Everyone who creates a succession plan will explore and find one’s own path, but that doesn’t mean that you can’t learn from others who have gone before you. This is the first generation of independent owners who have had to grapple with the fact that their practices, sometimes businesses, have amassed significant value. It’s only natural that, at this point, there will be more questions than answers. How best to handle a succession plan when you’re unsure of the path, unsure of the next-generation talent base? When is it too soon to start worrying, or too late to start planning? Where does one get good, reliable advice? What if things go wrong, or don’t go as planned? If any of those concerns sound familiar, this story is for you.

Succession Planning Case Study

James Warren operated Strategic Financial Management from a beautifully refurbished turn-of-the-century home in South Bend, Indiana. He had a staff of seven, four of whom were qualified advisor/producers in this hybrid, fee-based model. The four advisors, one of whom was James’s daughter, ranged in age from 27 to 38, and most had or were completing their Certified Financial Planner (CFP) course work; one had a Chartered Financial Analyst (CFA) designation as well.

Over the course of 30 years of work, James had gained a lot of experience, starting with a wirehouse, then moving to an insurance-based broker-dealer, then to a predominantly fee-based independent model under his stand-alone Registered Investment Adviser (RIA) while maintaining a relationship with an independent broker-dealer. As the years passed and James moved into his late 50s, he began to think seriously about his own succession plans and how he could better utilize and rely on the talents of his next-generation advisors to build an enduring and transferable business. James was working, on average, only about 30 hours a week at this point, and he had a comfortable living from a stable practice with predictable cash flow.

James had done most things right. He had set up an S corporation about 10 years earlier of which he was the 100 percent owner. He’d had his practice formally valued for the first time about five years ago; the valuation opinion of $2.1 million in 2008 was satisfying, but still a bit short of the mark based on James’s retirement goals.

James dutifully attended all of the succession planning presentations and webinars he could find, and he read the many magazine articles on this subject. So, when he first sat down with his company’s legal and tax counsel to discuss the issue of his own succession plan, he felt like he had a solid grasp of the subject matter. However, his lessons were just beginning.

James’s attorney strongly advised him to retain ownership of all of the stock in his S corporation and full, 100 percent control of his business until the day when he was ready to walk away—and then to sell the business to his key employees and next-generation advisors if they could come up with the money or a solid repayment plan. James pushed back and said that he didn’t have a clear exit point in his career, but that he was certain that such a date was at least seven or eight years in the future. He also expressed the concern that his key staff members might not be patient enough and still willing to work there and help him add another million dollars of value to the business if no ownership opportunity was forthcoming along the way.

The law firm suggested that James create a phantom stock plan to create “ownership-like benefits” in the meantime; that way, the key staff members could be rewarded monetarily for helping grow and strengthen the business. James’s attorney did his job well and shared a horror story or two with James about what it is like to have a bad partner, or to have to buy out a partner who subsequently leaves with part of the client base. James’s CPA was consulted as well, and after no objections were raised, several drafts of the plan were drawn up, reviewed, and ultimately presented to James’s key staff members.

The plan was discussed and analyzed in depth by James and his team over the course of the next year, and ultimately, $25,000 in legal and tax consulting fees later, all of the licensed producers rejected it, preferring instead to have a real ownership opportunity; they wanted to own stock in the business where they worked and to begin to amass an ownership position in the growing business and become principals of the business—just like James.

The advisors argued that a phantom stock plan would certainly provide them with additional compensation, for which they were grateful, but would not put them in a good position to buy out James’s ownership upon his retirement, or earlier in the event of his sudden disability or death. And then there was the nagging problem of buying what they felt they were building and already owned in some sense of the word.

The advisors were also concerned that James was beginning to reduce his hours worked and that more and more of the workload and the responsibility for growth were falling on their shoulders, with no ownership stake and no commensurate reward for the added workload. James told his team that he’d like to reduce his hours worked by another full day over the coming years as he got older, giving them more and more opportunity to make decisions and become leaders of the business, along with annual pay raises and bonuses to compensate them. But the harder they worked, they argued, the further the succession team was from buying out James’s position. In the end, buying out a growing company from a zero ownership position while James maintained his full salary and benefits felt a little disingenuous to them.

After another year or so passed, James decided to try something different. He hired a professional consulting company to help him—an investment banker familiar with the independent financial services sector. This second firm wisely counseled him on the merits of an internal ownership track and the benefits to James and his team by transitioning ownership internally, over time. They conducted a valuation of James’s firm, and did a thorough operational review. In the end, it all came down to one big question: Did James’s key staff members—his four potential investors—have what it would take to buy and run the business?

To answer that question, the consulting firm proposed putting the key staff members through a series of interviews and tests to try to determine if these next-generation advisors had what it would take to become owners and entrepreneurs. The process was thorough, even arduous. And in the end, the answer was, sadly, “No.” While the individuals ranked at various points along the evaluation spectrum, some being potential prospects with limited upside and others being rejected out of hand, the decision was made that selling internally was not a viable option. The investment banker’s expert opinion was to wait until James was ready to fully retire and walk away, and then sell the firm externally for several million dollars. They would, of course, be pleased to handle the sales process.

