One of the "luxuries" of operating as a solo financial advisor is the simplicity of dealing with advisor compensation: the gross revenue of the business, minus your costs, is your net income as the advisor/owner. However, at some point in time, many advisors will consider launching a multi-advisor partnership – either as a means to share (and split) growing overhead costs, or perhaps to try to build a multi-advisor "ensemble" firm that is bigger than what any one advisor can create on his/her own. Yet in the process of shifting to a multi-advisor firm, especially when merging together multiple existing firms with varying numbers of existing clients and revenue, it's necessary to navigate the messy process of determining how to split equity and partner compensation in the new business entity!
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss ways in which financial advisors choose to split equity and partner compensation when forming a multi-advisor business, and why the structure of the arrangement depends on heavily what type of firm you're ultimately trying to grow in the first place!
Historically, the most common reason to form a multi-advisor firm – whether as an RIA, or more often on an independent broker-dealer platform – was to share and split overhead costs (e.g., office rent, administrative staff, and perhaps gain some bargaining power to get a better payout rate as a group of advisors). In this context, all of the advisors still took their "own" revenue from their own clients, and the primary or sole purpose of the business was really just to split the costs. As a result, the "equity" split was really just a reflection of how to split the costs themselves, and all partners were compensated based on their own individual client revenue (reduced by those shared costs).
On the other hand, with some multi-advisor firms, the goal is actually to build a true standalone business, in which all the advisors contribute to the growth and success of the business (i.e., an "ensemble" firm) that is larger than any one of them alone. With this type of partnership, equity and compensation dynamics are different: the primary driver of value and wealth creation is not client revenue (less expenses), but net business profits and the (slice of) equity value of the aggregate business. Which means taking uniform salaries based on job descriptions (not revenue-based compensation from clients), plus perhaps a bonus for business development, and deriving most long-term value directly from the equity itself.
If the ensemble firm is being created from scratch, this typically results in an even equity split amongst all the partners. However, in most cases, at least some of the advisors already have existing clients and revenue, which may be uneven when they come to the table. Which means it's necessary to either set the ownership percentages based on the relative amount of revenue that’s being brought to the table in the first place (e.g., if a partner brings 70% of the revenue they receive 70% of the equity), or to equalize ownership at the start through a buy-out (e.g., if one partner brings 70% of the revenue the other partner buys them out of 20% and each gets 50% equity). The advantage to the latter strategy is that if growth between partners is relatively equal going forward, then each partner has an equal incentive to grow the firm, and receives an equal benefit for doing so.
The key point in all of this, though, is simply to recognize that there’s a big difference between forming a “let’s share the overhead costs” multi-advisor partnership, where each advisor keeps their own client revenue and their goal and upside is to build their own client base, versus a true “ensemble practice” where you’re trying to build the shared equity value and the upside isn’t your client revenue but your participation in the bottom line profits of a growing business entity. Because if you want to build an ensemble business, and the other partners just thought of this as a cost-sharing partnership… the visions are so different that, regardless of how equity and compensation are split, this partnership isn’t likely to go well!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
For today's episode, I want to talk about how do you structure an advisory firm when multiple advisors come together to form a partnership? Now, I'm not necessarily talking about legal entities here, or like an actual partnership entity as opposed to an LLC or an S corporation, but just the dynamics when advisors come together to form a "shared business entity" that will be their collective advisory firm, and what to think about when structuring that arrangement.
Today's specific question comes from Derek, who asked:
"When you're starting an RIA with multiple advisors and they each bring different amounts of existing clients and revenue to the firm, how do you split equity ownership and compensation?"
This is a great question, Derek, and the truth is that there are actually a lot of different answers to this because it depends on why exactly you're starting a multi-advisor firm in the first place.
Launching A Multi-Advisor Partnership To Split Overhead Costs? [Time - 1:12]
Historically, the most common reason that multi-advisor firms formed, whether as an RIA, or actually, even more commonly under an independent broker/dealer platform, was basically to share and split overhead costs.
So the idea was that the advisory firm wasn't really a "firm" in the traditional sense where everybody's trying to build a shared equity value in the firm. It was a way to share overhead expenses (e.g., office rent, admin staff, receptionist, maybe a little collective bargaining power to get a better payout rate as a group of advisors than an individual advisor from the broker/dealer). Now, when you're essentially a cost-sharing multi-advisory firm, ownership is usually actually a reflection of how you're splitting the costs, not the revenue. Because when this was actually done under an independent broker/dealer platform, it was very straightforward because the revenue normally isn't even paid to the business entity. It's paid to the registered rep because, technically, commissions have to be paid to a registered rep and the business entity really just handled the costs.
