With advisors retiring in droves, succession planning is a major industry issue. How do a firm’s founder and his successor unlock the greatest potential value for the business, while managing a smooth transition?

These excerpts from a new book, Success and Succession, attempt to answer this pressing question. The book grew out of a 2013 conference hosted by Financial Planning columnist Bob Veres, during which Eric Hehman and Jay Hummel took part in a discussion on transition issues. At the time, Hummel was president and COO of a large RIA, and Hehman was CEO of Austin Asset. Their co-author, Tim Kochis, is a principal of Aspiriant, where he has been both CEO and chairman.

The book that eventually emerged from that conference session considers how advisors can ensure a successful changing of the guard to the mutual benefit of the firms, founder, new owner and employees.

A PEOPLE FRAMEWORK (FROM CHAPTER 2)

Every high-performing organization should have expectations for each role. If people aren’t meeting the minimum expectations today, should they be around? The response to that question from an operational viewpoint is simple. How about three years from now? We live in a service economy. The client experience is the focus of every service organization. Clients know this and continually increase their expectation of what a good client experience looks like. Advisory businesses are no exception. The expectations of service delivery increase; consequently, the performance expectations for your people need to increase with it.

Having a culture that fosters raising the level of performance is important and can be accomplished only if that is a part of your performance appraisal process. The performance appraisal process does not need to be complex. Larger organizations often have a formal human resources program to manage this. Smaller firms may merely meet casually with employees once a year over lunch.

Whatever works for your firm is fine so long as a “better than average” performance today becomes only “average” performance three years from now, and average performance today may be considered an unsatisfactory level at some time in the future.

One way to begin to get this across is to have employees list their top 10 accomplishments each year as part of a self-appraisal process. This allows you to see how employees view their roles, what’s important to them and what they are proud of. If you do this each year you can compare the accomplishments, year over year, to see if their positive impact on the business has increased.

LET'S MAKE A DEAL (FROM CHAPTER 7)

In the end, owners need to make a deal with somebody if they want to transition out of the business. Unless they permit the firm to simply wither away, owners will either need to sell the business internally or externally, employ external capital, seek the assistance of an aggregator, engage in a merger … or some combination of all of these approaches.

What are founders and successors willing to do to keep the firm independent? While a discounted valuation is always the case in internal transactions, should successors still take on debt to buy more ownership? How do current owners and successors think through this process? How do successors protect themselves from risk of a minority stake in the business? How do selling owners protect themselves from a quick subsequent third-party sale? What should a successor ask for in a deal and what should a founder do if the successor doesn’t step up? How should founders and successors optimize a strategic merger or external sale?

Current owners have four financial options: 1. Retain a predominant ownership stake in the company, risking an eventual drop in equity value (hoping meanwhile to get enough cash out of it), 2. Complete an internal succession by selling shares at a discount, 3. Bring in outside capital to assist in an internal transition, or 4. Sell or merge the business. For a successor, the guiding principle in any of these scenarios is that while the founder needs to be treated fairly, it can’t be so favorable to the founder that the successor retains too little upside.

Let’s assume for the rest of this chapter, that option 1, milking the business, is off the table. ... “Doing nothing” … for now … is a legitimate strategy. But, it can’t be a permanent one. At some point, the strategic focus must move toward one of the other options, if it’s not too late. Strategic delay can become a form of perennial denial, permitting the founder to cultivate the delusion that there will, someday, be some attractive rescue. No one lives forever; not eventually escaping that denial toward one of the other strategies will not have a happy ending.

When is the optimal time to choose a more affirmative strategy? There is no general answer, but in the preceding chapters we’ve tried to identify some important clues as being when the urging of successors and the calculated “enough” for founders coincide.

IT MAY BE TIME TO CONSIDER A SALE OR MERGER (CHAPTER 7)

Much of this book focuses on the hope many firms have to be able to remain completely independent and accomplish a successful internal transition. Section I of this book was devoted to efforts toward building the organizational and operational foundation for doing that internal transition. Section III will address the emotional roller coaster that any transition, … but especially an internal one, … involves. Still, there may come a point where a sale or a merger makes the most sense. If an internal deal, even with some outside help, can’t be accomplished, a founder will ultimately try whatever has a reasonable chance of achieving his or her most important goals. In contrast, many successors are prone to consider it a failure if the entire business is sold to another entity or merged into one. But that new arrangement may well present opportunities that realistically weren’t available for successors in the existing scenario.

Outright sale, of course, involves some kind of direct payment, often in installments, often tied to continued employment by key principals and often with targets for financial performance going forward.

Mergers usually rely on continuing participation in business operations and a reconfigured sharing of the equity of the newly merged organization; very often, little if any cash changes hands.

Most mergers, however, are still a form of acquisition of one firm by another. Rarely are they true mergers of financial equals, despite the rhetoric often used to describe them. “Equivalency” can come, however, in the form of the aggregate worth of complementary characteristics, such as client service capabilities, professional talent, geographic market penetration, client diversification and management capabilities. Thus, most mergers are a very special kind of “sale,” … usually not for cash, but for a share of equity in a new entity where the whole is expected to be greater than the sum of its premerger parts.

Nevertheless, there’s no escaping some essential valuation calculation. How much of that new, merged entity’s equity will the respective owners of the premerger businesses come to own?

If the merger indeed brings complementary advantages, that sharing of the new firm’s total value should be accretive to owners of both participating firms … but it won’t be equal.

So, in either case, sale or merger, the two financial questions are: will someone want to buy or merge with your business? Will they pay, or allocate equity sharing on, what you think it’s worth?

WHAT DRIVES VALUE? (CHAPTER 7)

Many founders are stuck between determining whether to continue running the business, finding an external buyer or finding an internal buyer. These are business organizational and emotional decisions, but if a founder is on the fence, truly understanding what drives value is crucial. David DeVoe has been an advisory business thought leader on transitions for well over a decade. He has developed a screen of 40 value drivers for an acquirer’s valuation of a firm. In DeVoe’s hierarchy, the top three drivers are significantly more important than the others: “Is there someone in the business to keep the clients in their seats? Is the management team truly a team? Is there a single point of failure? If the founder is the only one making investment decisions, for example, a firm is probably worth less.”

DeVoe sees why acquirers struggle to value and buy advisory businesses: “Only about 25% of advisory businesses have developed any kind of succession plan. Once it’s obvious to a buyer or merger partner that there’s no plan in place other than to sell, founders can’t expect to get full value. Although we are hearing ‘I don’t need a succession plan because I’m going to die at my desk’ less frequently than we did a few years ago, we still hear something to that effect shockingly often.”   

Excerpted with permission of the publisher, Wiley, from “Success and Succession: Unlocking Value, Power, and Potential in the Professional Services and Advisory Space.” Copyright (c) 2015 by Eric Hehman, Jay W. Hummel and Tim Kochis. All rights reserved.

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