How do you find and retain employees who have the capacity to “think like an owner?”  One answer is equity based compensation - a powerful tool if you know how to use it.  

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After more than ten years of pioneering and studying the succession plans utilized in the financial services industry, I can report that the number one succession planning strategy used by independent financial advisors is: attrition. 

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This is not good news, but it is a strategy (and I use that term generously) that is declining fairly rapidly in the face of better techniques and the knowledge that a financial services practice is now the single largest, most valuable asset that most advisors own.  

Here’s what happens. At some point at around age 50, an advisors’ rate of annual revenue growth “plateaus” and subsequently begins to decline – these advisors are, in fact, “coasting” as opposed to building. In essence, this industry’s oldest and most experienced advisors have implemented a twenty year retirement plan punctuated by declining production numbers for the duration. From an advisor’s point of view, the issue is relatively simple. What’s more valuable - an ongoing paycheck until they die or quit, received at ordinary income tax rates, or the full value of their business (which most advisors don’t know) received at long term capital gains rates at some unknown and unpredictable point along the way?

The answer depends on how much longer the advisor wants to work. If time is not a factor (i.e., the advisor is not leaving the practice due to an extraneous issue), it can be better financially for an advisor to take the monthly “paychecks” (or business profits) over this span of time, assuming that the clients stay and the cash flow does not significantly decline. Basically, for a financial advisory practice with average overhead, the breakpoint is about four to five years — anything less than that time frame, an outright sale makes more sense; anything longer than that, staying in the business probably makes more sense.

In sum, for most advisors who are unsure of what they want to do next and have no precipitating reason to leave the industry immediately, the perceived value of their monthly “paychecks” is greater than the sale of the business at its peak, especially in the absence of a professional, formal valuation. This is why there aren’t more sellers. But we see this changing with each passing year.

One of the biggest changes to come about from the Great Recession is that financial service practices have become the single, largest, most valuable asset that advisor’s now own. As a result, equity management is being utilized by most of the major broker-dealers to ensure that advisors maintain their businesses and monitor value over time. The goal is to maintain both the compensation the business produces and the equity that will fuel an advisor’s retirement. You can and should have both rewards for the work that you do. With proper planning, it can happen. 

Like compensation, practice equity belongs to the retiring advisor. The responsibility for managing and protecting that equity, as well as for providing professional services on an enduring basis to a group of trusting clients and their families is that of the independent advisor and no one else. It’s time to step forward and take control of these independent businesses and the future.

If you’re thinking about selling stock in your advisory business to one or more employees (or a son or daughter), you need to know about minority discounts. 

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A minority discount is only relevant when valuing shares in a closely held or privately owned company.  The use of a minority discount can help move more ownership, or shares, into the hands of a son, a daughter, or employee, faster and with fewer tax consequences, if applied correctly.

A minority interest is non-controlling ownership, usually defined as less than 50% of a company's voting shares. A minority discount is a reduction in the price of stock from its fair market value because the minority interest owner(s) cannot direct or control the business operations, and because of lack of marketability of the stock.

The dynamics of the internal transition process in most financial service business models is one in which the owner(s) feels compelled, or at least in their interests, to facilitate the financing for the buyers, in one way or another. The company or the selling shareholder cannot gift shares of stock to a non-family member without tax consequences equal to ordinary income.  You can increase the employee’s salary, or give them a bonus, only to see them pay taxes at ordinary income rates and turn around and buy stock from a majority owner, creating long term capital gains rates for the seller. Most sellers don’t like that sequence of tax events. A minority discount sometimes makes more economic sense and can help advance the prospects of both parties, especially on the equity management issues of continuity planning and business growth.

In terms of minority discounts, the applicable range is between approximately 0% and 40% percent (I have seen 50%, but that’s pushing the envelope in my opinion). It is imperative that every owner and investor confer with their CPA first as to what is reasonable and appropriate in each situation.  Note that it is appropriate to calculate separate discounts for lack of control and for lack of liquidity. A discount, if offered, should be applied fairly and evenly. For example, if a 10% interest in the company is being sold to two investors at or about the same time, the same valuation method and the same level of discounting should apply to each sale.

Owners and employees, including sons and daughters in family-run businesses, agree in most cases to what is fair and reasonable after consultation with their tax counsel and after considering all the circumstances – there is no clear answer as to precisely what level of discount is appropriate.

Interestingly, in most cases, at least in the financial services industry at this value level ($4,000,000 to $5,000,000), the parties agree that the minority discount will be zero, but with some important considerations. Minority discounts are not always “packaged” as a discount in value; rather, such discounts or benefits are often embedded in the lending terms.

Consider that, in most internal sales, the owner or seller of the stock almost always provides very generous financing terms, enabling the purchase of the minority shares, perhaps even providing the funding through a salary increase or bonus or payment of dividends. Also consider that, in the majority of cases, the minority owners may have a direct path to majority ownership upon the owner’s death, disability or retirement, usually through a written continuity or succession plan (i.e., a Buy-Sell or Shareholders’ agreement, or a Right of First Opportunity), which also, again, is usually accompanied by very generous, long-term financing terms from the owner or the company (or the company itself in a redemption situation).

The reality of minority discounts lies in the answer to this question: how do you sell or transfer the equity in a financial services business, worth, say, $500,000, to an employee, son or daughter, who has little or no investible assets? The answer is, as an owner, you find a way to legally reduce the price per share. In order to do this, it is often necessary to sell the stock incrementally. Every share an employee, son or daughter buys, as long as they own less than 50%, is arguably subject to a minority discount for lack of control and for lack of liquidity.

For most owners, it is a combination of factors and misunderstood issues that sidetrack the process before it even begins.

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The following is a summary and explanation of the various elements underlying an internal ownership track for the average financial advisory business:

Control: The issue of control is both real and emotional, but providing one or more key employees with an ownership opportunity is not about surrendering control.   An internal ownership track isn’t about providing a certain quantity of stock – the goals under consideration in this posting can be easily accomplished with just 1% to 5% of the company’s stock.  The stock can be non-voting (even in an S-corporation), and will certainly have “hooks” attached to it that ensure it doesn’t leave if your employee does.