A contingency plan is an agreement between two or more advisors designed to protect your business in case of your death, disability (temporary or permanent), loss of license, and possibly even retirement (although most plans do not deal with succession planning). There are a variety of plan types to solve for these issues:
I already have life insurance (or, I don’t need the money), do I need a contingency plan?
A contingency plan has two main priorities: 1) Ensuring that your business and clients are taken care of in your absence; and 2) Providing you/your estate with a fair value for what you’ve built. Insurance can be a part of the second priority, but is only one piece of the “puzzle.” And, even if you don’t need or want the value out of your practice, making sure your clients are taken care of in the event something happens to you is a priority for all advisors. In a professional service business, death or the disability of the owner/founder leaves the clients, employees, and business without any direction and results in a rapid loss of the clients and therefore value. From a compliance perspective, those affiliated with a broker-dealer also need to ensure they comply with FINRA’s continuing commission policy, and if there is no bona fide plan in place, it is very challenging to get any value out of the practice.
There are three common strategies used in advisor contingency plans:
Should the value of my business be discounted for a contingency plan?
Yes, the value of your business under normal circumstances, such as retirement, will be greater than the value of your business if you are unable to support the transition (death or disability for example). The lower value can be accounted for in one of two ways: 1) Explicit discount; or 2) Implicit discount.
Most contingency plans are funded out of cash flow, over an extended period of time, meaning that the seller or seller’s estate will receive a lower value when the time value of money is considered. If the plan is to fund the practice over an industry standard payment length, something close to 4 or 5 years, then it is common to explicitly discount the value of the business by 15%-35% depending on the nuances of the business.
Contingency plans for advisors are typically funded either using a term life insurance policy on the seller’s life or out of the cash flow of the business.
A Revenue Sharing type of agreement is all paid to the seller or seller’s estate on a 1099-MISC, and is therefore less favorable to the seller. A Buy-Sell, Cross Purchase, or Shareholder Agreement will generally provide the recipient with long-term capital gains tax treatment, or in some cases no taxes at all depending on the spouse’s step-up in basis at the advisor’s passing. Once you have a draft of your plan put together, be sure to consult with your tax professional on your specific situation.
Most contingency plans are between two peers running separate practices. If possible, a plan with a partner or internal successor will generally provide for a smoother transition for the clients, but many internal successors are not necessarily ready to buy the business today should something happen. A plan with a peer provides for an immediate successor who knows how to service clients and run a business. And, a plan that is communicated to your clients in advance can often provide a qualified successor and reduced risk of attrition.
In most cases, although a spouse might know the clients and potentially work with you on a day-to-day basis, if the spouse is not licensed, the spouse would not be able to purchase the business and service the clients. They could agree to get licensed, but given contemplated triggering events, it is unlikely they will want to, or be able to, take the time to get licensed.
The next step is to communicate the plan to your stakeholders. A signed contract in a filing cabinet is better than no plan, but by a slim margin. For a plan to work well, the broker-dealer and OSJ need to be aware of it and be able to support it, as well as the clients. Most advisors will either send a letter or discuss the contingency plan with their clients, just in case it is ever needed.
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