As originally published in Financial Advisor magazine.
One of the most difficult issues in managing an advisory firm is establishing a fair balance in rewarding those who own a firm and those who contribute to its growth. Even though owners and contributors are often the same people, the degrees of ownership and contribution create some extremely difficult questions: “What should a firm be doing if someone contributes 30% of the business but owns only 5%?” On the other hand, what if someone owns 30% of the firm but contributes only 5% to the business?
Both these things occur frequently, and often simultaneously—say, when founders may be slowing down while the younger professionals are emerging as business developers, experts and leaders.
The intuitive rules of fairness would suggest that somebody contributing 30% to the success of a business should receive about 30% of the rewards. But the not-so-intuitive rules of equity dictate that ownership is something different from the work and has to do with purchasing the shares and investing capital into the firm. After all, no one expects Jeff Bezos, who owns approximately 12% of Amazon, to do 12% of the work and ship 12% of the packages (even though it’s a fun thought). Then again, if Bezos were to leave Amazon, the packages would still be shipping. In many advisory firms, by contrast, when a key person leaves, a lot of the firm’s activity and value may also leave as quickly as same-day delivery for a pair of boxing shorts (yes, Amazon sells those too).
This is perhaps the quintessential issue of ownership that makes professional services firms different—the value of the firm is so strongly connected to the effort of the professionals working that it is very difficult to not seek a connection between their contribution and ownership. Still, if we were to abandon “ownership” and only focus on those actively building the firm, then how can the advisory firm have any value? And if there is no value in a firm, why would anyone be investing in it?
In my mind, there is only one answer: For a firm to have equity value, it has to look for compensation and not equity to reward those non-owners who contribute the most. At the same time, for a firm to function and attract talent over the long term, it does have to find a way to invite those who contribute the most to also be the significant investors.
In other words, in the short term, equity and the work contribution don’t have to be aligned, but in the long term they probably should be. Finding that balance, however, is very difficult.
To even start this discussion, we need a good practical way of measuring “contribution.” I used an example of a 30% contributor who is only a 5% owner, but what does it mean to be a 30% contributor and what are the forms of contribution? An easy answer would be to look at who brings clients to the firm (business development) or who services the clients (revenue responsibility), but such a definition of contribution will ignore the entire investment and operations departments also vital to the success of a firm. In addition, what about the contributions of a CEO who grows and manages the firm through good decisions and leadership but is not involved in the service of clients or new business?
To resolve this, every firm should have a clear and explicit way of measuring people’s contribution. Without an explicit definition, the implicit understanding will likely gravitate to those involved in revenue origination (another fancy term for sales) and managing clients (though that might encourage client hoarding). There are very few firms in the industry that use balanced scorecards, but it seems to me that this is a perfect case for why and how balanced scorecards can help. If a firm has a clear understanding of who its best contributors are, it has a much easier time reconciling the friction between contributors and owners.
There is a very important trade-off that we need to recognize in order to build a healthy firm—the more we value equity, the more we will “undervalue” contribution. And the more we reward those who are contributing, the less value we will drive to owners.
Here’s an extreme example: Law firms tend to allocate their income to those who created it—by being rainmakers and billing the most hours. But law firms have no equity value whatsoever.
The trade-offs have a very real financial dimension. If we pay contributors 40% of the revenue, the normal benchmark, we have a very good chance of providing equity owners with a 25% profit margin (another benchmark). If we increase the pay to contributors to 60% of the revenue, we will pay more to those who created the revenue through their efforts but we will reduce dramatically the income to the owners. Not only will the profit be lower, but a permanently reduced profit margin will also likely reduce the multiple of profits someone is willing to pay to buy the firm, since the risk to owners will be higher. It is not likely that someone will pay six to eight times EBITDA for an advisory firm with a 5% profit margin.
There is another important trade-off at play here. If the equity is very valuable, it may become unaffordable to the people working hard to create that value. What if our 30% contributor is offered a 30% share but she simply can’t afford to buy it? Founders sometimes ask, “Why do I need to discount my equity in order to sell it to my partners who can’t pay for it when I don’t want to sell any of it even at a higher price?” The answer is that, unfortunately, if our 30% contributor can’t afford to buy at least some of the equity of the firm she is building, she might leave and then our firm may have 30% less value, especially if we keep all the equity.
Sometimes, owners confuse this fairness issue with a legal issue. They think that if we “tie up” our 30% contributor with non-compete, non-solicit and non-complain agreements, we don’t need to worry about the loss of value. Realistically though, just look around. More than half of the firms in the industry were created by someone who had such agreements with a bank, wirehouse or accounting firm and still left them to start a new business. The departing advisor does not even need to “take” the clients; her absence as a professional and as a business developer alone will result in the deterioration of the business even if she takes no clients whatsoever.
Even if she stays, her disappointment might prompt her to stop pouring her heart and soul into the business, and I promise you that this will also damage its value.
