Bringing in partners with potential

Report

New ways to finance your succession plan


A documented, well-planned succession strategy is vital to the long-term success of any partnership. But it's not just about maximising the value of your equity before retirement. Given the challenges with funding entry to equity ownership – particularly for younger incoming partners – many firms are developing creative solutions to retain and nurture people with the most potential.

"Anecdotally, we are probably seeing firms taking on partners at younger ages – especially in the professional services sector," says Cameron McMillan, Division Director of Macquarie Business Banking "Combine that with the trend of buying property later in life and housing affordability issues, and it may be harder to gear up for partnership at a time of peak debt in their lives."

At the same time, a generation of baby boomers are now interested in retiring and they want to optimise the value they take out of their firm. But they also want to do the right thing by their clients and their staff. It's not a simple decision and there are many factors to take into consideration – for both the incoming partner and the firm's leadership team.

Tapping the right talent

Identifying a potential successor is one of the first hurdles.

"Beyond functional capability and cultural fit, firms should consider the skills and responsibilities the partnership is seeking when planning succession," says McMillan.

Getting that fit right is more important for the business than making sure they have the capital to invest. "That's why larger firms may have arrangements like a peer equity system, where people can build up equity over time."

There are many potential scenarios. For example, you might bring them in as a part-equity partner – start at 10 per cent and over time this gradually increases. Over five years, they may get to 100 per cent full-equity partner through additional contribution or withholding profit. Alternatively, you could create a balloon acquisition at a five-year point.

"For incoming partners in their late 20s to early 40s, it's the peak borrowing time in their lives," explains McMillan. "They may have limited capacity in terms of personal assets, plus the additional expenses of starting a family. So, we're often helping our clients fund a bundled arrangement – the incoming partner contributes what they can and the firm finances the rest against equity."

Four ways to fund equity partners into your firm

  1. Financed funding – the firm may offer security to the bank to facilitate entry of a partner and they pay it back over time. Larger firms may be able to provide unsecured funding to incoming partners
  2. Bundled financing – the incoming partner may be able to pay part upfront (through a home loan, shares or cash reserves) and the firm will finance the balance
  3. Funding secured against equity – a bank may lend directly to the incoming partner, against their share in the firm. The firm is not exposed to risk, but the loan may need to be paid down quickly
  4. Vendor finance – less popular now, the outgoing partner will wait for payment – effectively funding the incoming partner as they transition out slowly.

You could combine any of the above methods to facilitate partner entry. "By understanding both the business and the personal position of the individual, it's possible to achieve an optimal funding structure and the best outcome for both parties," says McMillan.

It is also important to look beyond the initial or immediate funding requirements. Typically a new partner will start with the purchase of a smaller share of the business and then acquire more parcels over a one- to five-year period (or more). So it's important to model the funding solution for the whole period, to give all parties clarity. The funding structure should include additional tranches and principal reduction requirements.

Transfer of control

A succession plan should also consider the transfer of strategic and operational responsibilities and how that will change over time.

"If the equity positions of existing and new partners differ, is everyone's vote equal in the boardroom? Perhaps not in a smaller firm but in a larger practice, with several equity partners, everyone may get an equal vote and your equity level will impact your income level only. You also need to consider who is responsible for strategy, sales, marketing, human resources and other operational areas," explains McMillan.

Making those obligations clear upfront is essential. "Incoming partners need to know what is expected of them, and what they can expect of the other partners. They may or may not want a seat at the table."

Be informed and be clear

"I'm often surprised at how little prospective partners really know about the firm they're buying into," says McMillan. "I think many could do better with due diligence. They may just accept general statements about income or strategic direction, and then when they access the detailed financial information they may be surprised."

Being honest and sharing information is essential on both sides to avoid potential conflict. "Financial issues can be huge causes of dispute between partners, but often it's a symptom of a bigger issue," he says.

Sometimes the negotiation itself can be challenging. "We do see some prospective partners say they expect their loyalty or past service to be rewarded with some sort of discount on the business value. But that's not a given – you can't necessarily expect it."  

And if there isn't a clearly documented exit strategy and a retiring partner wants to stay longer with full-equity, it can also cause tension. "Junior partners should be made aware of the senior partner's retirement plans."

He says both sides need to get independent advice before signing any agreements.

"An independent valuation is essential so everyone is comfortable. The prospective partner should also seek financial and legal advice – what will the impact be on their income and tax for example, and is there a way to optimise that structure?"

Above all, he says that if you start with smaller shareholdings, make sure you have a plan to move beyond that. "Lock-step arrangements are great, but you need a documented strategy for how to increase that over a specific time period. The end goal is to make sure the business is in safe hands for the future."

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