June 27, 2018

The Wealth Management Firm Owner’s Dilemma?

Steve Putnam

Steve Putnam
President /Putnam Dispute Resolution

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Are smaller wealth management firms becoming roach motels where you can get in but you can’t get out? Many owners of these firms have built a very successful regional firm offering truly personalized service and investment advice to individuals and smaller institutions, but they are now facing significant challenges:

  • How do I convert my ownership in the Firm into a diversified investment portfolio more suitable for the beneficiaries of my estate?
  • How do I bring in and retain key professionals who will ensure continuity of the Firm for its clients so it is more than just a “book of business”?
  • If I sell to a large firm their philosophy will not be consistent with what has made this Firm attractive to our clients and our employees, but what other buyers are there?
  • I have brought in younger professionals who are interested in “buying” into the Firm, but they have educational expenses both their own student loans and in some cases those of their children as well as house and other debt to service so how can they buy the Firm?
  • Finally, if I sell my company am I going to be facing a significant capital gain on the profits from what I have built?

One alternative for succession planning exists which many owners in our industry are beginning to consider and which can solve many of the concerns for an owner and employees. As one owner was looking at this alternative it seemed to present the following positives:

  1. It allows all my employees to have an equity stake in the Firm and for me to initially continue to control the Company and gradually cede control to the employees.
  3. It allows for the Firm to borrow money to buy out my equity with the repayment coming in the form of tax-deductible payments from the Firm’s income.
  5. It doesn’t require employees to come up with any funds as they will buy the equity with deductible donations of Firm’s funds from profits.
  7. All funds that I receive will be capital gain tax sheltered (so long as I sell at least 30% of my ownership in the first transaction and invest in US securities within 12 months) until I sell the subsequent investments I make.
  9. It allows me to tell clients that our Firm continues to be a small employee-owned Firm.
  11. If the Firm needs additional capital to grow it can issue shares to the Plan and utilize the cash created by the tax deduction for Firm needs.
  13. The Firm can even deduct dividends paid on shares owned by the plan for the benefit of the employee shareholders.
  15. My employees can treat their ownership in the Plan the same way they would any other retirement plan deferring taxes on plan values even after they retire until their RMD date.
  17. Studies have shown that employee-owned companies tend to be more profitable than other companies in the same field so this may help my Firm’s profits.

Employee Shareholder Ownership Plan

This solution is called the Employee Shareholder Ownership Plan. It was created by the government in 1974 in order to encourage ownership of US companies by employees. It has grown dramatically especially from 2000 to 2010. Currently, there are 5,429 ESOP companies and an additional 1306 companies who have adopted a KSOP with matching contributions in company stock. Together they cover some 13.9 million employees and $262 billion in employer securities. Of these, 92% are private companies and 57% have less than 100 employees. Further, 78% of the companies are in other than manufacturing businesses. As you can see this is not a little known or fringe “loophole” type of solution.

In simple terms how does it work? The Company’s owners determine to set up an ESOP. They hire a firm or individual conversant in this area. One such firm Menke & Associates has set up over 3,000 plans. With their help, the owner determines the plan structure using a questionnaire technique. It will deal with such things as vesting schedules, buyout arrangements, forfeitures etc. Many owners who have 401k plans have already dealt with most of these issues. If the owner is going to be selling shares to the ESOP then there is the need for an independent trustee and valuation firm. In all cases, there is the need for a planning committee. All of these are picked by the owner and can be replaced by the owner. Before proceeding many companies want to have an indicated value which can be determined by a valuation firm who will not be involved in the actual valuation for the sale by the owner. If the owner feels that the price is within an acceptable range then the Company moves forward and establishes the plan. A knowledgeable individual can meet with employees and explain the plan and its benefits to all employees. One added benefit of the ESOP is that you can create the plan and receive a deduction for the year it was created but don’t have to decide on how much you are going to contribute and whether you are going to sell shares to the Plan or just issue new shares until the Company files its tax return.

Eventually, some employees will leave before they are vested. Their shares are distributed to those remaining employees. Later in the life of the Plan when an employee retires most plans call for the Plan to repurchase the shares generally over a period of time, but some allow the former employee to continue to own the stock.

The above is not an exhaustive discussion of the ESOP, its benefits and how it functions but rather an overview of its benefits and what it takes to set it up and operate it.

As for out of pocket costs, it will probably cost in the neighborhood of $40,000- $50,000 to initially set it up with ongoing administrative, trustee and valuation fees in the range of $25,000-$30,000 per year. These can be paid by the plan or more generally the Company insuring that more money in the plan is available to purchase stock.

I strongly believe that this solution is the key to allowing smaller wealth management firms to transition ownership to the next generation of “employee owners” and reward those who have built the business. In addition, this solution will allow these firms to continue to provide the individual service that has been so attractive to individual and smaller institutional clients and which is not available from large institutions today.

Comments? You can contact me directly via my AdvisoryCloud profile.

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