Acquisition Deal Components and Structures:

What are the components of an acquisition?

The Components of an Acquisition

PRICE

Purchase Price: Anything less than valuation price is a likely non-starter and if you’re in a competitive scenario, especially in a marketplace scenario expect to be competing against premium price offers. Recurring revenue multiples typically 2.5 to 3.5x.

TERMS

Payment Terms: Varies but commonly 100% bank financing (no down payment and no seller financing) either with/without a clawback or some percentage bank financed and the balance seller financed. Bank loans are typically ten years.

CONTINGENCIES

Contingencies: Added provisions accounting for what may happen usually referring to an Attrition Offset Clawback, and negative covenants like Non-compete and Non-solicit. Non-solicit is needed for all asset acquisition types.

**CONSIDERATIONS Considerations: Situations such as death and disability scenarios, family-based purchases, internal buyouts, attrition risk, can significantly impact the attractiveness of an acquisition. These elements represent internal or external considerations that may not be reflected in the financials but can heavily influence a buyer's decision-making process.

CONSULTING Consulting: The seller's responsibilities post-close primarily addressing the client transition period. This may be included in the purchase price or be paid a consulting fee during the consulting period. If buyer has SBA loan then only 1099 consulting agreement for 12 months.

TAX ALLOCATION Tax Allocation: For asset purchases typically 96% is allocated towards the client list which is considered good will and taxed as capital gains to the seller. Thee other 4% is split typically between covenants (like the non-compete/non solicit) and for the consulting/transition period. The buyer writes off good will and covenants on a 15 year amortization and consulting payments is a same year deduction.

What are the common acqusition payment strucutres?

100% Bank Financing: Allows the buyer to fund the acquisition without the need for a down payment or seller note. In these cases, the bank assumes all the immediate financial risk, and typical structures comprise 50% to 80% of the purchase price paid to the seller at closing, with the remaining 20% to 50% being placed into escrow, subject to offset/clawback provisions.

100% Down Payment: The 100% down payment model is less common, typically seen in partner buyouts or internal succession scenarios within the same broker-dealer. Here, sellers receive the entire purchase price at the time of closing, no seller financing or attrition offsets.

Down Payment + Earn-out: The down payment + earn-out approach involves a front-loaded payment of 25% to 75% of the purchase price, with the balance settled through an earn-out promissory note. Earn-outs can be legally complex and involve tax implications. It's crucial to verify broker-dealer policies, particularly if the seller is retiring during the earn-out period, and to note that earn-out down payments are generally not eligible for SBA loans.

100% usually fixed seller note with the expectation the buyer will refinance the seller note into a future bank note (usually two years) as soon as the note allows and escalates in increments (usually in two years periods) for the buyer to try again if unable to procure financing during the first period. The SBA has a two year standby period for refinancing seller promissory notes.

Down Payment + Fixed Seller Note: In the down payment + seller note structure, the seller note can be either fixed or adjustable. For a fixed note, the seller receives a set period of fixed payments without any offset/clawback. An adjustable note operates similarly, with the added element of an attrition-based clawback at a predetermined point or in an earn-out note (see earn-outs).

100% either fixed or adjustable seller note. For a fixed note, the seller receives a set period of fixed payments without any offset/clawback. An adjustable note operates similarly, with the added element of an attrition-based clawback at a predetermined point or in an earn-out note (see earn-outs)

Down Payment + Escrow: In scenarios where an escrow agreement is utilized, a portion of the purchase price is held in escrow, and after a predetermined period (usually one year), the seller receives all or part of these escrowed funds, depending on the attrition of the client base. The balance, often linked to an attrition offset formula agreed upon by both parties, can be "clawed back" by the buyer and is typically applied to reduce the buyer's loan balance.

What are typical attrition rates for advisor acquistions?

Typical Acquisition Attrition Rates

Attrition rates depend on a host of factors of which seller cooperation, participation and time investment are paramount. Our rule of thumb for attrition expectations for bank financed acquisitions when the seller fulfills their transition role is about:

0% to 3% - Internal Successor - Generational and partnership acquisition: 0% to 3% client attrition.

0% to 5% - Internal Platform - Advisor not in the same firm but same platform acquisition: 0% to 5%.

0% to 10% - External Platform - Advisor outside of platform where clients are repapered: 0% to 10%.

Generational attrition: Don’t forget to focus on spouse and multi-generational retention strategy with older clients. About 3/4 of widows leave the spouse’s advisor after the spouse dies. About 2/3 of adult children leave their parent’s advisor after receiving their inheritance.

What about acquisition restrictive covenants?

Restrictive Covenants: Non-Compete and Non-Solicitation Agreements Restrictive covenants such as non-compete and non-solicitation agreements are critical components in advisory M&A transactions to protect the investments and continuity of service to the clients post-acquisition. A non-compete clause is traditionally enforced for a two-year period and is geographically bounded, typically within a 25-mile radius of the purchaser's or seller's office. The intent is to prevent the seller from establishing a similar venture that could siphon off clients or referrals meant for the buyer. Moreover, it extends to deter the seller from poaching employees or business relations, maintaining the integrity of the acquired business's operations. This period and scope are commonly perceived as reasonable and defensible in court proceedings, balancing competitiveness with the seller's right to earn a living.