There was just one problem: James’s next-generation staff members still wanted to buy him out and were quite insistent that they would prove they had what it takes—on the job. So, after another year or so, James tried a third approach. He hired one more consultant and had the company revalued; this was an issue because the next-generation advisors did not fully trust the valuation processes they were seeing, and, as potential investors, they cared a lot about the value of the business. This time, James let two of his key staff members participate in the valuation input process, even reviewing the company’s income statements (for the first time) and providing the financial data, client demographic data, overhead and cost structures, compensation levels, and profitability during the valuation process.

Once the valuation was complete, the results were shared with the four advisors, and while the number was even larger than before, it was better received; this was a valuable fee-based business with good client demographics. The consultant developed and designed a detailed plan with James’s and his advisors’ input that allowed for a very limited initial buy-in to field-test the plan and observe how it worked. In the end, would this investment be as important to James’s next-generation team as it was to James and his wife, the founders of the company? Time would tell.

The investors would cumulatively purchase 20 percent of James’s stock, signing long-term, profit-based promissory notes (see Chapter 7 for more information on the Lifestyle Succession Plan). While the plan didn’t rely on anyone taking a cut in pay to make the investment, it did rely on a strong and sustainable growth rate, responsibility for which was to gradually transfer from James to the succession team. The investors, as James took to calling them, would have to prove to James and to themselves that they could eventually prosper on their own without his help—with the money coming from a redesigned cash flow structure capable of paying James many times more than the rules of thumb he’d heard about.

One of the most difficult parts of the plan was rethinking and restructuring the compensation strategy at the ownership level. James and his team had always been paid primarily based on what they produced—a revenue-sharing arrangement. As business owners, James realized that his succession team could no longer afford to focus on just one aspect of the business, even one as important as cash flow; there were too many other things they’d have to learn to do and be motivated to succeed at. The succession team would need to learn to work together and to widen their focus even while maintaining production of revenue as job number one. Somehow, the duties of maintaining or even improving profitability and all the systems and processes needed to continue to grow a strong and enduring business model had to enter the picture.

To help the succession team learn to work and think from an owner’s perspective, their consultant advised on shifting to a profit-based business model, essentially using the S corporation’s cash flow structure to do what it was designed to do: create business owners who are paid a reasonable wage for their work and a profit distribution in return for their investment. The profit-based business approach maintained revenue generation as the starting point, but used the payment of profit distributions (limited to actual owners) to connect the cost of that growth to each owner’s paycheck. On paper, it was clean and looked so easy to do.

But for the advisors, letting go of their revenue-sharing arrangements proved a challenge; instead of relying primarily on their own efforts to earn their paychecks and building their own books, the investors would now need to learn to work more as a team, a succession team, and to build one strong enterprise instead of four or five individual books. Revenue sharing was how they’d always done it, it was all they knew, and it was what they had been taught was normal. James, on the other hand, now in his early 60’s, wasn’t working as hard as he used to; his production was dropping. He was fully supportive of the plan, and acknowledged that he wished he had made the switch from a revenue-sharing model to a profit-based business 10 years earlier!

Two key steps helped the team work past this critical issue: (1) the promise that the investment opportunity would not require a pay cut to any of the investors and (2) the realization that, as owners, they would have two ways to earn their money from now on—wages plus profits—one tied to their individual efforts, the other result of the team’s collective effort. The consultant provided detailed spreadsheet models of the restructured cash flow model projections and showed the succession team the possible results 10 to 15 years into the future using conservative growth rates tied to the business’s actual cost structure. The advisors studied the data, did their homework, and did a lot of thinking, and then announced that they were ready to invest—all of them.

The plan was launched. Shortly after James’s 63rd birthday, he proudly announced in the company newsletter and a press release to the community newspaper that his business had expanded and now welcomed four new principals to better serve multiple generations of clients. Shortly thereafter, James further reduced his time in the office to an average of about two days a week, probably a little too soon, but there were other things he wanted to do. And he still watched over everything very carefully and checked in by phone on a daily basis. The succession team began to sort things out among themselves with James always available as a mentor and guide. James continued to meet with the largest and longest-tenured clients, and put a positive spin on the transition within his growing and enduring business.

The next-generation advisors were running more and more of the operations on their own, gradually proving the business could survive without James, at least in terms of client servicing. Eighty percent of the clients now had not met with James one-on-one in the past three or more years anyway, and the team seemed more than up to the job. Unfortunately, that wasn’t enough. As a new and younger group of advisors, the succession team faced challenges James had never been exposed to.

When James started the business some 30 years before, he quite literally began from scratch. He didn’t borrow any money, unless you count the credit card bills and the rising personal debt that resulted from a lack of paychecks. He still had the first dollar he’d ever earned in a frame behind his desk, along with other mementos and awards he’d earned over the years, and there were many. Back then, James made all the decisions and did most of the work—he was the “engine of production”; he made everything go. There wasn’t much input from others, but the decision-making chain was short and efficient!

