Friday, 31 August 2018

Changing over Ensemble Partner Compensation From Revenue-Based To Advisor Salary

An individual money related consultant can just ever work with such a significant number of customers before coming up short on whenever and ability to serve more.
Thus, all warning firms in the long run hit a limit divider, where they should either choose to quit developing or contract or band together with more guides to expand limit.

At the point when a few consultants meet up to make and expand on such limit, a "group firm" develops, where it's not any more about developing any individual counselor's training, and rather is tied in with developing "the firm" and customers of the firm (and procuring worker guides as important to benefit those customers).
The caveat, however, is that most advisors who come together to create such an ensemble firm are transitioning from existing individual practices, with separate expenses, separate revenue, and separate income. Which can make it especially hard to figure out how to actually transition advisor compensation from separate silos to a shared enterprise where all advisors are treated consistently… especially if there’s a large discrepancy in the revenues that each advisor brings to the table.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1 PM EST broadcast via Periscope, we discuss the mindset shift that must occur to successfully grow an ensemble firm with shared clients, how partners in an emerging ensemble advisory firm can equalize compensation levels and get to work growing their business, and when advisors are best able to make the shift from revenue-based compensation to ensemble salaries and bonuses instead.

One of the first challenges that advisors face when transitioning into an ensemble practice is changing their mindset from being an individual advisor with his/her own clients, to being an advisor in a larger firm that is responsible for servicing the firm’s clients. Because ultimately, if the ensemble business is truly going to grow and scale to 10X its size or more… the firm will eventually be so large that it’s no longer about the clients and revenue of any founder/partner/owner, but the collective value of the firm’s clients. After all, the whole point of building an ensemble practice in the first place is to create value from a business that’s larger than and goes beyond what either partner could have built with their own individual client base.

Still, different advisors come to the table with different existing client bases and revenue, which can make it challenging to equalize (or at least standardize) compensation levels, especially if one partner is responsible for generating substantially more revenue than the other.

One way to approach the issue is simply to go ahead and equalize ownership and compensation and get on with the work of building the business, because if the goal really is to create a sizable advisory business in the long run, then the personal wealth that’s created from the long-term value of the firm will dwarf the small differences in compensation in the initial stages anyway.

The second approach that can work – especially if there’s a large discrepancy in revenue-generation – is to have the lower-revenue partner buy a percentage of the business from the larger-revenue partner. Doing so makes it easier to even out both partners’ compensation structures, with the check the lower-revenue partner writes mitigating the step-down in pay taken by the larger-revenue partner.

The third approach is to blend advisor compensation, with a salary base for the “executive” functions of being an owner of the firm, and a partial revenue-based compensation for the job of servicing the founder/advisor’s existing clients. With the caveat that, as compensation for servicing clients in the business, advisor partners need to be cognizant that whatever they pay themselves should be the same compensation structure they would offer to other employee advisors in the business as well (as the additional upside for the partner should come from equity profits, not compensation for the job of being a “partner” in addition to an advisor).

Regardless of which approach is chosen to make the transition, the question also remains: “When is it best to make the switch from revenue-based silos to ensemble salary compensation?” While there’s no hard and fast rule, the shift typically takes place somewhere between the $500,000 and $1,000,000 in firm revenues, because at that level, there’s enough to not only pay the partners an appropriate salary for their work in the business but to have enough left over at the bottom line so that the partners can begin split the income generated from the business itself.

The bottom line, though, is simply that building a multi-advisor ensemble business is all about separating out the value being created by the business itself – for which owners generate profits – from the work of servicing clients that’s being done in the business, for which compensation should reflect what the job itself is actually worth (i.e., what would be paid to any employee in that role, partner or otherwise). And by making the compensation transition, ensemble firm owners truly create the most effective incentive for themselves to focus not on their own clients and revenue but building the shared enterprise value of the business itself.

Well, welcome, everyone. Welcome to Office Hours with Michael Kitces.

For today’s Office Hours, I want to talk about the rise of the so-called ensemble advisory firm, where multiple partners come together to build a shared business enterprise and some of the real-world compensation challenges that often crop up when firms are trying to transition from a group of individual advisors and producers into an ensemble practice.

