Eric Leeper: Why Compensation Structure Is Vital to M&A Success

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Welcome to Barron's The Way Forward. I'm Greg Bartolis, and my special guest is Eric Leeper, CFO and principal of FP Transitions. Welcome to the podcast, Eric.

Thanks for having me, Greg.

My pleasure. We're going to talk about comp structure and why, why it's so important to M&A success. Before we unpack that, tell us a little about your background, how you arrived at FP, and what the firm does.

Yeah, absolutely. So I started my career actually as an actuary. I studied math in school, and that was really one of the only appealing, you know, career choices available to me. And I quickly realized after becoming an actuary that I wasn't going to be long for that profession. So I started to seek out other opportunities that were sort of finance adjacent. Through a relatively circuitous path, I ended up as an equity research analyst at an investment bank. I did that stint for a number of years and decided the work hours were no longer tenable, and I joined a small company based out of Lake Oswego called FP Transitions. There were 12 employees at the time. This was in 2011, and it was, it was really at the infancy of M&A in the space. In fact, FP Transitions started in 1999, was one of the only firms that was actually taking an organized approach to mergers and acquisitions. It wasn't actually clear back in the late '90s if advisors could actually sell practices. So through the process, they actually created one of the first marketplaces for financial advisory practices back in the early 2000s. And since then, you know, I was the 12th employee at the company. We're now over 70 employees, and it's been an exciting, exciting path.

Yeah, I mean, it was quite early to this. What did the company see? What did management see that others didn't so early?

Yeah, actually, the story goes, the story goes back to David Graus Sr., who is the founder of FP Transitions, now retired. He's obviously a major contributor to thought leadership in the space over the years, and he was a securities attorney at the time. His wife was actually a real estate broker and suggested that after David had finished an engagement that was dealing with the legalities of selling a financial advisory practice, and it was determined at the time that, yes, you know, you can actually transition these legally under the regulatory structure, and there was a right way to do it. It was actually Penny Grau who suggested that, hey, maybe you should create something akin to like an MLS, you know, multiple listing service for financial advisory practices, and that's really what kind of jump-started it. The modern version of FP Transitions was then expanded on in 2006 when Brad Biermann joined the firm, and Brad came from, you know, very much an investment banking, you know, business brokerage mindset and said, We can start to institutionalize these processes, bring more formality to it. And Brad created the valuation, which was a standardized valuation approach, which advisors could then use. So obviously, we borrowed a lot in the early days from real estate law practices, and we sort of coalesced these ideas of practice management, succession planning, valuation around concepts we borrowed from those industries, and quickly it took on a life of its own.

Mm-hmm. Okay. And what are some of the biggest trends shaping the M&A activity that you're seeing right now?

Yeah, it's a common question, one that we get a lot. Ultimately, the biggest trend that we're seeing is that firms are acquiring practices well before the actual stated retirement goal of the business owner. What I mean by that is the traditional model for M&A used to be you worked until you were your early to mid-60s, sometimes, you know, as late as maybe 80. We still have a lot of 80-year-olds who are still in the practice. They love the business. We definitely encourage that, you know, stay in the practice as long as you want to. But when you were done with the practice, you went out and find a buyer, and we would help in building the marketplace around that and helping in structuring the deal. So the idea of M&A historically has been one of you sell the practice when you're done working or you no longer desire to work or don't have the means to work, sometimes health, family, events happen, things like that, lots of different reasons. But it was, I would call it a terminal transaction. You did the transaction and then you were no longer in business. You stayed on through a client transition period and then it was done. Not dissimilar to the way a veterinary practice or a dentist would come on and they would consult for a period and then sort of fade away. One of the trends that we started to really see, we really started to see it probably 2013, and it's really reached a fever pitch you know, under present times, that we're starting to see firms engaging in M&A much earlier than they would have traditionally done that. And we attribute that largely to the economies of scale that large practices have that can bring to the smaller practice that says, look, you don't have to work in the manner in which you're working for another 10 years. Why don't we partner? You might be in your early 50s or maybe late 40s. Why don't we partner now? And take a more constructive approach towards the management of the practice. Maybe your practice has grown to the size where there are tasks that you don't feel like doing anymore. Compliance is the obvious one, but there's a lot of back office functions that, you know, you don't build your practice with the idea that, you know, I'm good with client relationship and now 10 years later, now I have to be good at back office and compliance. People tend to want to stay in a zone where they're in their highest investment.

