When financial advisors choose independence and launch a registered investment advisor, despite the long-term rewards, in the short term, they are operating a business with no revenue and significant expenses.
Post-launch, client assets are in various stages of being transitioned to the new firm, creating a revenue base that ramps up over time.
At the same time, RIA principals may want to take home compensation on par with what they received previously. This often results in negative cash flow for the business.
There are several other reasons that RIA principals may need financing, including start-up costs, repayment of forgivable loans and retention bonuses, working capital and tuck-ins.
In preparing a business plan, advisors need to have a realistic forecast of the P&L, cash flow and balance sheet. This includes identifying the key costs and of course determining the way the business will be capitalized.
Generally, funding capital can be secured either through equity or credit.
Equity financing typically involves having an outside investor or a syndicate of investors take a financial stake in the new business. This offers the potential benefit of having investors with business experience who are financially aligned with the advisor and who can offer advice and moral support.
Long term, however, equity investors can be a more expensive approach to financing as the advisor is effectively selling a stake or a percentage in the business when its value hasn't been fully realized. The equity investor presumably will seek more concessions in the form of a greater equity percentage or operating rights than could normally be obtained were the business fully up and running.
Credit capital is the other approach to financing, typically taking the form of a loan where the lender doesn't participate in the profits of the business. A loan can be structured in a manner that provides flexible repayment terms, and the interest payments can be a deductible business expense.
Typically, the principals of the business have to provide personal guarantees on the loan as the business value is at this point non-existent or of insufficient collateral. By using credit financing, advisors retain 100% of their equity, and once their financing payments end, advisors own 100% of the cash flow generated by the business.
Once an RIA team determines how it wants to finance its business, it is recommended that there is a 10% to 20% cushion over and above the amount that is projected as necessary. Depending on the financing structure, it may be a disclosure item in the RIA's ADV.
Larger teams are more likely to use debt financing. They tend to be more sophisticated in their understanding of the merits of debt vs. equity and are hesitant to sell stakes in the business at an early stage, recognizing the value of their venture is in the future.
Constructed in the right way, many RIAs can manage a 50% payout to maintain comfortable salaries for the advisors and staff while they are simultaneously covering the debt service.
Amit Grover is a partner and the chief financial officer of Dynasty Financial Partners.
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