Grey areas in transition planning

If you are contemplating the purchase of a business, the transition process should be cemented well before a price has been finalized. All too often, key elements of the transition plan are not adequately negotiated, and the result is a difficult and even contentious turnover that costs the parties emotionally and financially. It is important to remember that the closing date is only the beginning of the transition process.

Transition issues are especially prevalent in smaller advisory practices in which only a handful of principal advisors are responsible for client relationships. In such a practice, the retention risks are significant, and, more often than not, the practice will rely more heavily on personality than on brand identity to attract and retain clients.

Despite any firm’s best efforts to “institutionalize” relationships, a client will always identify with the person sitting across the desk, making transition a central issue. This is especially true during market turmoil when the advisor/client relationship is already being tested. If your clients believe you are running away from them, they are going to be far less likely to trust you when you tell them to trust the new person across the desk.

The difficulties associated with transferring client relationships are a central reason that most small advisory practices will be sold without a fixed acquisition price. Rather, the payments will be contingent on performance over a predefined period. More often than not, it is common during the earn-out period for the seller to remain in a “consulting” capacity.

Since until this point the seller has wisely negotiated the deal in secrecy for fear of upsetting the client base, the consulting phase is an integral step in the transition of the business. Of course, this means there will in fact be three moving parts affecting the structure of the deal: the guaranteed payment amount, the terms of the earn-out and the amount to be paid for consulting services.

For transactions with a structured contingent payment, you’ll need a concrete agreement about the particulars of the earn-out. Normally, this will require that the parties agree about what the basis for the earn-out payments will be, including which clients make up the revenue basis for the earn-out. It is very common for a purchase and sale agreement to include an exhibit specifying the exact clients and the assets managed as of the transaction date.

Generally, calculating the earn-out includes the following steps: First, divide the agreed-on value of the firm by the first year’s adjusted cash flow. This will tell you how many years it will take for the practice to generate enough cash flow to pay for itself. Second, divide the adjusted cash flow by projected annual revenue to determine the annual return on ownership.

This amount, which is equal to the annual reward for ownership, is the amount that would be established as the earn-out amount. The term of the earn-out is established by determining the number of years needed to equate the earn-out amount with the agreed-upon price.

For example, if a practice generated $500,000 in revenues and $200,000 in net cash flow to the owner, the reward for ownership is 40% ($200,000/$500,000). The buyer would agree to pay no more than 40% of annual revenues to the seller. Assuming the buyer and seller agree that the business is worth $1 million, the term of the earn-out would be set at five years, equal to the term both buyer and seller would expect the payments to equal the agreed-upon period. If the buyer elects to pay more than 40%, the business would not finance the acquisition, and the buyer would be forced to finance the earn-out separately, most typically through the deferral of his or her own compensation.

Of course, a particular deal may be considerably different from this, affected by the relative negotiating strength of the buyer and seller. Other factors affecting the exact amount of the earn-out include the amount of compensation negotiated during the consulting phase and whether up-front or guaranteed money is paid.

The key point is when taken in total with the other sources of cash to the seller, the earn-out is structured so that when calculated using the most likely scenario, the payment amount will equal the agreed-upon price.

This process should create synergy between the buyer and the seller when it comes to transferring client relationships. Should the seller fail to adequately transfer the relationships during the consulting period, the amount of the earn-out will decrease. Conversely, a good earn-out can create an ongoing incentive for the departing shareholder to attract new business, leading to increased profits for the buyer and increased compensation for the seller.

Show me the money

Performance thresholds are important on both sides of the earn-out agreement. From the buyer’s perspective, the incentives are obvious, but it is advisable to be specific about the duties the seller will perform during the consulting phase. In addition to laying out the duration of the consulting arrangement and even the number of hours worked on a weekly basis, an agreement should be reached about the specifics of the seller’s obligations with respect to client turnover.

It’s a mistake to assume that the seller knows the best way to go about maximizing the transferability, so be clear. Direct the number of client meetings to be held in a joint setting. Document a veto right over any client correspondence announcing the transaction.

From a seller’s perspective, minimum payment thresholds need to be considered. These will protect against the buyer skimming the cream off the business. If there is no downside, the buyer could be inclined to focus on the high-value clients while ignoring other clients. Obviously, without a minimum payment threshold, the seller ends up paying for such behaviour. This is part of the reason most earn-outs will stipulate that the buyer must agree to produce at least 50% of the historical annual income over the earn-out term.

In the end, value is in part a function of who bears the risk of a failed transaction. If sellers wish to maximize value, they should expect to be around for at least one year following the transition. This is especially true in light of the recent stock market plunges, which have resulted in client relationships being strained by the realities of the marketplace.

Transition issues cannot be solved in advance, but if the responsibilities of buyer and seller are clearly defined, if the parties are reasonable about the time necessary to transfer relationships and if the motivations to transfer these relationships are established, the prospects for a successful transition will be significantly better.

Owen Dahl, CFA, LIFA, is a principal at Moss Adams in Seattle. He is the co-author of How to Value, Buy or Sell a Financial Advisory Practice: A Manual on Mergers, Acquisitions and Transition Planning (Bloomberg Press). feedback@advisor.ca

(12/09/08)