Yeah, and that's why they got into the profession often. So let them focus on the planning and, all the other stuff they can offload in a way.

That's exactly right. So what we're seeing is that as the practice grows in size, and these practices, a lot of them have very astonishing growth rates just because of the depth of client relationships that they build or the niches that they have in their community, we start to see an inflection point where they get taken away from the advisory role that they had been doing for the last, you know, several decades, and they have to switch into business management. And certain teams will make that switch very well, other teams really struggle with it. And that's when we start to see an entry point for partnership with larger firms who have been there, who have done that, who have systems and processes on the back end, and they can put you back on the track where you want to be. So again, we're starting to see younger firms engage in M&A, and I would say if you wanted to characterize it a different way, traditionally the model was purely acquisition. Now we're starting to see things that look more like, quote, mergers, right? And that term is used a little bit loosely, Uh, but we, we call a merger anything that has a partnership that is expected to last more than a couple of years. You need to create much more alignment. There's, there's a lot more rigor that is involved in finding that right partnership.

Yeah, the sell-and-stay approach, basically.

Exactly.

Right. So that, the, the gradual exit, it definitely makes a lot of sense for the advisor. They're offloading a lot of the work. They can focus on what they want, but then their, their wisdom is also there on hand. They have one foot in, so they're —kind of win-win for both sides, I would assume.

Yeah, exactly right. And I would even make a distinction. Sell and stay was a reaction to firms that— firms, individuals who did want to stay past the client transition period. You know, they wanted to be integrated with the firm. I would say that if you want to bring it even more recent, the term sell and stay is still very much in parlance in what we do. But one of the things that's even more prominent with the deals that we see and deals that we structure is the use of equity. So a sell and stay was traditionally it was traditionally relegated to debt instruments. I would stay on, and my participation in the company would be one of an employer-employee relationship. In other words, I would be staying in exchange for compensation, and that might be a 5-year employment contract. What we're seeing now, and again, as we go younger in terms of age that firms are engaging in these partnership discussions, the prominence of equity, so actual real long-lived incentives that have an income component, a capital appreciation component,, and it really creates a truer partnership. So a sell and stay was really the stop— we stopped at sell and stay in between outright sale into, you know, getting these longer tails to transactions, but we're really starting to see equity play a much more prominent role, which greatly increases the complexity of the transactions that we see, but it creates much better alignment with the stakeholders.

Okay, and speak about that comp structure and evaluation of the firm, like that interplay. Well, compensation.

So at FP, we're equal parts transactions and management consulting, so we focus on compensation a lot. And why compensation? Well, the reality is compensation is the single largest expense for a financial advisor. So firms will spend anywhere between 30% and 90% of their gross revenue on compensation. So if you can't solve compensation, you really can't engage in M&A in a meaningful way. And so the implications of compensation are it really does drive your valuation. It creates an incentive. For your team to grow. If you don't have compensation correctly, your team won't be incentivized to grow. If you don't have appropriate controls on it, your compensation levels can grow out of control, what I like to call negative operating leverage. You make more money, but you make less profit because you're paying out too much in compensation to individuals. And the implication there is that the more you pay your staff, or if you don't pay your staff in the right way, they may have a, I'm gonna call it a quote, phantom equity position in the company, So if you're tying too much of the compensation to a direct client-advisor relationship rather than tying the client relationship as owned by the firm, then what you end up doing is you end up creating silos in your practice where clients associate their relationship with an individual rather than an organization that's providing it.

