Path to Succession:
Navigating Partner Buy-In

Transcript

Matt Staninger

Hello and welcome to OnPoint, a podcast by Oak Street Funding, where we sit down with industry leaders to bring insights to the topics you want to hear about. I'm your host today, Matt Staninger, market research analyst at Oak Street Funding. And let's get on point. Today, I am joined by Alicia Chandler. Alicia is the president of Oak Street Funding. We’re going to be building off our mid-year update webinar to talk about succession and partner buy- in. We'll be covering options, what to include in the process, tips, and more. Alicia, thank you for joining me today.
                

Alicia Chandler

Thanks for having me today.
                

Matt Staninger

To start, why should someone create a succession plan?
                

Alicia Chandler

Matt, that's a great question and it's something that we are constantly beating the drum on. Depending on the industry, let's talk about the advisor space, you have a fiduciary duty to your client. You need to make sure that you have that plan in case the inevitable happens, which is you retire, or you have a medical event. And we can talk a little bit about that in more detail. But just generally speaking, you also owe it to your family. You need a succession plan because whether it's CPA, RIA, insurance or franchise, you have put your entire life into this business and spend a lot of your time and effort there, and sometimes to the detriment of spending time with your family. And you need to be able to recognize a liquidity event and be able to spend some time enjoying the fruits of your labor.
                

Matt Staninger

Very good points there. So, your employees, the people you love, yourself even, there are a lot of facets for why to have that succession plan in place.
                

Alicia Chandler

And actually that's another point. You mentioned employees. You need to think about... A lot of people want to create that legacy and they want to leave something behind to maybe either their son or daughter that's a successor or maybe their most valued employees that have worked side by side. And so again, just thinking through that creation of that legacy.
                

Matt Staninger

Absolutely. What are the common options for succession?
                

Alicia Chandler

I'm not sure there is a common theme or a common option. The creativity in the deals that we see, it's ever- changing. You think you've seen them all and then something else comes through. So typically, what we're seeing is you'll have someone that's... They'll come in and maybe they have a three-to-five-year plan. And so, the thought is, I have chosen one or more folks to succeed me in the business from a client relationship standpoint to an operational standpoint, and I would like them to buy me out over a three-to-five-year period. And some of it is because those folks need that time to integrate, to figure out how to operate the business, how to transition those clients because those are obviously very sensitive relationships and have been built over a long period of time. And also, there are some... And I'm not a tax expert, but I know there are some tax implications as well for having those payments set out over a longer period of time. So again, it's going to vary very much depending on the type of deal, the industry. But we are always happy to have those kind of conversations on the front end with the why and help people figure out how to get to what they want to do.
                

Matt Staninger

We just talked a little bit about the why. When is the best time for somebody to build a succession plan?
                

Alicia Chandler

As soon as possible. If you are planning on retiring tomorrow, you're too late. We suggest at least three to five years prior to the time that you're thinking about, I'll say retiring. And perhaps you don't want to retire. Perhaps you want to sell and stay as part of your succession plan. You want to slowly phase out. And so, the longer you give yourself to plan for those options, the better chance you have of making it successful. And again, when you have these intangible assets and you have client relationships that are going to be impacted, it's really about finding the right fit among your successor or successors at the end of the day. And so, you just can't rush that process. If you try to rush that process, there's going to be some missteps that we've seen, and you may put yourself in a bind where you're left with just selling the business outright and you don't have any options on succession.
                

Matt Staninger

Absolutely. So, three to five years before retirement, that's an ideal measure as long as things are going to plan. But of course, we know things might not go as predicted. There may be a sudden medical event, as you alluded to. So as soon as possible sounds like a great plan there. Do you have any tips for us on what makes a successful succession or a successful succession plan?
                

Alicia Chandler

We talk about this a lot and personally have experienced this with various borrowers and vendor partners that we have. I think a successful succession plan will involve a variety of partners. So obviously Oak Street as your lender, but also consultants. You need someone that is trusted, that understands the industry, whether it's CPA, insurance, RIA, or a franchise. You need someone that really lives and breathes that space and understands your plan and can talk to you about the legacy that you want to leave. You need attorneys that can guide you through the process and make sure that you are protected and that the buyers themselves are protected. Everyone should have their own counsel. And you also need a CPA, someone that can guide you on the tax implications of that succession plan. So, it's not just you thinking it through and documenting it, it's about working with folks that have done it and that live and breathe it so that you are taking care of what you need as well as leaving the business in the right hands.
                

