Financing Options for Advisor Succession

Transcription

1 Financing Options for Advisor Succession Ideas Without Limits TM Contents Seller Financing...2 Promissory Notes...3 Performance-Based Notes... 4 Bank Financing... 6 Security and Collateral...7 Summary... 8 Our partner in developing this white paper: Transitioning the ownership of a privately and independently owned financial services practice has significantly evolved over the past ten years. Today, these unique business models have measurable equity, an industry specific valuation system and a mountain of comparable sales and transactional data on which to base sales and acquisition decisions. The mechanical elements of assembling these deals and the often creative financing techniques that result from a cooperative effort between two generations, provide the foundation for equity transfers for future business owners. Moreover, the financing techniques that have evolved place a premium on maintaining the continuity of the practice. This often results in not only a positive outcome for the buyer and seller, but also a long-term advantage for the clients and the associated broker-dealer. Transactions between advisors result in a wide variety of plans and circumstances, ranging from a long-planned internal succession, to a sudden, unplanned sale due to the failing health of a principal. While every transaction is different, all transactions share certain common features and address similar issues. Understanding these mechanical elements and the choices that buyers, sellers and banks have contributes to the creation of practical financing options that can be relied on to produce predictable results, regardless of the situation. The acquisition or sale of a financial services practice, or an interest therein, is different than buying a turnkey, tangible-asset-based business. The financial services practice model is often characterized by one key advisor who anchors the client relationships. The terms of the sale and acquisition often represent a balancing of the risks in transferring this personality- and service-based intangible asset model. Post-closing motivation of both buyer and seller is an essential part of the payment arrangements and financing options. There are two primary lending sources in this industry. The first, and most prevalent source, is from the exiting or affected owners themselves, or, for larger firms, the business enterprise itself. This is often referred to as seller financing. The second lending source is a non-conventional, Small Business Administration (SBA)-backed bank loan, not yet a strong or reliable option for the financial services industry. Brokerdealer financing, while available, is provided on an ad hoc basis and is generally limited to acquisition of practices outside of the lending broker-dealers network and for these reasons, is not covered in this paper.

2 Seller Financing The most common funding mechanism in financial practice transactions is to rely in whole, or in part, on the seller to provide the financing, either through a note or an earn-out arrangement. Seller financing, in turn, means that practice sales and acquisitions require a high degree of cooperation and flexibility between the parties, both before the transaction is completed and for a period of time afterwards. Because of the past and continuing reliance in this industry on seller financing, recent banking woes and the credit crisis are expected to have little impact on the transitioning of privately owned financial service businesses. Seller or company financing also means that sellers look to their successors for more than just the highest purchase price or the largest down payment. In a seller-financed transaction, buyers rely heavily on their own cash reserves or lines of credit for the down payment and use seller financing to pay for the balance of the purchase price. In other words, it takes the buyer and seller, in a cooperative effort, to make a deal financially viable. This codependence often results in sellers choosing very highly qualified buyers who are excellent matches in terms of practice style, business model, investment philosophy and personality, which, in turn, results in very high client retention rates. There are three common components used to pay for a privately held financial services practice: 1. Cash (including down payments and earnest-money deposits) 2. Promissory notes 3. Earn-out arrangements Although no two deals are exactly alike, these components tend to be used in each, with the difference being the allocation of the purchase price among these structuring elements. Practices that sell on an internal basis, such as between partners or between employer and employee(s), are more often characterized by a small down payment and extended financing using a fixed or non-adjustable promissory note. Transactions to an outside third party are characterized by a higher down payment component, shorter terms and, possibly, less allocation (if any) to an earn-out component. The following chart illustrates the average allocations to each of the financing components in transactions over the past 12 months: Average Deal Structure Down Payment 36% Promissory Note 35% Earn-Out 29% 2 Financing Options for Advisor Succession