A case in point example is a recent inquiry I got through kitces.com from Jeremy who asked,

“Dear Michael, I’m a 50/50 partner in an $85 million advisory firm with another advisor. We originally joined together simply to split the cost of the office space and some administrative staff but have spent the past two years transitioning to an ensemble firm. However, we’re still paid by the business based on our client revenues, which aren’t even because I have about $55 million and the other advisor only has about $30 million, so we’re not certain how to restructure compensation going forward as I’ve read that advisors in ensemble firms are typically paid a salary. And while we want to build the business together as equal partners, it doesn’t seem fair to take an even salary when I’m bringing two-thirds of the clients and the revenue. How do you suggest we proceed?”
This is a great question, Jeremy, and a really common challenge that crops up as advisory firms start transitioning from this model of being a bunch of silos where each advisor has their own revenues, and maybe they were sharing some expenses, but they weren’t really a shared business enterprise, into something designed to be a true shared business enterprise, an ensemble firm, where you’re trying to build the business itself.

Vision Your Ensemble Practice After 10X’ing Your Business [1:49]
And because of that, as a starting point, I have to admit that I think I have to push back on Jeremy about some of the question as it was stated. You stated that your vision is to create an ensemble firm where you’re sharing ownership of the firm and building the enterprise, but then you immediately fell back to “your clients” with “your revenue” and “his clients” with “his revenue.” And the whole point of an ensemble firm is that they’re not your clients and his clients, they’re the firm’s clients, and an advisor may get paid something to service the firm’s clients that they’re responsible for, but they’re not the advisor’s clients, they’re the firm’s clients.

Now, I realize when it’s just the two of you and you’re creating this business from the collective clients that you each bring to the table, it’s harder to get a feel for what it’s truly like to have shared clients of the firm. So here’s what I suggest you do. And I think this is a good exercise for any growth-minded advisor trying to build a true advisory business, and especially building in a multi-advisor ensemble firm.
Here’s what I want you to do. Envision that your firm is 10 times the size it is today… 10 times as large. So for Jeremy’s firm, you have now grown from $85 million to $850 million under management. Which means it is not just you and your partner anymore, you might have six to eight advisors all servicing clients. You might have another 10 to 15 support employees. Depending on how affluent your clients are and the exact fee schedule, you’re probably somewhere between $6 million and $8 million of revenue. And if you’re running a typical 20% profit margin, the business is generating somewhere around $1.2 million to $1.6 million of profits that you and your partner are splitting.

Now, in this environment, a lot of important things have changed. Because the firm is so much larger, you two as partners are probably only managing 10% or 20% of the clients between you, if that. Most of that $1.2-plus million of profits in your business now are not based on your clients or his clients, it’s the firm’s clients that are being serviced by all the firm’s advisors, most of which are beyond just the two of you.

So suddenly, it’s not going to seem like such a big deal to say his client base is a bit smaller than yours because both of you are a very small fraction of the overall business that you’ve now built. And for both of you, your profits from the enterprise, which could be $600,000 or more in profit distributions for each of you, far trumps the modest difference in advisor compensation based on your revenue anyways. And frankly, by then you may not even be managing clients at all because you have to manage 20 to 30 employees in a $6 million to $8 million revenue business you built with your partner because your biggest increase in wealth at that point isn’t even just the $1.2 million of profits you’re splitting, it’s the joint ownership of a business enterprise that could be worth $12 million or $15 million or more.
In fact, that’s why I’m such a fan of the approach of resetting the vision of a business by imagining that you get 10X growth. If you think just 10% growth (right?), then it’s, “We get a couple more clients, it’s a good growth year,” and you’re still thinking, “Okay, for the next couple million dollars of AUM and the revenue that goes with it, is this my client? Is this his client? Who gets paid for what for that client?” When you think about 10X growth, everything changes. Everything has to change. You’re so much larger, you have to completely rebuild the business and your role in the business and what you do. And it can make these short-term differences like, “Here’s what I bring to the table and here’s what he brings to the table,” far less important.

