When your partner’s also your successor, clients benefit from continuity and familiarity. And prospects will see you’ve got a practice that can endure long after you’ve retired.

To make sure the process runs smoothly, create a partnership agreement that enumerates exit, transition, valuation and payment terms. We spoke with two advisory teams (see “The examples”) and found out how they structured their succession plans.

Partnership agreement necessities

Exit terms

Most transitions take place over three to five years, says Doug Hartkorn, partner, Taxation and Business Advisory at Shimmerman Penn LLP in Toronto.

Read: How to prep a business for sale

Partners David Hasson and Michael Nichols decided their transition would be at least four, and at most seven, years long. “We agreed to a slow approach so it was seamless to the clients,” says Nichols. “It’s Dave’s decision how quickly it occurs.”

The examples

Michael Nichols (54) and David Hasson (64), Raymond James, Guelph, Ont.

Hasson and Nichols “have been business and personal friends for the last 15 years,” says Nichols. During a round of golf four years ago, Hasson mentioned he wanted to work on his exit strategy.

“Out of that developed a conversation over the potential of amalgamating our practices,” says Nichols. “Once we agreed, we accomplished our initial negotiations in five minutes.”

Nichols attributes the speed to their similar planning-based approaches, existing rapport and the fact both were with the same firm. One difference: Nichols is a portfolio manager and Hasson isn’t. “I’m taking the clients that will be well-suited to discretionary,” Nichols says, while the remainder of Hasson’s clients will go to one of Nichols’s two junior advisors.

“We’ve found the discretionary platform an easy sell, since our clients aren’t hands-on people. The more they can be unfettered by administration, the happier they are.”

With the help of Raymond James, the pair drafted a partnership agreement. They agreed to combine offices for efficiency, but were a city apart. So Nichols commissioned a new building, located about halfway between their two offices. “We both owned buildings, and we’re each in the process of selling them,” he says. Hasson pays a regressive rent based on how far along the transition is—the changeover’s now two years in. “The more clients that have been transitioned to us, the less rent he pays,” says Nichols.

Read: Plan business owners’ successions

They renamed the merged teams Compass Private Wealth, and dissolved their individual teams, Legacy Financial and The Nichols Team. The acquisition grew Nichols’s book about 30%, and the new office houses seven people: Nichols and team make five, plus Hasson and his assistant. “Some elements are still separate as we finish the transition,” says Nichols. For instance, “Dave pays his support person.”

Murray Morton, branch manager (66) and Matthew Morton, investment advisor (36), HollisWealth, Toronto

While doing his music degree at Western University, Matthew worked for his father doing what Murray calls “the joe jobs.” After graduation in fall 2001, Matthew worked at a fund company call desk calming clients affected by the tech crash.

Then, in February 2003, Matthew became Murray’s assistant and got MFDA licenced later that year. In 2005, Matthew became MFDA branch manager and Murray became IIROC branch manager. Matthew earned his IIROC licence in 2007.

By that point, Murray had started thinking about succession. The pair had been handling clients virtually interchangeably, and in 2012, Murray decided to give Matthew a one-third equity share and draft a formal partnership agreement.

Murray owns his office’s building, a bungalow in the west end of Toronto. It’s in his wife’s name, and isn’t accounted for in the partnership agreement since it’s a separate part of Murray’s estate. Today their book is $90 million.

After they agreed to merge three years ago, they used the next 12 months to prepare for the first of four transitions (see “Compass Group’s schedule”). “Dave determined which clients would be best suited in each of the segments,” says Nichols.

Hasson took the lead with his clients and explained a larger team would now be serving them. “He’ll be involved in the background going forward as necessary,” says Nichols. “Whomever takes over is the front person for communication. So far, clients have been receptive.”

Read: Succession planning can boost business

As for Nichols’s own clients, “For the last 12 to 18 months, we’ve told clients a larger merged team gives us more opportunity to serve them better. And once we started the office moving process, we sent pictures of the building to them so they could see what was going on. The response has been favourable.”

Compass Group’s transition schedule

Year 1: First tranche of clients transitions to one of Michael Nichols’s junior advisors (complete)

Year 2: Second tranche of clients transitions to one of Nichols’s junior advisors; administrative transition occurs (complete)

Year 3: First half of clients suited for discretionary management will transition to Nichols (starting this month)

Year 4: Second half of clients suited for discretionary management will transition to Nichols (pending)

Payment terms

When Murray Morton retires, he and his son Matthew will use an earn-out formula. “I’ve used 1.5x recurring income,” says Murray; that way, large one-off payments are excluded. Under this formula, the seller gets half of the annual cash flow each year for three years (0.5*3 years = 1.5x).

They’d used this arrangement when acquiring external books, and it went well.

“You don’t have to come up with a large sum of capital without knowing the retention of the assets,” says Matthew. “And it allows the advisor taking over to still earn income, while sharing with the departing advisor.”

Nichols and Hasson are also basing payment on clients who stay. “We built in a retention rate based on assets after 12 months; it was a multiple approach,” says Nichols. “We’ve had essentially 100% retention.”

Sharon Gray, CA, CBV and partner with Trek Financial and Valuation Advisors in Calgary, says partners can specify a client attrition rate that wouldn’t change the purchase price.

“If an advisor’s been able to maintain 95% of clients over the last four years, and all of a sudden it drops to 75%,” she says, “there could be an earn-out adjustment on the purchase price.”

