As originally published by Financial Advisor magazine.
Conan the Barbarian opens with the line, “What does not kill me makes me stronger!” However, to quote Philip the Bulgarian, “Whatever kills me, kills me and that is really not good for me.”
Many succession plans are getting tested and they are not about to get stronger. They are about to get killed unless we help them.
For years and years, most advisory firms have carefully, even if slowly, constructed succession plans. They have recruited younger people, developed those recruits’ skills and given them leadership opportunities. Other firms have entered into a dialogue with friendly “neighbor” advisories or even sketched out deals with potential buyers or institutional investors. But now that the Covidian wave has appeared, it looks like our sandcastles may just wash away, and we may have to start all over again.
If the history of the great recession is any indicator, the damage will likely be extensive and will have a lasting impact. In our firm’s experience, the likely impact of a coronavirus crisis is that many firms will abandon their already fragile internal succession plans and seek refuge in the safety of institutional buyers and larger organizations. Unfortunately, many such buyers may themselves be vulnerable, and many may withdraw from the market—remember all the banks that were buying RIAs?
The likely result is that the industry will be in a state of confusion for some time, at least until the next bull market fuels another surge in private equity interest and/or firms regain enough confidence to engage in their own internal construction projects and build their castles again. Unfortunately, the last time this happened founders were in their late 50s and early 60s. That was 12 years ago. Those advisors are much older now, and as we speak, the waves are arriving at the beach.
In discussing the impact of the latest crisis on succession, I would propose we take the same approach as an emergency room: We should treat patients according to the severity of their condition, rather than to the order of their arrival.
Saving First-Time Buyers
For many professionals, the issue of failing succession structure is not an abstract idea about the future but a very real and pressing problem of the present. In a number of firms, up-and-coming team members (G2) have purchased equity from the founders and have financed the purchase with the help of a loan. Depending on the price of the equity, the loan payments could often be financed by the profit distributions of the firm with some cash outlay from the buyers, but not a significant amount. Unfortunately, the crisis has changed all of that.
Throughout the industry, many loans to new partners are “under the water” (to use a mortgage term). The professionals who bought the equity can only make the payments at the cost of significant personal sacrifices or else they might not be able to make the payments period.
As much as it is tempting to conclude that bear markets are part of the “natural” risk of the industry and that the buyers should have known that this is part of the deal, it is also best to remember that these are the “best and the brightest”—the select individuals we rewarded with ownership. We can’t let the reward punish them out of existence. Most firms should try and help if they can.
There are several ideas for helping “first-time” buyers—those with outstanding loans:
- Some firms have tried extending a second loan from the firm to the new partners to help them make the payments, essentially making the payments on their behalf. Such loans can be subordinated to the original loan and be repaid when the crisis is over. This is even easier if the firm is the lender (though in many cases we have been involved with, the professionals borrowed from a bank). Unfortunately, we’re assuming that firms have the capital to lend a hand when they may not.
- Another idea is for firms to try to protect their profit margins at the expense of compensation. There were a select few very large firms that did that in 2009: The partners took a pay cut so that the profit margins could stay at a healthy level and the new owners could continue making payments. Depending on the size of the firm, the partner compensation can be between 15% of the revenue (at a very large firm) and 40% (at a small firm) and the economic impact of that can be very significant. The political process behind these decisions, however, is anything but simple. A number of partners have to voluntarily give up compensation for the benefit of a few. This can be a real test of unity.
What we have to remember is the reason equity was sold to the new partners in the first place: so they could commit their energy and careers to their firms and therefore create not just succession but also growth and stability at their firms. The decision is a symbolic one too. By making professionals “partners,” we declare our commitment to one another.
Delayed Succession Gets Delayed Again
Those that fly a lot will recognize the phenomenon that when a flight is delayed once, it is 10 times more likely to be delayed again and again until it may even be canceled. In a similar fashion, succession plans that were already behind the ideal time line will become derailed by the current crisis and may need to be canceled entirely.
In his book Success and Succession, Tim Kochis made it clear that the process works best if you start early. If you start late, valuations and cash flow work against you. If you postpone the deal some more, you may never catch up. It was not until 2011 that partners saw their income reach the levels they expected before the great recession, and three years may be a very long time to wait for many plans to have a realistic chance.