So if there are three advisors who are going to split the costs three ways, they'd be one-third owners of the business. All expenses would go through the business. They'd contribute whatever dollars of their revenue was necessary to cover the costs of the business. But the split was about the costs split, not actually the revenue spilt. And if the revenue was paid to the business, it would typically still be allocated out to the partners based on their individual revenue contribution minus shared costs. For instance, if I brought $200,000 of revenue this year and my shared costs were $50k, then I get $150,000. If you brought $175,000 of revenue and you had the same $50,000 of shared costs, since they're shared evenly, you'd net $125,000 of revenue. And so this often would get done with an LLC where you can create these kinds of income allocations using guaranteed payments.
In essence, the actual ownership split didn't really matter much because the business wasn't building value unto itself. It wasn't intended to be sold, and the business' income was always netted down to zero every year by doing guaranteed payments out to the partners based on their individual revenue of their clients anyways, so that the partners were just basically using it as a pure pass-through to get back their own revenue just netted down by shared costs of the shared entity. Or alternatively, I have seen some firms that would split the ownership based on relative revenue simply because the advisor with more revenue usually has more clients and is probably using more of the shared resources. Right?
So if we're going to "share" the business but I bring 70% of the revenue and you bring 30%, and I also bring 70% of the clients and the work that has to be done and you bring 30%, then we structure the ownership 70/30 so I'm also absorbing 70% of the costs to match the 70% of revenue and 70% of clients and 70% of the burden. But the key point is that at the end, when you're really just running separate silos under a shared entity, it's really not actually about the shared ownership of the entity because all the income typically just gets routed back to the advisors who brought in the revenue. And ownership is really just about allocating costs for an entity that's not likely going to have much value and never generates any net profits.
Forming A Multi-Advisor Ensemble Firm [Time - 4:23]
We can contrast this to what happens when you build kind of the alternative version of a multi-advisor firm where the goal is actually to build a true stand-alone business that has value and you want all advisors to contribute to the growth and success of the business and participate in the profits of the business. Now about a decade ago this approach was coined by Moss Adams Consulting with the label "ensemble firm" to recognize there was a different kind of multi-advisor partnership than just a bunch of silos partnering together to share overhead costs. Because the point of the ensemble firm is that all the advisors actually act as an ensemble, so working together for the collective success of the firm and not just to build their individual client basis.
And that matters because it requires a different kind of ownership and income structure for a true ensemble practice. Because when you have a business, it's really just a collection of silos where each client is, in the end, a client of the advisor, not the firm. And the income is really the income of the advisor, not the firm. Then the income allocation just goes to the advisor who brought it in. You know, it's the classic "eat what you kill" model, and costs just get split. But this creates a lot of problems when you're trying to share revenue and profits and create a business with value.
David Grau of FP Transitions has written about this extensively. I'll highly recommend his book, "Succession Planning for Financial Advisors", from a few years ago, which talks about how multi-advisor firms that are paid revenue-based compensation for their clients make their primary focus their clients and not the firm. Buyers are much less interested because they can see that clients are the clients of the advisor and not the firm, and it makes succession planning much harder. It creates a lot of challenges. It's fine if you want to just run your silo, but not good in a multi-advisor ensemble firm. If you really want to incentivize all the partners of an advisory business to focus on the business, then you need to break the link between advising clients and revenue directly from the clients.
Which is why if you look at most ensemble firms, the compensation of the advisors, including the founders, is often structured as a salary plus some bonuses for new business development, or other incentives, but it's typically not pure revenue sharing. And what that does, is incentivizes everyone to grow the firm, not just their client base, because you don't have upside to your client base anymore if you're not getting revenue-based compensation. Your upside is based on the entity growing profits and participating in the higher profits that come when you bring more clients and more revenue to the table.
Equalizing Ownership And Compensation Of An Ensemble Advisory Firm [Time - 7:02]
Now, that's all well and good when you're starting from scratch and no one has existing clients and revenue, but obviously, it's a little more complicated when multiple advisors are bringing clients and revenue to the table and it's uneven. It's one thing to say, "Hey, everyone, let's grow a firm together where we win when the business gets more valuable and it's not just based on our personal client revenue." But that's a little awkward when we get started, I bring 70% of the actual clients and revenue and you bring only 30% and we say, "Hey, let's split all of this evenly to build the business together."
There are two primary ways around this that I see firms doing in practice. The first is just to set the ownership percentages based on the relative amount of revenue that's being brought to the table. So if I bring 70% of the revenue, I'm going to own 70% of the new business that we're creating. Now, even in this scenario, compensation or salary in the business, typically, still is even or at least similar in reflecting whatever roles we're taking on in the business. Because remember, if you brought 70% of the revenue and you want to participate in 70% of the upside, you're getting that with 70% of the equity shares. And ideally, the bulk of your income should come from the profits and not from the salary.