For James’s team of advisors, it was very different. The consultant advised James to begin the process either with equal ownership for the entire team or by forming two levels based on age or experience (or both) and providing equal ownership opportunities to each separate team or level. This approach was intended to balance the investment opportunity at the start of the process and, rather than anointing any one person to be the leader, to rely on the team of successors to figure that out on their own, certainly with James’s help and input as their mentor.

But the advisors didn’t all get along so well. The oldest and most experienced advisor, the CFA, also had more financial strength, and he made his payments on the note much faster than everyone else could. He had a different problem in that he could not effectively command the others. As a new owner, he changed, becoming more demanding of himself and everyone around him, to the point of divisiveness. One year later, he was gone, dismissed by James with the support of the entire office (yes, owners can still be fired, and this guy was). The business was solid and still growing, and the remaining three next-generation owners, who had matured beyond their years, stepped it up a notch and worked through every issue and challenge that was thrown at them. They were growing and succeeding as business owners, and the value of their investment was climbing steadily at about 17 percent per year. Another year later, James reduced his time in the office to an average of about one day per week; he still owned 85,000 of the 100,000 outstanding shares of the S corporation.

At this point, the business had grown to almost $3 million in value. The three next-generation owners had paid down a significant amount of their promissory notes, and all three got along very well; a leader emerged from their midst and, to no one’s surprise, it was not James’s daughter—she wanted to be an owner and a key role player, but not the “captain on the bridge.” The three investors ran most of the office and enjoyed the opportunity to think for themselves and figure things out even though the hours were long and the weekends short. James served as a mentor, continuing to check in daily from wherever he was as he thrived in semiretirement. He still was the signatory on the bank accounts, signed the checks, and paid the payroll; in fact, those duties took up most of the time he spent supervising the business operations.

But by now, it had been a couple of years since James had last met with the company’s largest clients; he hadn’t even met most of the newest clients. He was growing impatient with what amounted to a 20-year succession plan launched too late in his career—15 more years seemed like an eternity. He wanted to retire now, in full, and he needed about $2.5 million at long-term capital gains tax rates to do so. Fortunately, his 85 percent ownership stake came pretty close to solving that problem. Unfortunately, while the investors didn’t have $2.5 million, they realized for themselves that they, too, had a choice to make—a hard one, at that.

As James reduced his working hours, a predictable result occurred. The investors realized that while they cumulatively owned only 15 percent of the business, at least in terms of stock, and had paid for just more than half of that, they actually controlled almost 100 percent of the assets—specifically, the client relationships. In other words, the value of the stock that James owned quickly began to take a backseat to the value of the assets that the investors could exert control over. If the ownership team walked across the street and the three of them hung out their own shingle, they’d likely capture most of the business and pay little or nothing for it. They’d all be millionaires in terms of equity value, and have some great paychecks as well with the start of a new business—a rare but enviable opportunity. The alternative was that they could each sign a promissory note for about $850,000, or a combined note from the business for $2.55 million and personally guarantee that debt, and work for the next 10 years to fund James’s retirement plan with after-tax dollars before their turn came.

But this particular story has a more pleasant ending. James’s succession team did not come out and threaten him or his retirement. Instead, they negotiated from a position of strength, a position that held little resemblance to the 15 percent minority interest they owned and had not even finished paying for. The principle of the 30-hour threshold covered back in Chapter 2, as applied to this fact pattern, is this: Transfer stock at a rate proportionate to the founder’s physical control over the assets. If you separate the two issues, the stock could lose some or all of its value over time. This is a basic but important and often overlooked rule in transitioning a professional services practice. James and his succession team had to find another solution, and they did.

The facts were pretty simple. James wanted just over $2.5 million for his majority interest in the business he founded and a small but ongoing role in the business for a reasonable salary. The next-generation advisor/owners wanted to own the business but had no money of their own outside of the business’s cash flow, though they did cumulatively own a 15 percent equity stake in a $3 million business. It was time for a transfer of control and ownership. But how to make that happen?

The answer they chose was to utilize a popular attribute of many of today’s internal succession plans: accelerating the process by using bank financing to support the transaction. For founding owners who start the process too late or simply find that life, health, or other interests necessitate a more rapid conclusion to their plans, bank financing may provide the answer. This strategy provided James with most of the money he wanted, in cash, thereby reducing his risk, and provided the next-generation advisor/owners a decade of business cash flow and growth from which to pay the debt, leaving capital free to further grow the business, which they were more than excited about.

As a part of the deal’s terms, James agreed to remain on board for the next 12 to 18 months on a part-time basis to help with the transition; to be available to sit in on meetings with larger or more difficult clients; and to transition the banking relationships, bookkeeping, and payroll functions over to the new CFO of the company, a possible future owner as well.

The three advisor/owners decided on a more appropriate ownership structure going forward that reflected their risk in the transaction and their anticipated roles, titles, and hours worked over the next 10 years. The rigid structure of their S corporation and its predictable cash flow model helped them create a solid foundation for an enduring business organization that would, with a good plan, outlive each of them as second-generation owners.

This case study is the real thing. Having taken this opportunity to look over the shoulder of one of your peers and learn from his experiences, it is time to solve the problems and to start building that enduring business model and taking control of your future.