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So, and what that means is that's value dilutive. When you go to the market and you look for a partner, they're going to say, well, I'm really not dealing with a single owner. I'm really dealing with 4 advisors that have separate books of business and distinct client bases. So we can use compensation modeling and different equity structures to create a much tighter bond between not only the advisors and their business partners— we create a governance and a system around that— but also the clients and how they view your organization as not being a single individual managing their relationship, but a team of individuals with different skill sets and different ways to solve problems.

Okay, and let's talk about deal structuring and financing. What are some common elements of a well-structured deal? Yeah, absolutely.

So the major components that we have are obviously cash. Liquidity is one of the main reasons why people engage in M&A discussions to begin with. Liquidity allows the seller of the practice to diversify, and it's funny, what we're effectively advising advisors to do is what they tell their clients to do. If you had a client who had 80% of their net worth in Microsoft stock, you would say, hey, let's, why don't we diversify away from that? So a lot of times advisors will come to us and say, look, I need some cash so I can diversify away from the business and achieve my own personal financial objectives. The second structure we tend to see are adjustable promissory notes, and sometimes these are called retention payments. Retention payments are ways that buyers, the larger firm in the transaction, reduce the risk of client attrition. So it's kind of where you put your money where your mouth is. You know, they expect a certain amount of client attrition, usually somewhere between 95 and 99%, which by the way, anecdotally, and all of the data that we've been able to collect suggests that the client transition rate for well-structured deals is in excess of 98%. But the buy side tends to want to see downside protection. So if your client relationship is not as promised or you misled someone, They create this buffer and they say, we're gonna measure the performance of the client transition either on assets or revenue received, maybe 1, maybe again at 2 years post the closing of the transaction, and they'll use that as a way to adjust the purchase price. And then lastly, growth incentives, and growth incentives can come in a couple of different forms. The 2 most common are what are traditionally called earnouts, which suggests that if I, I'm able to create a business development atmosphere around my practice even under a new partnership, and I can grow my client base by capitalizing on my relationships in the community and referral relationships, there's an expectation that you'll be paid more for that, and buyers are very willing to do that. So what they will do is they'll add, you know, a certain amount of economics into a bucket called an earnout that will measure the growth of the practice, you know, usually at 3 to 5 years, and they'll pay you upside based on how much above baseline the practice grew over that period of time. Lots of different features in earnouts, it's very hard to generalize, you know, different firms have different approaches, but they're almost universally seen in transactions like this. And then compensation is another element, and this is where we kind of come back, right? 'Cause compensation drives the profitability of the company. So we want there to be a system in place that if I'm growing the practice, that the compensation still continues to flow, in a manner that is sensible. In a perfect world, the compensation system would not be dramatically different pre and post-transaction, which is again, why we spend so much time on aligning that, giving people industry standard compensation, which by the way, is not an off-the-shelf approach. You know, every firm is gonna have nuance and differences in their team dynamic that justify changes in the compensation system. Our job as consultants is to maximize the options that they have in the transaction. So a lot of times we'll get them close, and then we'll work with the buy and the sell side to fine-tune the compensation system to make a really strong alignment of goals and objectives post-deal.

Okay, and tell me a little more about succession planning and transition strategies. And this is kind of connected too, because you may have someone who's leaving who's underpaid relative to industry or making more, so you have to have assumptions for the present and what your assumed compensation will be in the future.

