Why ‘Equity shareholding’ -‘Liquidity Exits’ at broker dealer start ups are often the
biggest impediments and illusions to Advisor Growth.

It’s tough enough for advisors to evaluate public securities and predict the market. It’s a full time endeavour for the very best investment analysts and portfolio managers. Global events and regional complexities are so unpredictable on public companies that it transcends pure knowledge and intellect. Even the best investment managers get it wrong and very often too.

Investment advisors are in the business of evaluating stocks, bonds and a multitude of alternative instruments for their clients. Much of their portfolio lies in public holdings, but many are increasingly turning to alternative assets for diversification and portfolio optimization.

But while evaluating public securities is obviously easier from an evaluation and trading perspective, private investments don’t offer the same privileges.

If an advisor understands this, then he should understand exactly what his/her choices are when looking at making a transition.

While the banks are stable, growth based public equities and bastions of dividend paying securities, they have also become the one institution that most advisors have steadily exited over the past 5 years.

Among the independent broker dealers, there are many independent boutiques (some on the verge of death, others enjoying reasonable profit margins). Some of the larger independents cater to advisors with smaller size practices while others, hold very tight, respectable asset minimums. Brand power and offerings differ among firms.

But within this group of ‘larger independents’ lie some newer post start up broker dealers. (originally self – funded to start) There are very few of them. The reason is very obvious. In contrast with a money manager, IFM or EMD, a standard broker dealer in Canada is the most expensive form of wealth management start up. It requires a substantial amount of regular and growth capital, incredible intestinal fortitude and most of all, the very quick scale of advisor growth to become even marginally profitable. Regulatory, compliance and administrative oversight is often the biggest reason for escalating costs and thin margins. Not to mention growth capital (sign bonuses). And if the firm cannot strap on 10-20 advisors within a very short time frame, it will face insurmountable hurdles. It is already well on the road to disaster.

In the last 10-15 years alone, we have already witnessed a litany of brokerage closures. Increasing burdensome oversight, regulatory costs, inadequate advisor recruitment, and no proactive advisor succession planning – have all led to the demise of many old and newer firms (that simply never got off the ground).

Several of the new mid – sized independents too fall into this category. The reason for the struggles can be attributed to poor branding, poor infrastructure, an insurance focus (as opposed to an investment centric one). Others have a different set of problems. There are a few notable start – up firms that were originally self – funded and due to quick scale of advisor recruitment with signing bonuses, required additional outside investors to fund the business growth. The newer Canadian start – ups are private in kind and will not go public themselves. The mid – term play is a liquidity exit to one of the large banks or US wealth managers.

The exact reasons for why each advisor joins these newer start – ups is not always known. And whether they really understand the reasons and exact consequences of what/how and where the liquidity event will take place is also very much in doubt.

The reason for this is unlike public securities that display more standardized behaviour through the passage of time and strict protocols, private companies don’t offer the same stability of growth trajectory or predictability. Which makes the evaluation of start – ups and any growth predictability very complex.

Because of high costs associated with a broker dealer build out, there is great pressure to ramp up and scale to satisfy outside investors, owner-partners. And showing glossy presentations of current vs future share value to potential competitive recruits, (underwritten by a respectable accounting firm) doesn’t really mean a hill of beans. And broker beware! The advisor must make a very careful calculation – he must depend on the following criterion to occur for any successful outcome. And not one of these criteria. But ALL of them must occur for a successful liquidity event.

1. That the firm will be able to attract/retain a certain number of advisors within a very specific time period.
2. That the new advisors will be able to convert their clients/assets over even in the absence of firm branding
3. That the group of new advisors (all his fellow colleagues) will be able to move their client-assets with no firm history or relevant track record.
4. That the sanctity of shareholding in this new private entity can be preserved without dilution during its incremental growth
5. The firm already has or has sufficient stand by growth capital available to accommodate the first criteria without impacting the smooth ongoing operation of the business.

These conditions are considered contingent liabilities. Meaning: IF they happen, then a result may occur. But there’s no safe or secure way to assure that these events will happen. They are all contingent on many internal and external factors for a positive outcome. The problem here is there are simply too many intangibles and many are simply beyond the control of the individual advisor.