Imagine, for example, that a successor had planned to purchase 5% of the equity of a firm each year for the next five years. This would make them a 25% owner by 2025 and would allow one of the founders to retire. What happens now if we have to wait three years for a recovery to start the process again? Either the founder’s retirement has to be pushed back to 2028 or we have to somehow get the successor to buy larger “chunks” (for example, 3 x 8.33%) starting in 2023. Neither choice may be practical.
Some remarkable entrepreneurs I talked to in the last month looked at this problem and decided to forge ahead. The founders committed to continue selling equity, even at a lower valuation, and to finance the transaction so that it worked for the buyer. I truly admire such businesspeople, but unfortunately, they are likely in the minority. Even if the sellers stay committed, the buyers may not be there.
Buyers Get Scared
Internal buyers are a nervous bunch. Many of them had likely already been worried about what would happen during a recession amid a meteoric rise in advisory firm valuations, which they likely saw as unsustainable, and that likely made them wary of buying into equity that could decline. Now their fears have come true and the trauma may leave them without any further appetite for the risk of buying equity. They’re also facing a period of reduced or frozen compensation that will deplete their personal financial resources, perhaps force them to put personal projects on hold (home projects, for instance). It can be a bit like the feeling after you’ve twisted an ankle. You’re going to be afraid to jump for a while.
Hires and Development Are Delayed
It exacerbates the situation if the crisis forces you to delay much needed hires. Often, a firm needs three or four successors to replace a founder (it’s better risk management). A crisis delays those hires and then the period of time they need to acclimate and grow (and further derails the timing).
Sellers Are Reluctant to Sell
While buyers are nervous, sellers are very reluctant to sell too. There is a well-known phenomenon in psychology called attribution error. If you set up a romantic dinner with your partner and they arrive late, they are likely to blame something very specific, like traffic, while you are likely to blame them (“You are always late.”) When a firm’s profits go down, something similar happens. Founders tend to wave it off as a onetime thing, even if it’s severe, but successors see it as a symptom of something worse, and likely think it will keep happening. “What we have here is failure to communicate,” as they say in Cool Hand Luke (a line I first heard in a Guns N’ Roses song).
Valuations Come Under Question
It is very difficult to value a house on fire. You have to put out the fire first and then assess the damage, perhaps even fix it. In a crisis, buyers and sellers have a very hard time agreeing on the assumptions needed for a valuation. It is easy to see why. The most important components to any analysis are questions such as “What is the expected rate of growth?” How can you answer that when you are declining? “What is the expected profitability?” It would be nice if we had any at all. “What staff do you expect to hire?” It would be nice to not have to fire anyone.
Done Deals Are Undone
Even as I write this, we have already seen some carefully negotiated succession transactions get suspended. Unfortunately, succession deals don’t do well on the “back burner.” It is tempting to try to suspend a deal until things recover, but like a meal unconsumed, it might go bad. Either the buyer or seller or both might decide it’s not what they want. It’s possible, but hard, to find creative solutions to preserve the deal.
One way to reconcile the needs of buyers and sellers in an environment like this is to structure the payments and make them contingent on certain profitability milestones the firm has to reach to restore itself to its pre-crisis condition. For example, a buyer may base the purchase price on the pre-crisis EBITDA, but the guaranteed up-front portion may be driven off the much lower revenues endured during the bear market while the remaining payments are made when EBITDA reaches the pre-crisis level and then exceeds that threshold.
Beyond Institutional Buyers
Many firms delayed their plans after 2008 (which led to a boom more recently). The buyers also changed quite a bit between 2007 and 2019. Many of the most active ones in 2007 did not weather the storm well. Banks acquired a lot of firms, but these were “unacquired” afterward when the buyers found themselves with vulnerable balance sheets (they had used a lot of financial leverage).
This is why founders need to continue trying to save internal succession, even if it’s tempting to give up. Even institutional buyers prefer firms with internal succession. It comes down to commitment. In 2008 and 2009, a few firms persisted and continued to sell equity to new owners. But for most firms, that may not be possible. But when the generations can come together to go down that path, they might not only survive together but also create new and perhaps more resilient plans. The problems are many but when there is a will, there is a way.