Tell me more about that. Yeah, so succession planning is, you know, the term got very, it was very general in the past and then it got very specific. And what we're finding is it's become very general again. And succession planning was traditionally associated purely with M&A. And then we suggested, hey, succession planning is about a longer-term plan. It's about creating continuity and durability in the practice. And it's gone back and succession planning, it seems to have taken on the moniker that it really means M&A again. The realities of succession planning, the way we view it, are it's a multifaceted objective. To have a truly maximize the number of options you have as a practice owner, you need to be able to retain your team over a long period of time, control the compensation, the profitability of the company, and make yourself attractive potential buyers. What that means is that if you have the team and the staff in place and they're compensated correctly, Their option is always available to sell it to them, and there are lending facilities that will allow you to do that. They'll allow you to sell the practice in the form of a stock sale to your team of advisors, and sometimes we need to combine that with seller financing, other financial instruments to make it really compelling. But you always have that option, you know, to go internal, and a lot of times what firms will do is they'll start with that, but they always have the option to go external as well. And so we focus a lot on the governance of those internal stock sales to make sure that you do have options. And then if you do elect to go in a certain direction, there's an opportunity for the other stakeholders, the other equity partners that you brought on at the beginning of the plan to have a say in the direction of the company. They may not have absolute say, but allowing them to participate in the upside. And one of the things that is a relatively recent trend is that firms that had intended to engage in a succession plan, maybe 5 to 7 years ago, they came to us, they did an initial stock sale, Traditionally, we would have planned multiple tranches of equity sales into the future. What's happened is there's been a pretty severe dislocation in the value that an internal team can pay for the practice versus a strategic partner. Lots of reasons for that, which, you know, kind of bear its own, you know, private equity comes to mind. That's a very hot topic right now. Private equity is definitely prevalent. Also, the broader interest rate environment plays an important role. You know, when you're asking someone, to pay you back with the profits of the company of which you just bought, you know, sometimes called bootstrapping. If you're borrowing money to do that, there's a limit on the price that you can pay for that, and that limit is not as high as a strategic buyer who has a lower cost of capital, private equity backing, can pay for the practice. So ultimately, this all comes back to alignment of incentives. You may choose to go one direction or another, but if you do choose to seek a strategic buyer, not the internal model, there's a method in place to incentivize and keep your team happy through that transition, giving them a seat at the table, as I said. So there's a lot of different pressures that are happening on succession planning, but ultimately it's the option of the business owners and the partners to decide which direction they want to go.

Okay, excellent. And let's talk about briefly your firm. What sets FP apart from others in terms of helping companies navigate M&A?

Yeah, so I would say we take a consultative approach at first. I mean, our DNA is in management consulting. You know, we started as an organization that did, you know, what would by modern standards be simple M&A transactions, and we added the capabilities of, you know, management consulting, compensation consulting, valuation, appraisal. We have a team of legal consultants that helps advisors understand the governing implications. By the way, we don't offer legal advice, but what we do is we we allow them to start with a much more advanced understanding of governance and sometimes template documents that they can then take to local counsel. So we'll work directly with their local tax and legal counsel to give them something that is industry-specific. And to point out, most attorneys and accountants are not industry-specific. They don't understand the intricacies of FINRA and the SEC and RAA and compliance regulation. So what we like to do is we like to take an end-to-end approach, kind of a one-stop shop. We start with consulting, we do the financial analysis, we check the plans robustly to make sure that they make financial sense. We have relationships with debt and other capital partners that can come in and help support them from a financial instrument perspective. And then we have the legal expertise to ensure that the transaction is going to be, you know, well executed.

Terrific.

Any other Final thoughts? It's never been a more exciting time to be an independent RIA, I'll tell you that. You know, every— this has been such an interesting couple of years, I guess. You know, I guess it's almost 15 years I've been with the firm, so there's never a dull moment. It's a very dynamic industry and, you know, it's always exciting. Excellent.

Well, thank you so much for joining.

I appreciate it.

Thanks so much, Greg. My guest has been Eric Leeper. For more podcasts and the latest wealth management news, visit barons.com/advisor and be sure to check out The Way Forward The Way Forward: Next Generation, a new podcast that puts the spotlight on the emerging leaders who are shaping the future of financial advice. For The Way Forward, I'm Greg Bartalis.

This podcast was brought to you by Wells Fargo Advisors. Looking for a firm your clients can't outgrow? Wells Fargo Advisors offers financial advisors full balance sheet solutions with wealth planning, investment products, banking, and lending that meet the needs of affluent to ultra-high net worth clients. Build your practice your way and on your schedule with independent and employee model options designed to meet your needs today and tomorrow. Learn more at joinwfadvisors.com.