I mean, if you really 10X the firm and you’re $850 million, does it really matter way back when that someone had $10 million or $20 million more than someone else after you’ve added another $765 million of assets on top? That’s the whole point of building towards an ensemble practice. It’s about coming together to this shared vision of what you can build jointly in the future, not just about what you’re bringing to the table today. And in a true ensemble practice like that, your compensation is more likely to be primarily salary-based because part of the transition for advisory firms across the board are shifting to at least a partial salary basis, particularly for employee advisors. And especially for founders, because you may even not be doing a lot of client work in the practice at that point, you may be more focused on filling all the other executive roles in this large and growing business that you’ve created.
Managing The Partner Transition From Revenue-Based Compensation To Salary [6:14]
Now, that being said, I do understand the concern that’s here. That you may be creating the shared entity for the future about right now, you bring this much revenue and earn some income from it, he brings that much revenue and earn some income from it, and you don’t necessarily want to feel like you’re taking a step backwards and he gets a free step up by just immediately equalizing yourselves and your ownership and your compensation when you’re not bringing equal client base, assets, and revenue to the practice in the first place. So ultimately, I see one of three directions that you can go on this that other firms pursue.

The first is some firms simply say, “You know what? It’s close enough. Let’s just equalize everything for the sake of simplicity. We’re going to build a shared business together. We’re going to take the same salary. We’re going to participate equally in profits.” Because, remember, even if you’re transitioning from say a world where your client base gave you $300,000 of income from your side and his earns $250,000 and you agree, “Okay, the standard salary for senior advisor will be $200,000,” you’re not actually taking a big step back. Because between the two of you, your compensation was $550,000 of revenue from this $800,000 to $1 million revenue practice, which means if you now take $200,000 salaries each, there’s $150,000 of profits that drop to the bottom line, which is equal owners. You still share in 50/50, so your total compensation ends out being $200,000 of salary, $75,000 of profits, which means you really just split a small difference from where you were.
And if you’re about to build a firm that’s going to 10X in size and add hundreds of millions of dollars of assets and millions of dollars of revenue, this is probably not such a big deal in the grand scheme of things. But now your upside is not earning more salary or revenue-based competition in the business, it’s about getting the business more clients so you can generate more profits at the bottom line across all the advisors that you have now and will hire in the future. So when it’s close, sometimes firms just say, “You know what? It’s better to focus on what we’re building towards in the future. These differences aren’t going to matter in the long run.”

Now, the second path that some firms go is to equalize their salaries and share profits going forward, but they do it by having the lower-revenue partner buy out shares from the higher-revenue or higher-AUM partner to equalize them in the first place. So in a practice where you bring $55 million of AUM and he brings $30 million of AUM, so you’re driving about two-thirds of the revenue, he would buy 15% of the practice from you to equalize the revenue and contributions, and then going forward you can share in the profits and salaries evenly. But you don’t just walk away or give your larger share of the revenue to build something equal going forward, you sell it to be financially fair to everyone and then you build your joint enterprise going forward. And any drop in income that you have when you equalize compensation and profits is made up for the fact that you’re going to get a check for the relative shift in revenue and profits and the equity you sold to really make this equal.

The third approach that some firms adopt here is they just don’t fully equalize the compensation or don’t convert to straight salaries in the first place. Instead, they keep some revenue-based compensation. I see some firms set up things like there might be a salary base that says, “This is earmarked for your contributions to the firm as an executive,” and then a separate piece of revenue that says, “This is your compensation for the work you’re doing with client relationships and this amount of revenue that you’re responsible for.” And so the salary – or I should say the total compensation – is a blend of two: base for executive duties, revenue-based compensation for the clients you’re holding on to. With the caveat that, if or when as the firm owner you begin to transition from managing clients to managing the business and potentially transition those clients away, you have to honor that compensation structure and allow your revenue-based compensation to decline as you shift roles, ostensibly while you grow the bottom line of the business and take home more profits instead if it’s growing.

If this is your approach, though, I’d urge that you have to truly treat your role in the business as that, as an employee in the business, and compensate accordingly. So in other words, imagine how you would compensate the advisor employee that would replace you with your clients. So if you were going to hand off these clients to another advisor who didn’t have to do any business development and simply serve the client to retain them because you’re giving the clients to them, how would you compensate that person? What would you pay for clients where they were being handed to the advisor? Would you pay revenue-based compensation? Would you pay salary with maybe a separate bonus if they also do a little business development and maybe even a separate bonus simply for good retention?
Now, I realize you got those clients and want the rewards of having done the business development, but you’re getting the rewards. You own the business and share in the profits. At this point, your existing clients are a service role that you may need to someday hand off to another advisor to service so that you could run and grow the business. So if you’re going to keep the clients (or need to keep the clients), that’s fine, but compensate yourself for the servicing role the way you’d pay any other advisor to do that non-business development servicing job in the business, because again, you’re already participating with equity value and profits for having brought the clients and grown the business in the first place.

