From the September 2008 issue of Wealth Manager Web • Subscribe!

September 1, 2008

Partnerships--A Leap of Faith

Chess players often say that the perfect game ends in a draw. After a series of precisely calculated moves on both sides, the result is a fruitless standstill. In a way, to win a chess game a player must take some risk and embark on a path of moves that cannot always be predicted, but that his gut tells him may be full of opportunity. The same can be said about negotiating partnership agreements: When two advisors or two advisory firms come together to negotiate a merger, they have to take a chance--a leap of faith--and believe that the merger will work out even if they cannot foresee all the risks, nor calculate how each and every dollar of income will be allocated. The perfectly negotiated partnership probably ends in a stalemate. For each merging partner to win, both have to be willing to expose themselves to risk while believing in a fruitful outcome.

Mergers between advisory firms or individual advisors are accelerating throughout the industry, driven by the increasing urgency of the succession issues many practices face and the opportunity to create larger firms with better competitive positioning. Most of the time, however, the attempted negotiations are stymied by an issue that is difficult to resolve from a pure contractual perspective and requires that "leap of faith"-- trust in each other.

The most common issues that sabotage negotiations are:

? Valuing the practices

? The notion of "firm clients"

? Side businesses

? Roles, responsibilities and compensation

? Arrangements for breaking-up

In my experience, there are no "scientific" ways to perfectly resolve these issues. Each is very important and each can have significant consequences--financial and otherwise. While there are ways to analyze each issue, it is impossible to find a perfect solution and avoid a stalemate. In the end, both parties will have to believe in each other and take the leap of faith. That said, there are good moves and bad moves in this position, so let's analyze the issues.

We are partners... kind of.

First and foremost, we probably need to define the term "partnership." To me, a real partnership is a form of business where two or more advisors share in the same profits and the same equity value in an arrangement that is difficult or costly to break. Another term that has become accepted for such an arrangement is an "ensemble."

However, an ensemble is very different from arrangements where advisors share the same office. And it differs from advisors who share the same firm name but retain their own client base. The key here is shared bottom line. As long as the vast majority of the advisor's income is generated as a direct function of his or her personal production, we have more of a loose network of professionals than a true partnership. Another important test is whether a buyer can acquire both practices at the same time through a single transaction or has to negotiate with each partner independently.

The true expression of a partnership is when each partner enters into activities where it is not clear how he or she will personally be compensated for the specific activity, but it is clear how the firm will benefit. The mentality of "activity-based compensation"--the notion that an advisor will not do something unless it is immediately clear how he or she will personally benefit--is the single biggest reason why partnerships fail to form or underperform. Until advisors understand that in a partnership they will often have to do things for which they are not directly compensated, there will be no ensemble firm.

My practice is more valuable because...

The only accurate valuation is the one that comes on a check; everything else is an estimate. Unfortunately, when advisors try to combine practices, they inevitably trip up on the question of how to value their books. Attempts to create a perfect valuation model end up mired in the difficult mechanics of the valuation process. For an academically sound valuation estimate to be possible, advisors must agree on:

? A clear picture of the profitability of both practices--net of owner compensation

? A projection of cash flows over the next five years

? A required rate of return

While the analysis will be incredibly valuable, the process can be overwhelming. Most of all, it is fraught with possible arguments that somehow one practice is better than the other.

I am not suggesting that advisors jump blindly into an agreement without analysis, but I believe that for the process to be practical, the level of precision must be controlled. The perfect valuation is simply not possible without selling the firm. Everything else is an estimate. The reason why the two practices are merging is because they see the potential to grow together. Therefore, in my mind, the absolute valuation is irrelevant. What is important is the relative valuation of each practice. For instance, if my partner Stuart Silverman and I are combining our practices, it is not important whether my practice is worth $5 million or $10 million. What is important is how the value of my practice compares to Stuart's. The key is to determine if my practice is equal in value to his or if it is 80 percent or 60 percent of the value of his practice. The two questions are very different. To establish the absolute value, we need to agree on what the practice can do in isolation. To establish the relative value we can focus on what we can do together.

Remember that what we are trying to establish is what percentage of the combined firm each of us will own--not the dollar value of each. As is true with the rest of the bullet points, the fundamental premise behind the combination is that both practices like each other, value each other and trust each other.

What if I bring in a client?

The mentality of split commissions is the single most significant barrier to creating partnerships. Unfortunately, it also is deeply ingrained in the DNA of many professionals--especially those who come from brokerage and insurance firms. As a result, advisors try to anticipate and define every situation and attach a commission split code to it. This endless number of scenarios creates a confusing economic picture on an ongoing basis, but most importantly creates issues around the equity of the firm. If two advisors split the revenue of one relationship, true ownership of that relationship is unclear.

The conversion to a common client base, however is not easy, and the leap of faith here is critical. There is no perfect way to compensate everyone for their fractional participation in the relationship with the client. Basically, split arrangements make the statement that there is no shared bottom line. A true partnership by definition is the opposite.

Migrating from an individual book of business to a shared one is difficult, especially if the two partners are not equal. Here are some steps that help in the transition:

? Set up a process for continuously updating the equity ownership of the firm;

? Create a good base compensation model;

? Avoid drastic increases or decreases in interest.

No matter how well-crafted the transition is, some discomfort will be inevitable. A restaurant-owner client of mine told me how most restaurants share a service that supplies clean tablecloths every day. The linens are shared among the subscribers in the program rather than individually tracked, allowing for faster and more efficient service. He told me that inevitably, new restaurants that sign up believe their tablecloths are better maintained than the others, and that they are hurt by the sharing. The lesson? Sometimes you have to believe that you are just as likely to spill your soup as other people are.

Next month: Partnerships Part 2--The End Game


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