3 Examples of recent seller-financed transactions illustrate this point: Third-Party Acquisition: Purchase Price $ 1,100,000 Buyer Down Payment $ 400,000 Seller Carry (Note) $ 350,000 Seller Carry (Earn-Out) $ 350,000 Loan Term 5 years Employee Buy-Out: Purchase Price $ 600,000 Buyer Down Payment $ 50,000 Seller Carry (Note) $ 550,000 Loan Term 10 years These payment methods, present in one form or another in almost every deal, are used regardless of practice size, warranting a closer look at the two non-cash financing elements. Promissory Notes All promissory notes are used to establish the payment of a sum that is certain over a specific period of time. The advantage of using a promissory note, from the seller s perspective, is that the payments are fixed and predictable, and, in the event of a default, easier to convert to a judgment from which to begin a collection action. A promissory note is also easier to guarantee and secure (as opposed to an earn-out arrangement), since it is for a certain sum. Using a promissory note, however, can place undue risk on the buyer, since it locks in the principal and payments, regardless of the success in delivering and retaining the client relationships. For this reason, fixed notes are more commonly used on internal transactions, where the risk of client attrition due to the equity transfer is often reduced. Many third-party or external buyers prefer to use an adjustable note, which is tied to the success of the transition and the long-term retention of the seller s clients. Some buyers and sellers refer to this method as guaranteeing the revenues being sold. If the revenues are not delivered and retained by the buyer for at least one year, a new, reduced note is executed reflecting the actual transition rates. These issues are generally not present in the purchase and sale of a minority interest in a financial services firm, since the ownership or management team remains in place. It is not unusual for the parties to agree in advance to measure the gross revenue or amount of assets under management that have transferred to the buyer six months or more after closing. If, for example, it is determined that 87% of the seller s clients assets or gross revenues have transitioned to the buyer at a point in time after closing, the parties might agree that the note and remaining payments will be accordingly reduced, and then fixed and secured for the duration of the agreed repayment period, with no further adjustments or look backs. This ensures that the seller is motivated for a reasonable length of time, post-closing, to help transition the clients to their new advisor. Ideas without Limits 3

4 Interest rates between the buyer and seller in a seller-financed transaction reflect the fact that the risk premium has been built into the pricing of the transaction; hence, a relatively low interest rate is commonly applied, at least when compared to a conventional lending arrangement. Buyers typically agree to pay interest of about 7.5% on the unpaid balance on a promissory note, but this can range from a low of 5% to a high of 9%. Performance-Based Notes A performance-based note, commonly known as an earn-out arrangement, is one in which the buyer pays the seller a percentage of the future practice revenues for an agreed-upon period, or up to a set amount, of time. Buyers and sellers can structure an earn-out arrangement in many different ways. Depending on the needs of the parties, payments can be made monthly, quarterly or annually and the percentage rate can increase, stay the same or decrease from the first payment to the last. Earn-out arrangements are based on gross revenues from the acquired client base only. The most common method is to create an earn-out for a fixed period of time, typically two to five years. Earn-outs, by their nature, are always paid in arrears, based on the actual cash flow received from the acquired client base. To calculate an earn-out, you need to know the purchase price, the gross revenues derived from the acquired client base for the 12 months preceding closing, the amount of the cash down payment, the amount of any promissory note or notes and the length of seller financing. The examples below show some of the different ways to pay the same balance. Earn-out arrangements typically do not carry interest on the unpaid balance (although, for tax purposes, interest will be imputed). Most earn-outs are also not capped or limited in the amount to be paid. If the gross revenues from the acquired client base rapidly grow in the buyer s hands, the earn-out payments will also increase at the same pace. Obviously, the opposite is true as well. Although a buyer and seller may agree to a set the purchase price, the use of an earn-out arrangement creates flexibility that will reward and motivate the seller for his or her ongoing efforts after the sale to deliver and help the buyer retain the clients and assets. Conversely, if a seller does not assist in the transition, or does not choose a buyer or successor who is a good match for the practice, then the earn-out arrangement may result in the seller receiving final payments that are less than the agreed-upon purchase price. Using a performance-based note in a transaction provides greater flexibility in structuring the payout to the seller. Here are two examples of how different earn-out payment arrangements can be structured for the same balance: 4 Financing Options for Advisor Succession

