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When Independence Makes More Economic Sense

Why so many advisors are passing up the up-front gain for the longer-term payout.

Over the last five years, a number of advisors have left the wirehouses and other employee models to go independent. In fact, the asset market share of the wirehouses, national and regional broker/dealers, has declined from about 63 percent in 2011 to nearly 59 percent at year-end 2016, according to Cerulli Associates. At the same time, independent channels—independent broker/dealers, RIAs and hybrid RIAs—saw a jump in market share from about 37 percent in 2011 to 41 percent in 2016.

Many advisors ask me about the economics of going independent compared with the present value of taking a check from a wirehouse or other major brokerage firm (today maxing at 175 percent cash up front).

Let’s make some assumptions about an advisor, Rob, who is beginning to explore his options. Rob has been with the same wirehouse firm for his whole career (let’s say 20 years at this point), generating around $3 million in annual production, 75 percent of which is fee based, and managing just shy of $350 million in assets. He is expressing the same frustrations that so many of his colleagues around the country are: He’s tired of bureaucracy and feeling marginalized, worried about the bank encroaching on his clients, sick of having his payout messed with, and wants more independence and control. After months of weighing his options, he calls me and asks, “Why is it that so many top advisors are passing up much bigger transition deals from larger, well-branded firms to go independent?”

Running the Numbers

Let’s presume Rob has been offered 175 percent cash up front as a recruiting bonus on a nine-year forgivable note (representing a taxable event at ordinary income rate). A typical wirehouse net payout is around 45 percent. (For many advisors, the true net is even lower than that if you take into account haircuts by the firm, advisor-paid support staff and other expenses.)

A move to the RIA space (assuming you do so without bringing in outside investors) would represent the following:

At least a 20 percent bump in take-home economy. The margins for a well-run RIA firm hover around 65 percent, depending on geography and how a practice is managed. (We’ve seen some come in at around 70 percent.)

The building of an enterprise with tangible value. If you choose to sell it, let’s say in a nine-year period (to mirror the length of the note you would sign if you were to move to another major firm), you can do so by putting the business on the open market, creating optionality and competition for it, or choose to sell to your next gen. Even if your practice has not grown a bit in nine years (which is unlikely), a $350 million business would probably sell for seven times earnings before interest, taxes, depreciation and amortization (EBITDA) at capital-gains rate.

Back-of-the-envelope calculations would show that this $3 million business as an RIA would have an EBITDA of $1.95 million ($3 million x 65 percent). The value of that business would be approximately $13.65 million ($1.95 million x 7).

So if Rob chose to take the RIA route, he would take home an additional $600,000 per year as a result of the payout boost, and in the same nine-year period would realize an uptick of $5.4 million. Taken together with the business valuation of $13.65 million, this represents a total value of $19.05 million, or $1.67 million more (not factoring in the difference in tax consequences) than the $17.38 million this advisor would take home at a wirehouse. We got the valuation at the wirehouse by adding his up-front money (175 percent x $3 million, or $5.25 million) to his earnings (45 percent payout on $3 million over nine years, or $12.15 million).

The superior long-term economics of the independent space are indisputable. And there is much to say about the benefits for clients. Yet no matter how compelling the numbers might be, independence is decidedly not for everyone. There are many valid reasons why an advisor would choose to continue to practice as an employee at a major firm, not the least of which is the turnkey nature of it and the ability to take some meaningful chips off the table in the short term.

No doubt the numbers are pretty compelling. But what it really comes down to is this: Do you have the entrepreneurial spirit it takes to be independent? And will this move you closer to living what I like to call “your best business life"?

The reality is that seeing the numbers and actually understanding their “real value” are two completely different things. As long as you know what you are accepting, or potentially leaving on the table, your decision is a perfectly reasonable one. Ultimately, knowing yourself and being true to the voice that drives you should be the catalyst that defines the real value in deciding which path to take toward your best business life—not the economics.

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