Matt Staninger

It takes a small army for that succession team, and as you alluded to, somebody who's experienced. You of course, typically will only do one succession over the course of your life. So having that experience on your side is important.
                

Alicia Chandler

Right. And paying the cost. I know some people think, "Well, I don't want to pay an attorney to do that. We can do it ourselves. I don't want to pay a consultant to give me a valuation or to help me plan this." It's worth every penny. And using those advisors as special advisors will ultimately help you, I think, get a better price and also ensure that you're not tripping up with some of the things that we've seen with folks that don't have that team and they end up having some pitfalls that they just didn't foresee.
                

Matt Staninger

Right. There are so many nuances. So, something that successors can commonly run into is being unable to afford the business that they've set up to purchase as multiples have changed, purchase prices have changed significantly in the recent past and really the present. What can a successor do if they're running into this problem?
                

Alicia Chandler

We hear that a lot in the various events that we go to. And what we always tell them is, look, that's one of the reasons why Oak Street's here. We provide financing for succession plans or partner buy- ins. So, if you have a company, a firm, an agency that you want to just sell off pieces in advance of perhaps even your succession plan, Oak Street is here to finance those partners that want to buy in. So, for example, I want to buy into your company, Matt. I would go to Oak Street and I could say, "Look, I want to buy 5% of Matt's company. Here's the purchase price, here's the multiple. And I've been out of school for maybe 10 years and I have a mortgage, I have student debt, I have three kids. I don't have a bag of money sitting around that I can just give to Matt to buy into the firm or the agency." Oak Street can say, "Look, I can help you finance that." And we can finance up to a hundred percent of that buy-in in tranches over a couple year period without having to have you tap into your personal liquidity or take out a second mortgage on your house. And so that is one of the things that we've seen a really explosive growth in over the last two years is helping people with those partner buy- ins so they can afford it.
                

Matt Staninger

Structures have really changed and we have seen a lot more of those multi-tranches, taking a minority stake little by little. And you mentioned it being a partner buy-in or a succession to one successor. How does that work if there's multiple successors? Is that option available as well?
                

Alicia Chandler

It sure is. So, we could, and we have done multiple partner buy-ins for one particular borrower. So actually, I can talk about... We have a specific borrower that I'm thinking of. They came to Oak Street to borrow money to acquire, and so they continue to acquire and grow organically, but they also have done, I'm going to say at least a dozen partner buy-ins over the last three years with Oak Street. And so, they have these junior partners that have bought in several tranches over the past three years. And so, we're kind of running a simultaneous process with this borrower to set them up for the future. They're growing and they're allowing these younger folks to buy into the company. They're also allowing those partners to participate in the growth as it continues on. So, they'll do a new valuation each year and they'll set up that new purchase price for the next additional tranche. And Oak Street has been able to provide the loan for each of those partners that buy in.
                

Matt Staninger

Wonderful. So, another option for flexibility and a change in structure that we've seen in the recent past. So talking about succession planning, we mentioned a little bit about some of those outside team members that you need in the deal process. Who should really be included in the succession planning process internally?
                

Alicia Chandler

And I know this is going to sound funny and I'm not trying to be flippant, but the successor or the successors, the folks that you have identified that you think should ultimately succeed you in the business, you really need to have those conversations. We've seen multiple situations where perhaps there's an assumption that, "Hey, Colin, he's going to succeed me in the business. Or Jack. But I haven't sat down and said, 'Look, do you guys actually want to be a partner in this firm? Do you want to be an owner? Do you want to be an operator? Do you want to do the operations side? Do you want to be the partner that deals with the clients?" And if you don't have those conversations and you're waiting until the last minute, you may find out that those folks actually don't want to take on ownership. Maybe they just want to stay as an employee in that role. Then you are struggling and scrambling to find maybe an outside party to come in and to take on that role. And so it's really important to have those open and honest conversations well in advance so you can actually put that plan into place and carry it out.
                

Matt Staninger

You can't make any assumptions throughout the process. And there's no question that is going to be too low level to be able to ask to get through that process. What are the keys to making a succession plan good?
                

Alicia Chandler

So, I think a good succession plan, as we've previously chatted, involves the experts. Just retaining the help of those folks. I cannot say that enough. And specifically, one of the things that we've experienced is attorneys that are not experienced in your specific line of business. So again, whether it's franchise, whether it's the wealth space, advisors, whether it's CPAs, whether it's insurance, if you don't have an attorney or a law firm that understands the nuances of those businesses, they're ultimately not going to be very helpful at helping you with that succession plan or a transition. There are things that they're going to miss. Maybe they're a real estate attorney by trade. Maybe they're family law. But they won't understand those specifics. And they really will not understand, I think, the lending parameters and some of the specific perhaps covenants that lenders like Oak Street have in place to go along with that succession plan or that partner buy-in. And then it causes a lot of friction during the process.
                

