Beyond the Forgivable Loan: The Evolution of Advisor Transition Deal Structures

Competition and an expanded landscape of options have resulted in additional deal structures for transitioning advisors.

Advisors are a lucky lot: They have many ways to monetize their life’s work and take advantage of new opportunities for growth, both in the short and long term.

The transition deal is one way that advisors can financially de-risk a move through what is traditionally known as a forgivable loan—a note that typically binds the advisor to the firm for a given length of time.

Yet the paradigm has evolved over recent years, resulting from the extraordinary expansion of the industry landscape and increased competition for top talent.

Advisors can now choose from a much wider variety of legitimate options (in terms of models and firms) than ever before, and there is a greater breadth of deal structures beyond the traditional note.

So then, how should an advisor consider the various types of deals available and which makes the most sense for their business?

Let’s explore the pros and cons of the three most common deal structures:

The Traditional Forgivable Loan

What it is: Also called a promissory note, this is how most traditional firms (wirehouses, regional firms, etc.) recruit advisors. The firm is effectively giving the advisor a total package between 150-300% of revenue to incent the advisor to move their book of business. These deals are typically based on top-line revenue, are consummated at ordinary income (as opposed to long-term capital gains), often 9-13 years in length, and come with both upfront and back-end earnout components.

Pros: At the end of the forgivable loan period, the advisor has not sold their book of business, so they are, in theory, free to move again. A top-line-based deal means that the advisor need not be worried about expense discipline. The loan is not a contract, so the advisor is free to make a change during the life of the note, assuming they are comfortable paying back the unvested note balance.? In addition to recruiting deals, many firms also offer sunset or retire-in-place packages that afford advisors a second bite at the proverbial apple without the need to make another transition down the road.

Cons: These structures are consummated at ordinary income tax treatment, and they include a requirement to pay back the outstanding balance if the advisor is terminated or leaves the firm prior to the loan forgiving. In some cases, they also require meaningful growth to achieve the full headline deal package.

The Asset Purchase/EBITDA-Based Structure

What it is: This structure is how many RIAs, private equity firms, roll-ups, aggregators, and investors will “buy into” wealth management firms. The buyer/investor will look at a seller/target’s EBITDA or EBOC (Earnings Before Owner’s Compensation) and then apply an industry-competitive multiple to that number. Multiples vary based on the quality and size of the underlying business.

Pros: These deals are executed at long-term capital gains tax treatment and often include a mix of cash and equity. Such structures align advisor and acquirer on profitability focus, often with a more lucrative total package than that of the forgivable loan. If the advisor received equity in the purchaser in the transaction (which is common), they could sell that equity down the line at a high multiple. If the advisor doesn’t sell 100% of their equity, they control their operating leverage, i.e., as they grow, the value of the equity they own in their business also grows.

Cons: This structure typically involves an asset sale and, therefore, an onerous selling agreement that dramatically limits the advisor’s ability to transact the business again. It often comes with a low ongoing payout post-transaction (30-35%). Asset portability and retention are required to realize the majority of deal economics.

A Hybrid Approach

What it is: Many savvy firms realized the benefits and drawbacks of the above two structures, so they set out to create a hybrid structure that includes elements of both. It is common to see a recruiting deal structured as a forgivable loan (as described above) but with an equity deal component (i.e., the advisor may receive a total potential transition deal of 300%, but 100% of it may be paid in equity).

Pros: From the advisor’s perspective, this structure allows for monetization of the book now and also a potentially lucrative “second bite of the apple” down the line via a liquidity event for the equity they received. It also ensures the firm is invested maximally in their ongoing success. From the firm’s perspective, whenever an advisor accepts equity, they are aligned more explicitly with the future success and strategy of the firm. It is also less capitally intensive on day one since not all deal proceeds are paid in cash.

Cons: The obvious downside of this structure is that the equity awarded to advisors is usually granted in lieu of additional cash considerations. The first structure described above may be more palatable and attractive for an advisor who prioritizes day-one economics since the full deal is paid in cash. Also, the cash component of this structure is paid at ordinary income just as is the case of a traditional forgivable loan.

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In the old-world order, a wirehouse advisor probably didn’t need to be concerned with the second and third structures described above. But in the modern landscape, even a captive advisor might reasonably sell their business on the open market (to a minority or majority investor, a private equity firm, an RIA, etc.) and would typically do so using the second approach described above.

While each structure allows advisors to monetize their book of business for potentially life-changing money, the mechanics, sharing of risk between buyer and seller, and legal ramifications vary considerably from one approach to the other. So, it’s critical that advisors understand each of these structures, their unique advantages and drawbacks, and how they align with an advisor’s goals and vision for their business life.

As seen on WealthManagement.com ...

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