Execute a continuity agreement in which your business agrees to become the continuity partner, and guardian if need be and if possible, for a single-owner practice. And then do it over and over again.
These stand-by arrangements provide the owner of the smaller practice with backup protection, perhaps even a guardian in case of temporary disability, and an obligated buyer to pay fair market value with agreed-upon payment terms at long-term capital gains rates, and even a possible employer for the key staff members. For the prospective seller, this arrangement is far superior to the popular but questionable revenue-sharing approach outlined earlier. Many times, these continuity arrangements lead into more formal succession plans or even mergers with the continuity partner. It’s like tying up a couple of life rafts next to your ship.
This solution also provides the single, one-generational practice owner with a great answer to the question clients start asking at some point or another: “What happens to me if something happens to you?”
Communicating Your Plan
On previous occasions in this book, we’ve asked you an important question on behalf of your clients: “What happens to me if something happens to you?” Let’s answer that question now, and emphatically.
Your answer is (or should be): “I have a plan. I have a long-term plan for this business, which is being built to serve not only you, but your children and grandchildren, and, by the way, I’d like to meet them and help make them a part of your long-term planning process. I also have a short-term plan, just in case I get hit by the proverbial bus. Would you like to know more?”
Once you have the structure in place and you’re in the process of building an enduring and strong business, tell people! Tell your clients, tell your family, tell your staff, and tell the community! There are too few enduring businesses in this industry—but that is a positive if you’re one of the few, one of the shipbuilders. You can offer something to your clients and to future advisor recruits and new hires that a one-owner, one-generational practice can never compete with. You’re building something to last and to make a difference.