Kitces: When should advisors put the brakes on growth?

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As the advisory industry has grown less transactional and more relationship-based, the total number of clients that any one advisor can handle has decreased dramatically.

This shift is carrying advisors to what we might call a capacity crossroads, where they must consciously decide to stop growing or hire additional staff to increase the firm’s capacity. Yet for those who choose the latter path, little suggests that they’ll realize any economies of scale. In fact, top-performing solo advisors often have the same take-home pay as the average partner at a $1-billion-plus ensemble.

The key consideration, then, is simply to follow the choice that will maximize their sense of accomplishment and happiness. By intentionally setting a vision for the type of business they want to build, advisors can rest assured they’re moving down the right path.

In the early days of the profession, advisors rarely had to consider their capacity to take on business because the business itself was more transactional. The focus every year was on finding new opportunities. Clients, meanwhile, were simply people who the advisor had once sold a product to and had minimal ongoing service needs.

That’s why brokers or insurance agents often had hundreds of clients — many of whom the advisor might not have actually met with in one, three or even five-plus years.

Today, however, there are only so many hours in the week to take all meetings and perform all service work. As it is, the human brain can only handle so many relationships; researchers have estimated that number at approximately 150 people, often leaving advisors with room for no more than 75-100 clients.

The most straightforward way for an advisor to navigate past the capacity crossroads is simply to hire more staff. This often entails first hiring an administrative assistant to handle more of the servicing work, then adding a paraplanner to help with the planning support, and eventually a servicing advisor to manage at least a portion of client relationships.

Adding staff, however, means that the advisor now has to manage a team. This often results in a material amount of additional work — in the name of generating what is often remarkably little additional income. That’s because early clients generate substantial income for the advisor-owner doing the work, but the owner only generates the profit margin remaining after other advisors start doing the work.

Example: Celia started her advisory practice with the goal of earning a good, healthy income. After her first year in business she was happily advising 25 clients, with an annual gross revenue of $50,000 and a net revenue of $35,000.

She loved spending time with her clients, having lengthy discussions about their lives and goals, and creating thoughtful, detailed plans for them. However, she did such a good job that they quickly began referring several of their friends. She didn’t want to refuse her clients’ referrals, but without a clear vision of what she wanted to grow toward — or who her ideal target client was — the firm quickly mushroomed to over 100 clients.

With an increase of gross revenue to $250,000 across those 100 clients, Celia had to hire an assistant at $40,000 per year and a paraplanner at $55,000 per year. Now that she had employees and a much larger client base, she also needed a larger office space and other new overhead expenses, e.g., insurance, payroll services and tax, new office equipment, supplies, etc.

Once Celia’s employees and overhead expenses were paid, her net revenue was only $105,000. Despite the fact that she quadrupled her client base, adding more than $200,000 of additional revenue, her net take-home income was up only to $70,000.

Celia was stressed out and unhappy. And because she had so many more clients, she couldn’t spend the focused time on plans that she once enjoyed so much. There was little opportunity to catch up with her favorite clients over lunch or drinks, and she resented having to maintain a strict meeting schedule just to ensure she could give all her clients at least some attention.

The fact is that some advisors don’t want to hire and manage people — lest they begin to feel stuck managing more people than they ever wanted to. This has led to a dichotomy in the industry between so-called lifestyle firms that choose not to hire and remain founder-centric, and becoming an enterprise firm that grows beyond the founder.

The flaw of this dichotomy is that many or even most firms don’t appear to clearly fit either definition. As while some firms focus on being high-income solo advisors and others on rapid growth and scaling to become a large enterprise, there is a substantial subset of advisory firms that do eventually grow beyond their founders, adding in associate advisors, service advisors and sometimes even partners, in a desire to serve more clients. The crucial difference is that they don’t have the mentality of being enterprise builders by any classic definition.

Rather than grow for growth’s sake — maybe with the goal of a sale and liquidity event for the founders — these firms are simply trying to get better at delivering whatever unique service they have created.

In 2006 Bo Burlingham, the former executive editor of Inc. magazine, published a book called “Small Giants.” His subject was a subset of companies that, to quote the book’s subheading, “choose to be great instead of big.” The core thesis of the book was that these companies are purpose-driven, not making decisions to maximize growth but instead aiming to be the best at whatever they did.

A key distinction of small giants is that not only are they not huge, but also that they’re not publicly traded. Instead they’re privately held by their founders — or at least carefully guarded in the hands of shared owners, all committed to the same company vision and goals.

This allows the advisory firm to maintain its control and freedom. It also means the owners have the luxury of balancing a broader range of needs and stakeholders than just concerning themselves with maximizing profit and shareholder value.

One of the key traits of small giants is that they don’t necessarily have to grow very much at all — because again, their focus isn’t exclusively on maximizing the value of the company, but on being excellent at whatever the company does. Quoting business gurus Tom Peters and Robert H. Waterman, Jr., and their book “In Search of Excellence,” Burlingham notes that “great organizations originate from people who have ‘not totally stupid obsessions’ around which they build their businesses.”

In turn, part of what make small giants successful is precisely their holistic focus. Being better and prioritizing service not only to customers/clients but also to employees, vendors/suppliers and communities is the goal.

This in turn encourages higher-quality relationships, reinforcing these stakeholders’ attraction to the business in the first place. All of this creates what Burlingham calls the “mojo” of small giants: the business equivalent of a leader’s charisma, which in turn makes people want to connect with the company.