When To Make The Transition From Revenue-Based Silos To Ensemble Compensation [11:37]
Now, it’s worth noting that for some firms, that the challenge isn’t just figuring out how to equalize compensation or pool equity together to build an ensemble practice, but also when to do it. In theory, you just try to do this as soon as you can all come together as partners and agree to build a shared business. And if you’re starting from scratch, it’s pretty straightforward. Everything is at zero, so you could just blend together. And if you happen to come together with virtually equal practices, it’s pretty simple to then blend them together 50/50 because you’re making comparable contributions. But for the rest – which is most advisors… rarely do these things line up perfectly – it’s a messy conversation to have even if well-intentioned. Which I suspect is why Jeremy sent me this question for Office Hours in the first place today.

There’s no hard and fast rule for this, but I will say, from what I’ve seen, this transition happens most commonly as the business grows from $500,000 of revenue to $1 million of revenue when you’ve got 2 advisors that are coming together. And the reason for that is, when you look at industry benchmarking studies, firms at this size tend to drive as much as about 60 cents to 70 cents of every dollar of revenue into the owners’ pockets. Now technically, some of that is for your work in the business, some of that is for building the business and getting profits from the business. When it’s just you, the distinctions are relevant. And when you’re still in silos, it’s also a moot point.

But when you come together and the owners are taking home 60 cents or 70 cents on the dollar of revenue and profits, if you’re between half a million and $1 million of revenue, the partners are probably splitting somewhere between $300,000 and maybe $600,000 or $700,000 in net income… so income per partner, probably somewhere between $150,000 and $300,000. And at that level, the income per partner is high enough that you can reasonably pay a partner an appropriate salary or base-plus-bonus to service the clients they’re responsible for and have some profit left over that then drops to the bottom line that the partners split as income from the business, not “servicing” in the business.

When revenue is materially lower than $500,000, it gets hard to assign salaries and equalize compensation because there just aren’t enough dollars to pay everyone a going rate for their given duties because there isn’t enough revenue yet to pay everyone their full value plus staff and overhead… the business needs to grow a little more. But as you grow from half a million to $1 million of revenue, the math just starts to line up more easily.

Perhaps it’s supported by a small intra-partner transaction where the lower-revenue partner buys out the higher-revenue partner to equalize the equity further, but it’s just much easier to make the math work where each partner can end out roughly where they were before, but just not compensate in a manner that merges it all together. Instead, it properly separates out, “Here’s your income from the work you’re doing in the business, here’s your participation in the profits of the business,” and then all the partners can focus on growing the business, because most of the growth in an ensemble practice is not from your income in the business, it’s your profits from the bottom line and the enterprise value that you’re building.

Now, if you’re above $1 million in revenue and you haven’t still made this transition, well, you can certainly do so now, but by now, one or more of your partners may actually have a much larger client and revenue base than the others, so it may be a little bit harder to equalize again or it may require a little bit more in transactions or adjustments to make it work. So you can do it… and frankly, if you want to build a shared practice, you need to do it… but if you’ve allowed it to grow this far in silos, I would urge you to sit down and have the hard conversation: Do you really actually want to build a shared enterprise because you’ve gone awfully far by not actually fully coming together and still treating yourselves like separate silos where you get paid on your clients and he gets on his and she gets paid on hers?

The key takeaway, though, is just understanding that in any advisory business, there’s still a fundamental difference between the income you earn in the business for the work that you do and your profits that you generate from the business entity that you own. And when you’re going to have multiple partners and build a shared entity where, in the long-term, hopefully, you really can 10X the business, most of the value creation comes from the profits and the enterprise value, not your revenue from servicing clients. And that’s why it’s so crucial to formally separate out your income in the business from your profits on the business. Which means restructuring compensation to properly reflect roles and make sure that everybody’s incentives are lined up, not to grow their client base, but to grow the business.
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