It is vital for advisory firms to review those agreements before partners face a crisis or an impending sale to make sure that partners can transition ownership smoothly, ensure liquidity and avoid expensive litigation.

Even though shares of a privately held RIA can’t be sold without a buy-sell agreement, this critical document is too often ignored, forgotten or given short shrift.

“Nobody thinks about the buy-sell agreement when business is good and everybody gets along,” Matt Crow, president of Memphis-based M&A valuation firm Mercer Capital, said. “But when something happens and the partners have to take it out of the drawer and blow the dust off, they may not like what they see, but they’re stuck with it.”

That’s why it’s imperative for advisory firms to review those agreements before partners face a crisis or an impending sale to make sure that partners can transition ownership smoothly, ensure liquidity and avoid expensive litigation.

A buy-sell agreement should define the conditions which trigger its implementation, describe the mechanism by which shares are priced, address the funding of the transaction and satisfy all applicable laws and regulations.

But in a fast growing and dynamic industry like wealth management, conditions can change rapidly and buy-sell agreements need to adapt to accommodate growth, scale and the breadth and composition of ownership.

Partners need to keep in mind that this legal document literally holds the key to the future. It’s foundational for the firm’s succession plan and will determine what some individuals walk away with and others get to keep. As Crow put it: “Without a governing agreement you don’t know what your interest is worth and what you can get out of it.” 

In a just-released series on buy-sell agreement basics for wealth managers, Mercer recommends:

•    Reviews - The agreement should make sense in the context of your firm’s vision and in partnership with its other governing documents. If you already have one, hire an attorney who didn’t draw it up to review it. If you don’t have an agreement in place, draft one with the help of legal counsel and an independent valuation expert.

•    Define value - Specify the terms and define the process for determining the price at which shares are transacted when an owner exits. This is often a point of contention, since a retiring partner will want the highest share price possible while continuing partners have to finance this repurchase.

“Fair market value” is the most common and widely adopted standard of value, according to Mercer, with “a lengthy history of court interpretation” and Internal Revenue Service rulings to back it up. It is not the same as market value, the price at which a company’s stock trades, or intrinsic value, what experts believe a security is worth based on a particular valuation model. 

The standard of value is critical to defining the parameters of a valuation and Mercer recommends that RIAs name the standard and specifically cite which definition is applicable. Otherwise, “the downsides of an ambiguous or home-breed definition can be severe.”

•    Determine value - “Pricing mechanisms are the biggest problem we see in shareholder agreements,” according to Crow.

Overvaluing shares can lead to disastrous consequences, he warned. When a partner who held a 25 per cent stake in an RIA Mercer worked with died, the buy-sell agreement compelled the firm to pay the deceased partner’s estate around 45 per cent of the firm’s value.  

“The resulting dilution to the remaining shareholders put a huge strain on the business model, succession planning and sustainability of the company,” Crow said.

Mercer warned financial advisors to avoid “formula pricing” such as a multiple of AuM, revenue or cash flow. These “rules of thumb” can become outdated and inadequate and are often “key reasons for costly disputes of disruptions down the road.”

A wealth management firm’s value, according to Mercer, should be based on a wide array of factors, including client demographics, trends in operating performance, current market conditions, compensation agreements, profit margins, growth expectations and relative differences in stated or realized fee schedules.

•    Avoid creating winners and losers - “Buy-sell provisions shouldn’t benefit one party at the expense of others,” Crow said. 

What’s known in valuation circles as “the level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Buy-sell agreements function best, according to Mercer, “when they memorialize the parties’ understanding of what level of value will be used in advance of a triggering event occurring.”

Fairness and sustainability should be key considerations in buy-sell agreements. “The ownership mechanism should serve the business model,” Crow said, “not inhibit it.”