Ultimately, Burlingham finds that the defining characteristics of small giants are their mission-driven purpose; their service leadership; their intimate, employee-first culture; their relationship-centric approach to customers and suppliers/vendors; their deep roots in their communities; and their focus on not necessarily maximizing profits, but being certain to protect their gross margins to remain stable without compromising company values.

This again goes beyond the lifestyle firm that reaches its capacity and stops growing, but isn’t necessarily the same as a classic enterprise that pursues growth and maximizing shareholder value — with whatever outside capital and potential loss of control that may entail.

The conventional view of business is that it’s a grow-or-die world, and that all owners should always and only want to keep growing and maximizing profits.

Yet in recent years, industry benchmarking studies have revealed that the connection between advisory firm growth and its anticipated benefits are not so straightforward. It appears that there are virtually no economies of scale to be found in the operation of an advisory firm as it grows from $50 million to $250 million to $1 billion to $3 billion, as overhead expense ratios and profit margins remain remarkably steady up to a multibillion-dollar size that exceeds what the overwhelming majority of advisory firms ever grow to in a lifetime.

In other words, there’s no discernible growth-leads-to-efficiencies link to be found among 99%-plus of all advisory firms.

Additionally, ongoing growth in a service- and client-intensive business like planning often necessitates introducing new partners to the business who have a stake in what is being built, otherwise they’ll walk away with their clients and revenue. This results in a dilutive effect to equity and profits even as the firm grows.

More generally, the mere fact that for the first 100 clients the advisor earns virtually all the net revenue, minus just a small allocation for overhead expenses — which can be as high as $0.70 to $0.80 on the dollar — but earns just the profit margin, which may be no more than $0.20 to $0.30 on the dollar beyond that point, means actual take-home income growth ends out being far slower than revenue growth as advisory firms grow past their founder’s capacity.

This is even more common for firms reinvesting heavily to produce that growth, such that they can’t even enjoy 20% to 30% profit margins because of all the additional capacity hiring they must do. On the other hand, the growing availability of technology has made solo advisory firms more efficient and profitable than ever.

Industry benchmarking studies have shown that the top-performing solo advisory firms can actually generate the same take-home pay as the average partner at a $1-billion-plus AUM super-ensemble advisory firm. And some high-producing solo advisors can be even more profitable.

Of course, advisory firm founders who build larger ensembles do build the value of their equity, in addition to the income stream. Yet owing to the necessary burden of reinvestment of profits to fuel that growth, owners of growing ensemble firms typically take home even less in income for years or decades — such that the value of the equity may not materially enrich the founder, and instead merely makes up for the foregone profits along the way, except for perhaps a small subset of the very largest enterprise advisory firms.

That the wealth-building potential of most lifestyle, small giant and enterprise advisory firms can be remarkably similar raises an interesting question: If continued growth doesn’t necessarily result in greater wealth, what is the best path for an advisory firm owner to take at the capacity crossroads?

In essence, the choice comes down not to what is financially best, but to what the advisor wants to build.

A lifestyle firm becomes the preference for those who would rather work to live, rather than live to work. This includes those advisors who not only want to balance the demands of the business against their nonbusiness goals and desires, but specifically want to remain primarily client-facing and to avoid the burdens of managing a substantial number of people. Lifestyle firms are simply those where advisors are first and foremost paid for the advisory work they do.

Notably, lifestyle firms are rarely sold. Instead the most profitable path for them is simply to remain in the business and realize an income as long as they can, which is more remunerative than selling the firm anyway.

A small giant is preferable for those who don’t only want to make a good income, but feel a fundamental drive and desire to have their business deliver a better solution. These individuals recognize that such a path will inevitably mean the advisory business must grow beyond its founder, and the founder will ultimately wear the hats of advisor and firm owner managing a growing team.

Small giants tend to pursue internal succession plans and/or heavily utilize employee stock ownership plans, recognizing that when a unique purpose-driven business is built, it’s extremely difficult to find external buyers who will honor the business’ original vision and purpose. Internally developed talent, steeped in the culture of the firm and able to carry the legacy and vision of the business forward, is infinitely preferable here.

An enterprise, meanwhile, is the preference for those who truly feel driven and motivated to transform from an advisor to an advisory firm business owner.

For enterprise builders, it’s common and even likely that the founder will eventually move away from client relationships altogether, and instead immerse themselves in the growth and development of their people and their culture instead, as well as building and maximizing the shareholder value of the business by whatever path it takes.

This may take the form of organic or inorganic growth — self-funded or strategically taking outside investor capital — often with an eventual goal of a liquidity event that may take the form of a sale to a larger firm, an acquisition by a strategic partner or private equity firm, or an IPO in the public markets.

The key point is simply to recognize that the decision to keep growing past the capacity crossroads doesn’t have to be an all-in-or-all-out decision. There is a middle ground: the small giant, the purpose-driven business that may happen to grow along the way, but isn’t necessarily motivated by pure profit as much as a desire to blend financial and nonfinancial goals in delivering the business’ purpose-driven value.

The unhappiest advisory firm owners tend to be accidental business owners — individuals who find themselves developing their business down an undesired path. They may make more money, but they become far less happy as they’re forced to take on roles to support the business that they never envisioned.

By setting a vision that aligns to your goals and values, arriving at the capacity crossroads becomes not a moment to fear, but rather just a stop on your journey toward becoming something greater.

This article originally appeared in the Michael Kitces blog Nerd's Eye View
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