Advisors have many ways to monetize their life's work and take advantage of new opportunities for growth, both short-term and long-term.
The transition agreement is one way advisers can de-risk a move financially through what is traditionally known as a forgivable loan – a note that usually ties the adviser to the firm for a set amount of time.
However, the paradigm has evolved over the past few years. Advisers can now choose from a much wider variety of options than ever before, and there is a greater breadth of deal structures beyond traditional underwriting.
So then, how should an advisor consider the various deals available and which one makes the most sense for their business?
Let's examine the pros and cons of the three most common deal structures:
Traditional loan forgivable
What is: Also called a promissory note, this is how most traditional firms (wire, regional firms, etc.) recruit advisors. The firm effectively gives the advisor a total package of between 150% and 300% of revenue to incentivize the advisor to move their book of business. These deals are typically based on top-line income, amortized with ordinary income (as opposed to long-term capital gains), often nine to 13 years in duration, and come with upfront and trailing earnings components.
Pros: At the end of the forgivable loan period, the advisor has not sold their book of business, so they are, in theory, free to move again. A bottom-line arrangement means the adviser doesn't have to worry about spending discipline. The loan is not a contract, so the adviser is free to make a change during the life of the note, assuming they are happy to pay off the outstanding note balance. In addition to recruitment deals, many firms also offer sunset or retirement packages that allow advisors a second bite at the proverbial apple without having to make another transition down the road.
ANTI: These structures overlap with ordinary income tax treatment and include a requirement to pay the outstanding balance if the advisor terminates or leaves the firm before the loan is forgiven. In some cases, they also require significant increases to achieve the full package of the master deal.
Structure based on asset acquisition/EBITDA
What is: This structure is how many RIAs, private equity firms, crowdfunding, aggregators and investors will “buy” into wealth management firms. The buyer/investor will look at a seller/target's EBITDA or EBOC and then apply a competitive industry multiple to that number. Multiples vary based on the quality and size of the underlying business.
Pros: These deals are executed with long-term capital gains tax treatment and often involve a mix of cash and equity. Such structures match the adviser and the buyer in a profitable focus, often with a more profitable total package than that of the forgiven loan. If the advisor has received equity in the buyer in the transaction (which is common), they can sell that equity on the line at a high multiple. If the advisor does not sell 100% of their equity, they control their operating leverage, ie as they grow, so does the value of the equity they own in their business.
ANTI: This structure typically involves a sale of assets and, therefore, a onerous sale agreement that dramatically limits the advisor's ability to carry on business again. It often comes with a low ongoing payment after the transaction (30% to 35%). Portability and retention of assets are required to realize most of the economics of the arrangement.
A hybrid approach
What is: Many smart firms realized the advantages and disadvantages of the above two structures, so they decided to create a hybrid structure that includes elements of both. It is common to see a recruitment deal structured like a forgivable loan (as described above) but with an equity deal component. For example, the advisor may receive a total potential transition deal of 300%, but 100% of it may be paid in equity.
Pros: From the advisor's perspective, this structure allows for book profit now and a potentially profitable “second bite at the apple” through a liquidity event for the capital they received. It also ensures that the firm is fully invested in the advisor's continued success. From the firm's perspective, whenever an advisor accepts equity, they are more clearly aligned with the firm's future success and strategy. It is also less capital intensive on day one since not all of the proceeds from the deal are paid in cash.
ANTI: The downside of this structure is that the equity awarded to advisors is usually given in lieu of additional cash considerations. The first structure described above may be more palatable and attractive to an advisor who prioritizes day one economics since the entire deal is paid in cash. Also, the cash component of this structure is paid off with ordinary income, just as is the case with a traditional forgivable loan.
In the past, a string advisor probably didn't need to bother with the second and third structures described above. But today, even a captive advisor can reasonably sell its business on the open market (a minority or majority investor, a private equity firm, an RIA, etc.) and would typically do so using the second approach described above.
While each structure allows advisors to monetize their book of business for potentially life-changing cash, the mechanics, risk sharing between buyer and seller, and legal ramifications vary significantly from one approach to another. So it is essential that advisors understand each of these structures, their unique advantages and disadvantages, and how they align with an advisor's goals and vision for their business life.
Jason Diamond is Vice President, Senior Consultant of Diamond Consultants – a nationally recognized recruiting and consulting firm based in Morristown, NJ that focuses on serving financial advisors, independent business owners and financial services firms.