5 Example 1: Projected Period Gross Revenue % Payment Example 2: Year 1 $ 500,000 30% $150,000 Year 2 $ 500,000 30% $150,000 Year 3 $ 500,000 20% $100,000 Year 4 $ 500,000 20% $100,000 Total Payments for 4-Year Period = $500,000 Projected Period Gross Revenue % Payment Year 1 $ 500,000 40% $200,000 Year 2 $ 500,000 40% $200,000 Year 3 $ 500,000 20% $100,000 Total Payments for 3-Year Period = $500,000 It is important to understand that the use of an earn-out arrangement may increase or decrease the final purchase price, depending on the retained assets and clients and new business referrals. The use of an earn-out arrangement means that every payment the seller receives, whether on a monthly, quarterly or annual basis, will be for a different amount, as compared to the equal payments received under a promissory note format. Each earn-out payment must be individually calculated by the buyer and may need to be confirmed by the former owner an important consideration if the payments are to be received by a surviving spouse. Before using a performance-based note, it is important to seek professional guidance specific to the transaction. The use of an earn-out arrangement is not permitted by all broker-dealers or in all situations. Payments received by a seller under an earn-out arrangement may also require the seller to be licensed in states where the transitioned clients are located. Financial Industry Regulatory Authority (FINRA) rules on this issue are not clear, so use of an earn-out should be carefully considered in conjunction with the parties post-closing licensing situation and broker-dealer affiliations. It should also be noted that performance-based financing of an acquisition should not be confused with a revenue sharing agreement. For example, using a joint rep code is not a financing or a deal structuring technique. From a tax standpoint, a revenue split is not a purchase or sale at all. A revenue-sharing arrangement may keep both parties names in front of the clients, but it also results in the revenue being allocated as ordinary income tax rates for the seller. One of the key benefits of selling a practice is the ability to receive much of the purchase price at long-term capital gains tax rates. Ideas without Limits 5

6 Bank Financing Bank loans are just beginning to emerge as a viable option for the parties in an independently-owned financial services transaction and are being used with increasing frequency by business partners and third parties. The one caveat is that contingent financing methods, such as adjustable notes and earn-out arrangements are not usually available for use in a bank-financed transaction. Bank financing offers numerous advantages to buyers and sellers and is often used in conjunction with seller financing. Acquisition financing for a financial services practice is considered to be non-conventional due to the paucity of tangible assets in the transaction and, therefore, is best accomplished using an SBA guarantee financing. The SBA, as a government guaranteed loan program, is well equipped to finance a business sale or acquisition in which the assets are intangible. Conventional lenders, by way of comparison, are historically hard asset lenders. In addition, when conventional lenders do look at cash flow, they are strictly looking at past performance, while an SBA lender can look forward. When loans are made by conventional lenders, they tend to have large down payment requirements, short financing terms and high collateral requirements. There are two main SBA loan programs: 7(a) and 504. Financial service transactions almost always fall under 7(a), since the 504 program is for real estate only. The maximum loan amount using the 7(a) program is $2 million, but loans can be made for third-party acquisitions, manager and employee buyouts and even partner buyouts. For lending purposes, it does not matter whether the transaction is an asset-based sale or a stock-based transaction. For example, Evergreen Financial Services is selling their business for $2 million and the building from which they run the business for $1 million. A bank using an SBA guarantee program can finance the business acquisition through the 7(a) program and then use the 504 program to finance the real estate portion. Banks will typically require at least a 10% to 15% down payment of the purchase price of the business. Inadequate collateral coverage is acceptable an SBA-backed lender is a cash flow lender, not a collateral lender. Longer amortizations (up to 10 years) are possible and will help to improve the cash flow for a buyer, and banks will often include working capital as a part of the loan proceeds. A business plan is required for every acquisition, along with projections with assumptions. Banks look for at least a 1.35x debt service coverage ratio, determined by dividing cash flow available to service the debt by the annual principal and interest payments. Cash flow available to service the debt is typically calculated by combining the net income of the business, depreciation, interest expense, amortization, additional owner s salary (above what is considered reasonable and necessary) and, perhaps any charitable contributions. Banks collect an SBA guarantee fee, most of which is paid directly to the SBA. These fees can be significant. For example, assume that the buyer borrows $1 million. The SBA will guarantee 75% of that loan. The fees are based upon the loan amount and are about 3.5%, which is a fee of $26,000. This fee can be financed in the loan. Interest 6 Financing Options for Advisor Succession