Read: Help an ailing business owner

As for insurance, Nichols and Hasson have key-person insurance; the Mortons have buy-sell insurance, which will pay out if either Murray or Matthew dies unexpectedly. That way, the surviving partner will have cash to buy out the deceased’s shares. If the book was worth more than the insurance payout, the Mortons say they’d likely pay the remaining balance on an as-earned basis to the estate.

Shotgun clause

This clause stipulates a lower price and shorter terms, and any shareholder can trigger it if he or she decides the partnership is
beyond saving.

“It’s a safety valve when you’re not able to work with someone,” says Hartkorn. “You would typically see a two-to-three year payout, as opposed to a five-year deal.” But only use these in acrimonious situations, he cautions. “It’s there to be a hammer.”

To that end, “you want someone out when you’re losing accounts,” he says. Other possible shotgun triggers: “When you see investment strategies that don’t make sense. When the advisor’s not reacting to the markets. When clients don’t get calls back.”

He adds the partners would want to see the same mistakes consistently, and address them with the offending partner, before invoking the shotgun clause.

Hartkorn suggests stipulating that a buyout could also be triggered by lack of action. For instance, if the older partner is healthy, but doesn’t show up for work for six months, he could be deemed to have constructively retired, and the other partners would have the right to buy him out. “It’s better than letting someone’s book fester away while he’s collecting an annuity,” Hartkorn says.

But once succession begins, a stopgap isn’t needed. “We have no back-out clause,” says Nichols. “We agreed this was good for clients and for the practice. We both committed up front, and it was totally binding.”

The valuation

A third-party business valuator can provide an objective number to start with.

“Chartered Business Valuators typically estimate fair market value, which is different than price,” says Gray. “Price is transaction contingent and buyer-specific.”

She says buyers would then inflate or deflate line items based on their plans for the book. “They’d say, ‘We can increase its value, capitalize on clients, remove these costs.’ ”

Gray says 1x to 3x revenues has been the historical price range, contingent on profitability. Acquirers who can absorb new clients while incurring minimal additional administrative costs may be willing to pay toward the higher end.

Read: Tax consequences of selling a business

As for the lower end, “If you’re dealing with a client list that holds a lot of speculative investments, or if revenue is primarily trading commissions, there’s more risk,” she says.

And specific to Alberta, “Since we’re commodity-based, a lot of traders still work on a trading fee and tend to make more in hot markets. So you’d look at the commodity cycle.”

Hartkorn uses EBITDA. “If the deal pays out over five years or more, 5x to 7x EBITDA would be the range. If you’re simply saying, ‘I want my money now,’ you could be looking at a two-year payout and a 40% discount because there’s no assurance of retention.” Both experts caution these deals vary. In fact, says Hartkorn, multiples can vary even among partners.

“Someone may want to be gone in three years, others in five. The people who are staying longer will get higher prices. If one partner offers no transition assistance, there will be different terms for that commitment.” Nichols and Hasson’s brokerage firm, Raymond James, determined the
multiple used.

Each retained independent lawyers, but used a joint accounting practice for tax work.

Minimizing taxes when selling your stake

When an incoming partner receives sweat equity, she still has to pay capital gains tax. Yet there are ways to minimize that tax.

If the incoming partner’s an unrelated party (e.g., not family), Toronto accountant Doug Hartkorn says she can earn a deferred stock option benefit (DSOB).

For instance, if the incoming partner’s share is worth $250,000, the firm can sell her that share for $1. She then receives a DSOB of $249,999 and doesn’t pay tax on the benefit until she sells the shares.

If she holds the shares for more than two years, she’ll only owe half the tax on the benefit. New shareholders could pay fair value after the initial $1 share price.

If the incoming partner’s a related party (e.g., a son or daughter), a DSOB won’t work. “The tax deferral doesn’t apply to non-arm’s-length employees,” says Hartkorn. “Transferring equity for inadequate consideration means you could have a deemed disposition gain.”

The owner could gift her shares if they qualify for the capital gains exemption. “But I don’t see a lot of gifting, even between family members,” says Hartkorn. “People try to save their capital gains exemptions.” Instead, the owner can do a partial share freeze.

Let’s say there’s one owner: Mom. She would get the business appraised, and then take back preferred shares equal to that value (e.g., $1 million). This freezes her equity at $1 million.

Then, Daughter and Mom each buy new common shares out of Treasury for a nominal amount ($1 each). If they want to do a 60/40 split, and there are 100 shares, Mom would pay $60 for 60 shares and Daughter would pay $40 for 40 shares. As the business grows, Daughter gets 40% of the upside, and Mom gets the original $1 million plus 60% of growth.

When it’s time for Mom to retire, says Hartkorn, Daughter could purchase the 60 common shares and the $1 million worth of preferred shares, or the company could buy back the shares.

Another reason to freeze share value is to avoid diluting existing shareholders when bringing in new partners.

If Mom finds a new partner she wants to bring on at 25%, Daughter may say she wants to stay at 40%. So, Mom can freeze the share value again.

Daughter and Mom would trade their common shares for Class B preferred shares; Mom would then own Class A (from the first partial freeze) and Class B preferred shares. Then, they’d purchase new common shares from Treasury: the new partner would get 25 shares for $25; Mom would buy 35 shares for $35; and Daughter would buy 40 shares for $40. Daughter stays at 40%, and Mom has another way to monetize her shares and gradually exit the business.

Melissa Shin, deputy editor of Advisor Group.