The RIA founder's dilemma: Choose your successor or sell

This is the 28th installment in a Financial Planning series by Chief Correspondent Tobias Salinger on how to build a successful RIA. See the previous stories here, or find them by following Salinger on LinkedIn.

Registered investment advisory firm founders who build profitable businesses with a stable base of clients must one day decide how they would like to pick a successor.

With around a third of the industry's financial advisors expecting to retire in the next decade and a looming potential shortfall of professionals compared to the demand for advice, RIA  successors will either emerge internally or through an acquisition. One path at that fork in the road likely poses a more lucrative exit from the field, but with less autonomy about the transition of clients to a new advisor after selling the firm. The other trail enshrines an advisor's legacy with those clients under the same company with handpicked successors. But developing those successors has proven challenging for many firms that are simultaneously fielding higher bids from RIA aggregators.

Internal successions equate to a "natural discount of at least 30%" compared to selling to private equity-backed firms and other RIA and advisory team consolidators, said Steven Tenney, a former advisor who is the founder of consulting and RIA coaching firm Grandview & Co. and the author of a new book published earlier this month called, "RIA Succession Alpha." They also require "empowering the next generation of successors," so that "the firm starts to run on its own, with less input from the founder," he noted. After an RIA has created its plan, its one or more owners and their team must work together through the transition.

"Without clarity, you're aimless, and so you've got to start there," Tenney said. "Many people treat succession planning as an event, as opposed to a necessary part of business. There is near-perfect overlap between succession planning and good business planning. It's one and the same."

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By the numbers

Signs are emerging that RIAs are getting the message on their imperative to hire new talent. More than three quarters of RIAs with at least $250 million in client assets who were part of Charles Schwab's latest annual RIA Benchmarking Study hired employees last year, with the median firm adding at least two staff members. Those median firms must add four roles in the next five years to keep up with the current rate of growth at RIAs. And at least 47% of the participants with fewer than $250 million in client assets had no succession plan, with more than a third — 36% — of those above $250 million admitting they don't have one either. Even without taking retirements, attrition or new RIAs into account, industry expansion rates entail hiring tens of thousands of new staff members in the next five years, Schwab's study said.

Most RIA founders would prefer succession plans that transfer ownership of the firm internally to another member of their teams over one involving an M&A deal with an external investor, according to another survey released earlier this year by consulting firm Advisor Growth Strategies. Owners view internal succession as a better means of legacy preservation, a long-term benefit for clients and a leadership opportunity for current staff members who show potential. 

On the other hand, the "obstacles to consider when pursuing an internal succession plan" include the fact that "firm leaders may be leaving money on the table due to the much higher multiples that come with external transitions," the report said. External deals bring a purchase price at a median ratio of 11 times a firm's earnings before interest, taxes, depreciation and amortization for an external deal, compared to a multiple of 7x EBITDA for an internal transition, the report said.

"Next-gen leaders may face challenges while waiting to take over the business, including affordability issues and balancing personal income with equity commitments," it said. "For firm leaders, next-gen leadership training can also be time-consuming and expensive. In certain instances, the professionals that drive business development and revenue growth tend to be the founders, while next-gen leadership do not have the skills or track record to drive future client growth."

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Takes two or more to tango

The difference in skills involved with the various parts of RIAs explains why Brandon Kawal, a partner at Advisor Growth Strategies, often guides founders to consider two to four successors for each one selling equity in the firm, he noted. Sometimes the owners forget that "the other side of it is, you have to have willing participants on the other side who want to take on the responsibility of running a business and buying equity and being a successor in the fullest sense," he said. 

"You're playing the odds that everyone wants to be an owner, that they want to step into that leadership role," Kawal said. "Some may not want that at all at their current stage of life, so timelines have to match up, not only for the founders but also for the next generation that are coming into these businesses."

Successful transitions require focused compensation, successor career paths and appointing specialists for the many aspects involved with running an RIA rather than striving toward the "tall order" of finding someone who is "functional in all the areas" that many founders take on for themselves, said David Grau, CEO of consulting firm Succession Resource Group. Picking a successor means hiring "the right people" instead of "trying to create little Mini-Me's," he said.

"Much like building an NBA roster we need the vets for sure, but we also have to have an eye on young talent," Grau said. "You don't find them, you build them, and you have to be very intentional about continuing to hire and train."

After a roughly three-year process, Dominique "Dom" Henderson, a planner who is the founder of Dallas-based RIA firm DJH Capital Management and the Jumpstart Coaching Lab, an advisor training and coaching firm, is carrying out his own succession plan. 

Henderson has informed clients that he intends to withdraw his RIA registration within the next 16 to 18 months and join a "strategic buyer" firm to focus on his advisor coaching and consulting business, he noted. While he declined to discuss which firm is acquiring his planning business, Henderson described the deal as a "unicorn" in the sense that the firm has hired his consulting firm to "come in and coach advisors I'm recruiting." That will enable him to identify possible successors for his clients out of the incoming teams.

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Beginning the handoff

For firms that opt for internal deals, a much different approach is required, and Henderson and other experts point out the time and careful attention involved with documenting and executing the plan. Part of that is understanding that a refusal to let go of the many parts of running an RIA will not "translate to value in the marketplace," Henderson said. So a founder must add administrative personnel to the RIA's team until the staff handles day-to-day duties and a successor begins to join client meetings and manage more aspects of the account.

"This person gets 20, 30, 40 relationships and they learn the business that way," Henderson said. "As you grow your firm in revenue, you're bringing on these strategic pieces with it in mind that you are not going to be able to do this forever."

The combination of factors — including the ability for successors to finance pricey deals, high failure rates among novice advisors and some tensions around firm owners stepping down from their roles — make internal succession a tough task for any RIA, Tenney said. As part of writing his book, he interviewed the owners of "a company that had been around for 170 years, and they couldn't figure it out," he noted. The successors may or may not be ready to own and operate an RIA, while owners could struggle to adjust to the change as well.

"It is very difficult for owners and founders to relinquish that control," he said. "There's a strong sense of identity loss, where these founders have been at it for 30 to 40 years. They did it a certain way and it worked, it was immensely successful. And now they're going to turn over the reins, and that's hard to do."