Deciding to pay a current or future partner in equity is only the first step in a complex process for registered investment advisory firm owners.
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But stock compensation can help firms attract and retain financial advisor talent, create a succession plan and boost their valuation, according to a webinar held last month by consulting firm Succession Resource Group and led by Julia Sexton, the firm’s director of strategic organizational planning, and Nicole Frey, its director of team solutions.
A successful equity pay plan requires choosing the right structure for the firm’s goals and the correct corporate entity for tax and compliance. Advisors should start by figuring out the end goal with the compensation, Sexton said. This helps clarify complex decisions, such as whether to pay with phantom equity (which provides appreciation or liquidation rights without technical ownership) and how possible voting rights may affect the firm’s governance, taxes or possible future M&A deals.
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Watch out for these common mistakes
To do this, owners must shed the misconception that “they have to immediately give away ownership in order to create incentives,” she said. Other compensation methods can “create financial participation without giving up control.”
“Before you start implementing a plan, you have to ask yourself why and who as it relates to equity sharing, because, if these aren’t clear, the plans usually become — or the creation of the plans can become — messy, and the strategy and structure really do work best when it’s aligned with your actual long-term goals for the firm,” she continued. “Once you know why you are doing this, or can answer that question, it becomes a lot easier to identify who should participate, what plan or options make sense and then how that plan should ultimately be implemented.”
Many original owners have essentially gone backward into that process by using a traditional form of equity pay that assigns ownership of certain portions of the client base to individual advisors, according to Sexton. That works the same way as paying advisors splits of revenue production — a recipe for “a siloed business model” that doesn’t lead to any succession plan but does pose “a cost right off the top that directly detracts from your overall company value,” especially when one team member leaves someday and takes the clients away, too, she said. The difference between paying equity in a group of clients versus in a company itself often amounts to as much as $1 million in the firm’s valuation over a decade’s time.
“This is why it is an important mind shift,” Sexton said. “A lot of firms, as I mentioned, historically, have rewarded advisors by carving out pieces of client relationships, or giving them what they’ve sourced. However, more firms today are trying to build a team-based or ensemble-based business structure, because this is what’s creating that true enterprise value that survives well beyond any one individual advisor.”
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Governance, ‘goodwill’ and selecting a future partner
Once they have avoided that pitfall, the current owners must figure out how their equity pay aligns with the career paths for advisors and other key personnel.
More owners are using phantom equity, which can be tied to value appreciation or liquidation transactions early in those tracks based on specific criteria around performance, tenure, vesting and other determinations. Eventually, the recipients could qualify to gain actual equity through grants, purchases or — in a method that is increasingly common in M&A deals — swaps. The latter type makes the fine print of provisions like the voting rights and timelines especially pivotal. Nothing is as significant as whom the owner chooses to receive that equity.
“Once we start talking about actual ownership or partnership, we’re also talking about corporate governance — what decision-making powers you may be sharing, fiduciary responsibilities that these employees will take on or have, and the long-term partnership dynamics of those considerations,” Sexton said. “This is why candidate selection becomes incredibly important, because you are not just simply rewarding a high performer. You’re potentially adding a future business partner, which means you are needing to evaluate leadership, culture fit, communication style, decision-making ability, and again, considering that long-term alignment with your business goals.”
No owners’ goals for the future include paying higher taxes. That means owners must home in on what kind of business entity is holding what is known as the “personal goodwill” of the firm, which revolves around the valuable relationships between advisors and their clients. Owners must use a corporate structure outside of a sole proprietorship in order to avoid exposing themselves to legal liability for any partners’ actions and ensure future equity transfers can move to a successor, according to Frey.
“We can all agree that equity is intended to represent value, but, before value can be shared, we need to understand where it actually resides,” she said. “And in many advisory firms, that means clarifying whether the goodwill, which is your business value, belongs to the individual advisor, or if that goodwill is something that we can document and record in the operating entity.”
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Succession Resource Group
Tax impact and compliance complications
That documentation doesn’t pose many challenges for advisory practices that don’t use external brokerages or RIAs. Those that do will need to complete “some extra steps that we have to take to make sure you actually are ready for equity sharing,” Frey said.
The goodwill, revenue, expenses, profit and other compensation have to flow into and out of an operating entity, rather than any particular person’s account, and that structure also provides “a contractual basis for that assignment of the income” in a way that reduces the risk of audits, she noted. If they elect to use an S-corporation structure, the auditors will expect to see verification that they are receiving a reasonable salary. Every aspect of the formation documents must fit into the firm’s business model, which may have commissions revenue alongside advisory fees.
“There was a recent no-action letter from the SEC last year that did confirm that advisors can put that type of revenue into an operating entity so you can cover your expenses,” Frey said. “There are some few more nuances that we typically help teams with to make sure that this is still utilized properly once that revenue ends up in the entity, but the short answer here is you can get that revenue into the entity as well.”
Besides the tax impact, the choice of operating entity could affect ownership classes, voting rights and management structure. These elements determine how much control an employee retains over the business after receiving equity. Owners who are concerned about giving up too much operational control may opt for a “manager-managed” limited liability company over the more common member-managed structure.
“You could be the only manager making most of the decisions, and there might be some decisions, just a few, that are left for the members to decide, including yourself, that pertain to either the life of your entity or the rights and responsibilities of the members,” Frey said. “That’s one of those structures that might work well for certain founders if they’re worried about control, but typically we see this type of management structure more for larger companies with a lot of partners where you have to worry about efficiencies.”