Matt Staninger

Dot your i's, cross your t's as you're doing the preparing for it.
                

Alicia Chandler

Right. Right.
                

Matt Staninger

Is there such thing as a bad succession plan or what could make a succession plan less than good?
                

Alicia Chandler

The worst thing you can do is make assumptions, as we have talked about. Sometimes forcing it on someone that doesn't ultimately want to be in that seat or is not a good fit for that seat. And sometimes, you do see that when you have family relationships. Sometimes, there may be a son or daughter involved in the business and the parent really wants them to be the successor, and perhaps they're not. Maybe they either don't want to be or they're just ultimately not qualified. And so I think, sometimes, that's where we see the rub come in, is when you have those family dynamics. And that's where I think a third-party consultant really is invaluable because they can play that, I'll say, mediator and say, "Look, this is what you want, but this is not ultimately the best plan for your legacy or for the firm." Or maybe this is the role this person should play versus that. And so I think that's one of the common missteps we see.
                

Matt Staninger

Great details there. Of course, again, that affects so many people beyond yourself with your employees, your current clients that are going to continue to be your future clients or new future clients. So there are a lot of different aspects of really who that affects. Let's switch gears a little bit now. We talked mainly about succession itself there. Let's talk a little bit more about the partner buy- in situation. So that's an option on the path to ownership of an agency or a firm. What's a partner buy- in financing for and really how does that work?
                

Alicia Chandler

With Oak Street, when we're doing partner buy-in loans, those are going to be smaller minority pieces of the overall business. So think anywhere from, we've seen as low as like 0.5 to 10, 15% when we have partner buy-ins. And again, that could be over a couple year period, which is what we commonly see, where someone will say, "Year one, I'm going to buy in 1%." And the purchase price is $250,000. "Year two, I want to buy in another two to 3%." And that's maybe another $250,000. And so we can set that out as a multiple stage loan for the particular partner or partners that want to buy in. And so in that case, the partner themselves would be the borrower. The firm or the agency, the business that they're buying into would be the guarantor. Because ultimately, the cash flow to repay that loan is going to come from that company or that firm. They're going to be giving distributions for that partner. They're going to be paying a salary to that partner. And so ultimately, if we're looking at where the repayment source is, it's going to come to that partner from that ultimate repayment source, the firm. And so when we're also looking at that, we're going to look at the debt-to-income ratio of that partner buying in. We don't want to see that exceed 50%. And we're going to take a look at their personal financial statement. If they're living beyond their means, that's definitely something that's going to be a problem. So we're going to dig into their personal credit and make sure that they don't have any potential issues there or they're not over leveraged. The other big thing that we're going to do is make sure that they don't have any disclosures. If they're an advisor, make sure they don't have any disclosures on their ADV. And CPAs, they have licenses. So we're going to do those license checks for the CPA space or the insurance space. And so it's really going to be a commercial loan to that individual that's going to be backstopped by the company that they're buying into.
                

Matt Staninger

So you're looking at some of the past performance, you're looking at some personal performance as well. You're also looking at some of the pro-forma or the future anticipated performance. What kind of financial adjustments through that partner buy- in process might one expect to have to go? Are they paying new salaries to new partners or are there some expenses that might be changing, whether it's increasing or reducing? What kind of adjustments do you typically see there?
                

Alicia Chandler

So when we're talking about the partner buy-in loans in particular, we're really going to underwrite and pay attention to the distributions that they're going to receive. So up to the point that they're an owner, they're going to be receiving just a salary of X dollars per year, and that's what they're living off of. And we're going to look at their personal expenses. But then going forward, we're going to take into account the distributions and what that looks like coming from the firm on typically a quarterly basis is what we see. And we also have to take into account the taxes that they're going to have to pay as a new owner. And so those are all things that are going to have to be taken into account and adjusted going forward. Looking at that in addition to their personal expenses.
                

Matt Staninger

Can you describe the process for what a partner buy-in typically looks like?
                