In other words, in an industry where the best contributors get the opportunity to become owners, not selling equity to your top people will likely damage the quality of the talent you can attract and therefore the value of the equity you are holding on to.
The friction can be significantly reduced by the proper use of compensation. If somehow, conceptually, everyone is paid very well for their work, they will have less of an issue with not being owners or not being bigger ones. On the other hand, if someone is undercompensated in the hopes of someday being an owner, they will be very eager for that “someday” to arrive soon.
It’s important to say what being paid “well” means:
- For one, it means a competitive base compensation—a salary or some other income that is competitive in the industry. No one is undercompensated for their position and skills, and there are no “promises” that supplant or supplement compensation.
- It also means compensation that is equitable internally. In other words, the top contributors earn the top compensation. This is where many if not most firms fail—the top contributors are often not the best compensated people in the firm.
- It means performance is rewarded. There is a well-functioning form of performance measurement that is tied to incentive compensation, and the top performers are rewarded for their achievements.
- It means growth is compensated. If you were to ask valuation experts what creates the most value in a professional services firm, the answer will undoubtedly be “growth.” It’s precious, and while it is not the only form of contribution, it should be rewarded because it is so scarce and because it makes everything else work.
Still, as one of our clients put it, “As long as the firm has value, there is no amount of income that will make me forgo the equity.” This is both a recognition of our tax code (the value of cap gains over ordinary income) as well as a recognition of behavior—we spend income, but we accumulate wealth through equity. In many ways, it is also part of the culture of the industry. Equity carries a prestige that income just doesn’t.
Am I Buying What I Am Building?
One of the most common questions of balance between ownership and contribution arises when younger professionals realize that every client they bring to the firm makes it a more expensive firm when it’s time for them to buy equity. They might ask: Am I not buying my own contribution?
Finding a good answer to that question is not easy, but if there’s a well-functioning compensation system, a firm can explain why an employee needs to buy what they create. The professional is well paid for what they do. By contract, everything that the employee does is owned by the firm and is work for hire. For example, if a builder constructs a house, he will likely not argue that he has equity in the house because he was paid for the construction. Michelangelo did not get any shares of the Sistine Chapel and Michael Jordan never got any shares of the Chicago Bulls.
“Sweat equity” by definition is the notion of ownership that was created through effort that was not compensated. If I am paid well for what I do, I can’t argue that I have sweat equity. You can’t have both. You can either take the pay or forgo the pay to build equity, which is what founders often do.
Equity As Compensation?
Can equity be used as compensation? There are at least a couple of ideas I have seen at work in this direction.
Stock grants. We have worked with a couple of firms that use stock as compensation through stock grants. The idea is very simple. Instead of paying cash bonuses, the firm pays the bonuses in stock. The employees can choose to convert the entire bonus into stock and pay the taxes out of their own pocket or take two-thirds of the bonus as stock and use the remaining one-third for taxes.
The idea is quite powerful and promises perfect alignment of contribution and equity. In fact, many industries routinely use this. For example, technology firms use a lot of stock option compensation, which is a very similar idea.
There are two drawbacks, however.
One is that the amounts at play are relatively small, and the process is too slow. A typical bonus for an advisor is $30,000 to $50,000, and if two-thirds of that is converted into stock, at most larger firms the result is ownership measured in basis points rather than percentages. Given that there are significant administrative complications when you issue or sell stock, the result may not be worth it.
The second issue is that when employees get stock through bonuses, they seem to be a bit more reluctant to buy stock. For some reason, if you can earn it, you don’t want to buy it.
Intentional dilution. The second idea is very interesting to me but unfortunately is quite complicated. What if a firm were to issue new stock every two years and to grant or sell that stock based on contribution? If you are a 30% contributor, you get 30% of the new stock. If you fall behind in your contribution relative to your ownership, you get diluted. If you contribute ahead of your ownership, your ownership increases.
If you want to aim for better alignment of equity and contribution, you can speed up the process by issuing more stock, more often. If you want to respect equity more, you can slow down the process by issuing less or less often.
The issue with this interesting idea is, again, the administrative complications (I cannot even begin to think through the tax consequences) and the fact that it can hurt passive owners.
Ordering the line. Rather than doing something proactive, such as issuing or granting shares, a firm may choose to “order the line” based on merit whenever equity becomes available. For example, when one of our clients has a partner retiring and selling their shares, the firm will make the equity available to other owners based on their average performance scores from the firm’s balanced scorecard. This is a potentially simple and effective idea.
Ultimately, all of these approaches come down to a clear and well-thought-out approach to equity within a firm. Ideally, every firm can clearly define who are the owners, what is expected of the owners and how they can continue to contribute. A good philosophy will answer the fundamental question, “Do we allow passive owners?” It will also define the allocation of value between contributors and investors. Unfortunately, if we don’t explicitly define who built a firm and who owns it, we may find that both builders and owners lose interest in the whole thing.