If you want to grow your income further from here, grow the business. And as long as you're both contributing equally to the business growth from here, you both get the same salary and bonus structure for your work in the business. And what you brought to the table will be reflected in your ownership percentages and the percentage of profits you keep from the bottom line of the growth from here. Now, the second approach that I see a growing number of advisors actually taking is that they equalize the ownership. Which means if I bring 70% and you bring 30%, you buy me out of 20% so that we're 50/50. And now, we get the same salary and the same bonus structure and have the same profits interest and the same equity interest, and we're all equally incentivized to grow the business the same way.
Because the challenges that I've seen crop up with uneven ownership, it gets messy over time if the business is successful. Right? It might be very fair that, when we launch the multi-advisor ensemble firm, if I brought 70% of the revenue and you brought 30%, then I get 70% of the equity and profits and you get 30%. But what happens if, in the next five years, we work together as partners and we evenly grow the business? Now the 30% partner starts to feel resentful that they're generating 50% of the new growth, but only participating in 30% of the upside. And the more uneven that ownership interest is based on what was brought to the table, the more awkward it gets.
Whereas if we do an internal transaction, equalize the business interest, then now we've got equal salaries, equal compensation, equal ownership, equal incentives, and equal participation in growth. And the person who brought the bigger slice of revenue still gets compensated because the smaller ownership share buys the larger ownership share to equalize it, and pays it out. Which, I realize, is a big commitment for the partner that comes to the table with less. But the good news is you should largely be able to finance, now, the profits of your newly created shared business entity. And if you're really committed to growing the new, shared ensemble firm, then frankly, I'd think you'd want to buy up an even share.
Picking The Right Partners For An Ensemble Practice Vs Cost-Sharing Partnership [Time - 10:17]
The key point of all this, though, is to recognize that there's a big difference between forming a "let's share the overhead costs" kind of multi-advisor partnership where each advisor keeps their own client revenue and their goal and upside is their own client base versus a true ensemble practice where you're trying to build shared equity value and your upside is not your client revenue, but your participation in the bottom-line profits of a growing business entity, and maybe a liquidity event for the entity itself at some point down the road. Now, it's also worth noting that particularly for advisors who are used to operating as solo advisors in the first place, coming together in an ensemble-style practice is a really difficult change.
You have to accept giving up some control and some ownership because, frankly, that's what it takes if you want to build a business that's bigger than just yourself. But it's a big change, and you need all your partners to make the same commitment. Because of course, if you want to build an ensemble practice and the other partners just saw this as a cost-sharing partnership, this isn't going to go well. They're not going to let go of control. You're going to have a lot of friction if you grow the business, they participate and they're putting their walls around their clients, and you end up losing out if you're the only ensemble-minded advisor in a cost-sharing practice.
And that's why I really recommend that you really spend your time on due diligence upfront, and figuring out whether you really want to be in business with these other advisors as partners, especially if you're looking to build an ensemble firm. So I'd get a partnership compatibility assessment. We've written a prior article on this site about a firm called Partnership Resource Group that does this. And have a plan about not just how you're going to structure the equity and the compensation of the business coming in, but also how you'll dissolve it if it doesn't work out. Because when you commit your clients to a common business, it gets a little messier if you want to unwind it, too. And that's part of the trade-off and that mentality shift from your clients to the business' clients instead. It's harder to extract them back if this doesn't work out.
And I also have to highly recommend having every perspective partner buy a copy of Philip Palaveev's book, "The Ensemble Practice", specifically written on what an ensemble firm really is all about, what it takes to build a successful one, and including that mindset shift that goes along with it. Now again, you don't have to build an ensemble firm. In reality, I find that most advisor partnerships, just by numbers, are of the cost-sharing variety. They're not looking to create a shared vision and commit their clients into a common core. They just want to serve their clients, get paid their client revenue, and split some costs with some other people because it's expensive hiring staff members and easier when you can share them.
But at a minimum, you should know what kind of multi-advisor partnership you're trying to build because it really does impact how you structure everything from compensation…is it salary and bonus versus client revenue based? The equity ownership splits, and whether you do even a transaction to equalize the ownership when you formulate the firm. Or again, whether most of that's unnecessary because if you're simply going to get paid on your own client revenue reduced by shared costs, and that's that, that's a relatively simple partnership to set up. I hope this is helpful food for thought for all of you thinking about coming together into some kind of multi-advisor partnership. Ultimately, you need to actually figure out what the goal is so that you can then have a productive conversation about how to share the equity and compensation accordingly.
This is "Office Hours with Michael Kitces." We're normally 1 p.m. East Coast time on Tuesdays, obviously a bit late recording on Wednesday this week. Thanks for joining us and have a great day, everyone!
So what do you think? How do you split equity and compensation across multiple advisor partners? How do you make sure incentives align and compensation remains "fair" as a firm grows? Have you thought about forming a partnership to share overhead costs or grow an ensemble firm? Please share your thoughts in the comments below!