7 rates on the loans are primarily variable, and are based on The Wall Street Journal Prime Rate for the 7(a) program. Recent Bank-financed Transactions Third-Party Acquisition: Purchase Price $700,000 Bank Loan $200,000 Seller Carry (Note) $300,000 Buyer Down Payment $170,000 Working Capital $ 30,000 Loan Term 10 years Partner-to-Partner Sales: Purchase Price $750,000 Bank Loan $600,000 Seller Carry (Note) $ 50,000 Buyer Down Payment $ 100,000 Loan Term 10 years Excellent resources for more information on bank financing include and Security and Collateral Regardless of whether the transaction is bank- or seller-financed, adequate security and collateral for the transaction is always a consideration. The amount of security required and the type of collateral used depends on how the transaction is structured, the acquiring entity or individual and the type of practice being acquired. At a minimum, every selleror lender-based transaction should be personally guaranteed by the buyer and their spouse. An additional level of security involves the filing of a Uniform Commercial Code, or UCC-1, financing statement, creating a lien on the acquired assets. Bank-financed transactions will result in the bank having a first position on all of the accepted collateral. In other words, any seller financing or seller-carried paper, regardless of the amount or whether it is more or less than the bank loan, will be subordinate to the bank s interest in the collateral. It is easier to secure a balance owed when the debt is in the form of a promissory note for a sum that is certain. Most promissory notes are personally guaranteed and backed with a lien on the acquired assets. However, even earn-out arrangements can be secured and guaranteed; the security and guarantee are specially written to accommodate the flexible and contingent payment method. Internal acquisitions of a minority interest by an employee or family member that involve seller or company financing present a special case and may not require any security or collateral, as the ownership is usually limited by contract to an active, licensed employee in the business. If the debt is large enough, however, the selling shareholder or the company can hold the certificates issued for the acquired stock Ideas without Limits 7

8 as a stock pledge until payment is made in full. A personal guaranty may also be appropriate. Acquisitions of a controlling interest that are supported by seller or company financing are often accompanied by increased levels of collateral and security, including a lien on the business assets and a lien on the buyer s real property. Summary Knowing how to finance a transaction impacts the implementation of an equity transfer, whether it is a long-term retirement plan or a short-term continuity or disaster plan. In other words, financing options determine how a practice owner is going to actually realize his or her value and put it in the bank. Financing options also play an essential role in creating and implementing a path to ownership for succeeding generations of advisors and may well determine whether the transaction is completed within a broker-dealers network of advisors, or between advisors at two different broker-dealers. Advisors are discovering that, notwithstanding recent market volatility, their business models are a terrific source of equity. This value, however, is ultimately protected and paid only as a result of a close match between buyer and seller and the creation of a win-win deal structure. Creating such a structure, by understanding and implementing the proper financing approach, has been good for the clients these professionals serve, as well as for creating an enduring business model. Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. 8 Financing Options for Advisor Succession

9 Ideas Without Limits TM This white paper is part of Ideas Without Limits TM, a program designed to help financial services firms and investment professionals identify trends, enhance operations and grow revenue. It represents Pershing s unique approach to practice management support going beyond high-level guidance to offer actionable information, personalized consulting, and ready-to-execute programs. To learn more about Pershing, visit us at Ideas without Limits 9

10 Notes 10 Financing Options for Advisor Succession

11 Notes Ideas without Limits 11

12 About Us Pershing LLC (member FINRA, NYSE, SIPC) is a leading global provider of financial business solutions to more than 1,150 institutional and retail financial organizations and independent registered investment advisors who collectively represent over five million active investors. Financial organizations, investment professionals and independent registered investment advisors depend on Pershing s depth of experience and consultative approach to provide them with forwardthinking solutions that help them to grow their businesses. Located in 20 offices worldwide, Pershing and its affiliates are committed to delivering dependable operational support, robust trading services, flexible technology, an expansive array of investment solutions, practice management support and service excellence. Pershing is a member of every major U.S. securities exchange and its international affiliates are members of the Deutsche Börse, the Irish Stock Exchange and the London Stock Exchange. Pershing LLC is a subsidiary of The Bank of New York Mellon Corporation. Additional information is available at About FP Transitions FP Transitions is the foremost financial practice valuation, sales and consulting company. Headquartered in beautiful Portland, Oregon, the firm works with buyers and sellers of financial service practices, advisors interested in internal succession plans, financial practitioners seeking to protect their practices and those interested in valuing the equity they have in their practices across the U.S. FP Transitions is completely independent, in that we are not owned by any broker-dealer or custodian. We do not underwrite, trade or distribute securities or otherwise compete in any aspect with our clients businesses. Our advice is straightforward and fact-based - we will tell you what we think WP-PER-FIOPT-7-09