To satisfy any single criteria is a tall order. And very few broker firms have shown the ability to satisfy all 5 necessary criteria. In general, most Canadian start up firms may check off a few criteria but not all 5. The most common reasons for failure remain the following:

1. Insufficient growth capital to fund ongoing advisor acquisition
2. Shareholding being re evaluated causing divisions, litigation and early advisor exits
3. Executive desire for an early exit against the wishes/knowledge of many other ‘partners’ to stem potential asset losses and economic disaster.
4. Insufficient capital for operation & planning divisions due to disproportionate budge allocated to advisor growth. This affects the sanctity of the overall wealth management structure.

One of the more obvious considerations an advisor must make is that if he/she joins, the success of this entire venture will depend on each and every advisor not merely moving their original book over but that that their projected future growth trajectory will also be a part of the overall economic objective. And if some or many advisors either a) don’t port over their assets and / or b) don’t grow beyond their original practice, the entire scheme dissipates. This often triggers a re-evaluation or early sale.

And for most advisors who are independent and entrepreneurial by nature, the mere idea of depending on other advisors (most of who you don’t even know and have never worked with) achieving their own asset targets for every other advisor’s eventual liquidity to materialize – contradicts why they became independent in the first instance (to not be dependent on an institution or fellow advisor for your own economic franchise). It is more often than not a Casino Rama, Blackjack gamble

This is not to say they never work. On rare occasion, it does, but once again, like the real estate seminar putting on their top 1% producing brokers on show, it is the exception not the rule. The problem is many advisors are salesman who often easily buy the sale. And in many past instances in the Canadian wealth management industry, more start up brokerages have failed than not. The odds are clearly not in their favour.

If an advisor is reluctant to buy a private security for his client (due to disproportionate risk & liquidity), then he needs to ask him/herself one big question.

Why would he work for a private firm? Indeed, he/she would be stuck with the same problems.

Advisors joining a start – up must contend with the challenge of moving his/her clients to a relatively unknown, untested entity. That is no easy feat. But to then assume additional risk by voluntarily depending on fellow advisors to meet their asset goals also means losing control. Indeed, he/she is actually giving up a certain measure of control regarding the ongoing calculation and evaluation of his/her shareholding and the viability of a final event taking place. We are no longer talking about ownership in one single business. But a part owner in a business with several hundred shareholders.

The advisor can control his/her own practice but certainly not of any other. And those are the individuals he/she would be depending on to have a liquidity event. It begs the question, why would an advisor voluntarily place his / her faith in people he doesn’t know and has never worked with. He is merely adding more risk to the gamble.

In contrast, working for an established independent firm that has history and branding offers several key advantages:

Brand recognition makes it easier for the advisor to communicate the narrative to his investor client in the transition process.

Brand recognition gives the client a measure of warmth and comfort which gives the advisor the confidence he needs to make the transition along with the asset transfer itself. One often necessitates the other.

A firm with age and history gives the client-investor the comfort he needs to provide his/her advisor with consent to transfer out. It assures the investor of the sanctity of the institution itself and the advisor’s own security within it.

An established dealer offers powerful signing bonuses and retirement buy-outs, allowing the advisor to precisely calculate what his present and future economic value will be, unaffected by any other advisors or considerations. He/She becomes master of their own destiny. Their own practice makes them the ultimate individual of capital rather than being a shareholder in an untested, undetermined entity

Very few independent Broker dealers meet this threshold. But for those that have strong presence, branding and quality infrastructure together with strong profit margins and operational/growth capital – these institutions best provide strong grid payouts, competitive signing bonuses and attractive buy outs for retiring advisors:

All these advantages currently exist without the all too common sinister tragedies of shareholding reviews, dilutions, share valuations, or early sell outs. These common issues become nothing but harmful complications and impediments to any advisor preoccupied with the transition, on boarding and smooth continuity of his/her own business.

Shareholding can sometimes be a virtue. But in a struggling private broker dealer, it becomes a vice with an albatross around his neck: The advisor is locked in. And getting out is a nightmare of a potential economic loss and the single biggest distraction to his business.

By their very nature and stage of development, early-mid stage start – ups often create ongoing distractions that impede an advisor’s growth and stunt his confidence in a firm with very subjective, conflicting agendas.

In the advisor’s quest for the next transition, the Advisor-Portfolio Manager needs to conduct the same due diligence on his/her own transition as he / she does on the client’s investment portfolio. Because focusing on making a transition for the right reasons and the right structural environment is not only in the client’s best interest but ultimately the
advisor’s too.