Alicia Chandler

Yeah. So usually, how we see it happening is we'll have a firm that'll call us up and say, "Look, I have a couple folks or a folk, a specific person, that I want to start selling some tranches off to." And they'll introduce that person to one of our specialty lenders in one of our verticals. And they'll start talking. Usually, it's going to be a conversation with both the firm owner and maybe the CFO or someone that has the financial wherewithal and the control, and that individual that's going to be buying in. Because again, as we had talked about, they're going to be talking about not only that individual's personal financial statement and what they have, their personal obligations, but we're going to be talking about what those distributions are going to look like and what the company's current leverage looks like. So we can take that whole picture into account. But ultimately, the information that we request that we're going to have the individual fill out, just like any other borrower would for a company loan. So the loan officer will talk to that individual. They'll have them submit all the appropriate through their MyStreet portal, they'll have them fill out an updated personal financial statement. We'll look at their taxes and make sure they don't have any outstanding tax obligations that are due and that they've been properly and timely paying their taxes. We're going to run a background check and make sure there's no concerns there. Then we're going to ask for copies of the company operating agreement. We're going to want to understand what that buy-in looks like, if they're going to be a part of an operating agreement or part of a corporation. There could be some differences there with the taxes and things like that. And so we're just going to want to dig into those details as well and look at how that's going to play. The other issue that we want to look at is what happens if something happens between that partner that's buying in and the firm. If they decide it's not going to work out after a couple of years, or if they get sick or something happens, that firm, we need to make sure that that firm has the ability to buy back those shares and pay off the debt completely. And so that is certainly one of the things that we're going to want to understand is what is the firm's obligation to buy that back if there is a problem.
                

Matt Staninger

And really, that's for everyone's protection.
                

Alicia Chandler

It is. It ultimately covers everybody. Because a firm is not going to want any lender to own a minority piece of their business going forward. And so we will look to have that firm buy that back.
                

Matt Staninger

Absolutely. So really comparing to most business loans, it's not a grueling process there. I imagine that certain times, as you alluded to, challenges can arise though. You mentioned maybe someone's interest in the business fades away or maybe they're not able to pay off their portion of what they owe for taking ownership. What are some of those common challenges in the partner buy-in process?
                

Alicia Chandler

So I think if it's planned well and you do have that well thought out succession plan or partner buy-in tranche program, there's not typically big surprises. But of course, there could always be something that happens. Like we've seen situations where someone's had some medical issues and they've had to step back from the partnership. We've seen situations where, maybe not just the partner themselves, but a family member has something that's going on and they need to take a step back. And so it doesn't necessarily have to be something where they just can't afford it. It could truly be some life-changing event. And of course, we don't want anyone to be stuck holding the bag. And so we are more than happy to and have worked through situations where a partner has had to step back for a variety of reasons and work with the firm to buy that back and then pay off the debt so that everybody can go back to status quo.
                

Matt Staninger

So should that happen... Even though that's rare. It's not like that's a very common occurrence, of course. Should that happen, there are plans in place to make things work out for every party.
                

Alicia Chandler

Right.
                

Matt Staninger

Thatt's great. To wrap up now, what are some eligibility criteria for a new partner?
                

Alicia Chandler

So one of the most common questions I get surprisingly is, do they have to be a family member? I got that at a conference a couple weeks ago, and I was surprised. I guess, again, I made an assumption that everyone knew what the criteria was. Look, if you are buying into a firm, you don't have to be a family member. You can be an employee that's been with them for a while. Say you're an advisor in a firm and you've been there for six, seven years and you have a nice client book and you're maybe taking on some roles within the management team or the financial aspects of the company and you want to buy in and you've been offered a chance to buy in, that's fine. It does not have to be someone that's related. And the other thing is, look, we need to understand ultimately the plan. Like, how do you fit into that firm or that agency's goals? What is your ultimate role going to be? And so really, it's taking a look at the ownership, the management team, and how all those pieces fit together. Because, just because you are the single partner buying in, or if you are the single partner buying in, we are going to look at the whole picture. And so it's not just this isolated microscopic view. We're going to want to understand the long- term goal of yourself and that firm and your role in it.
                

Matt Staninger

Very good information and very good insights shared today, Alicia. Thank you for being here.
                

Alicia Chandler

Thank you for having me.
                

Matt Staninger

I learned a lot. I'm sure our listeners did as well. Thank you everyone for listening to OnPoint, a podcast by Oak Street Funding. I'm Matt Staninger, and tune in next time wherever you listen to podcasts as we get on point. Don't forget to follow us on Instagram @onpoint.with.osf. Subscribe and leave a review.