On the other hand, a non-solicitation agreement extends beyond such bounds, with an impactful and lengthy duration of ten years. No geographical limitation applies to this agreement; it strictly prohibits the seller from soliciting or servicing the sold clients, irrespective of who initiated the contact. This addresses regulatory concerns, ensuring the client's freedom to choose their advisor while legally binding the seller to honor the contract.

Do lenders care how the acquisition deal is structured?

Yes. Conventional lenders have fewer restrictions to how acquisition deal terms are structured but will have deal structures they are and aren’t comfortable with. The SBA has strict deal structure requirements for an acquisition loan and then each SBA lender will have their own preferences on top of those SBA requirements that a buyer borrower may need to navigate.

What are contingencies in an acquisition deal?

Typical contingencies in typical advisory acquisitions CONTINGENCY PROVISION: ATTRITION OFFSET

Attrition Offsets are just potential pricing readjustments based upon client attrition at a predetermined time. This provision protects (somewhat) the buyer if client or revenue attrition is higher than expected. The provision allows for the buyer to “claw back” a portion or the purchase price if based on a predetermined attrition formula.

Attrition offset provisions and clawbacks are mechanisms in the buying and selling of financial practices that protect the buyer. Attrition offsets allow for price readjustments based on client attrition after the sale, acting as insurance for the buyer if client retention falls below a predetermined benchmark.

Clawbacks, on the other hand, give the buyer the right to reclaim a portion of the purchase price based on the established attrition formula. These provisions mitigate the financial risks associated with client turnover and ensure the buyer's investment is protected.

Attrition Offsets and Clawbacks In a typical advisor M&A (mergers and acquisitions) deal, a clawback provision is a contractual arrangement between the buyer and the seller. It serves as a safeguard for the buyer against excessive revenue loss due to client attrition post-acquisition. The clawback provision typically includes a predefined benchmark or threshold for client retention.

If the actual client retention falls short of this benchmark, the buyer has the right to recoup part of the purchase amount from the seller. The amount to be clawed back is usually determined by a formula or agreed-upon calculation based on the deviation from the benchmark.

For example, if the benchmark for client retention is 90% and the actual retention rate is 85%, the clawback provision might allow the buyer to recoup a percentage of the purchase price that corresponds to the 5% deviation from the benchmark.

Overall, clawback provisions provide financial protection for the buyer by ensuring that the purchase price is adjusted based on the actual client retention after the acquisition. It encourages the seller to maintain a certain level of client retention and reduces the buyer's risk of revenue loss due to post-acquisition client attrition.

A buyer advisor would particularly want to ensure the presence of an offset provision in the following situations:

1. External acquisitions: When acquiring a financial practice from an external party, especially if new client agreements need to be established, an offset provision becomes crucial. It provides protection to the buyer in case client retention and revenue fall below expected levels after the acquisition.

2. Significant client concentration risk: If the financial practice has a high concentration of clients, such as relying heavily on a few key clients, there is an increased risk of attrition. In such cases, an offset provision becomes vital to safeguard the buyer from potential revenue loss due to client departures.

It is possible to have a clawback structured differently for a group of higher retention risk clients while excluding or having a different structure for other clients being purchased. This type of approach recognizes that not all clients carry the same level of retention risk or contribute equally to the overall revenue or value of the financial practice.

For example, if there are certain clients within the client base that are deemed to have a higher likelihood of attrition due to specific circumstances, the clawback provision can be tailored accordingly. The clawback structure for this group of clients can be more stringent or have a higher percentage or graduated scale compared to the rest of the clients.

Do lenders require retention/attrition or claw-back provisions?

Claw-backs are provisions that protect the borrower (somewhat) if client (and therefore revenue) attrition is higher than expected. Banks prefer to see a provision that allows for the buyer to “claw-back” a portion or the purchase price if a retention benchmark is not met. However, most lenders do not require a claw-back.

How are claw-back provisions structured?

Claw-back provisions can be structured in many different ways. Most lenders aren’t as concerned with the makeup of the structure so long it is reasonable. Buyers and sellers have a lot of flexibility in how they decide to structure it.

The vast majority of loans we see that have a claw-back provision, the claw-back period is for the first year. Claw-backs are just potential pricing readjustments based upon higher than expected client attrition, however with SBA loans the adjustment can’t go up, only down.

When would a lender not care about a claw-back provision?

Some lenders will be more relaxed about this for internal acquisitions and succession acquisitions; in case of a “fire sale” based on the seller’s death or disability; or if an appropriate discount to the purchase price has been made to accommodate for a lack of a claw-back provision.

When would a lender might request a claw-back provision?

The bank may want a claw-back provision on an external acquisition (where clients need to be re-papered). Banks will often request added claw-back provisions that may extend for a longer period of time to protect against transitional attrition of specific clients if there is heavy concentration with a few clients, or a large percentage of the revenue is from one client.

When is an escrow agreement used and how does it work?

Escrow agreements are typically utilized in 100% financed loans for the claw-back provision. The seller will typically receive most of the purchase price at closing wired from the lender. The portion set aside (typically from 20% to 50%) for the claw-back provision is wired into the escrow account. Some lenders will handle the escrow internally and others will require you to find your own escrow firm. In either case, there is an escrow agreement between the buyer and seller.

The agreement spells out when the money will be distributed and the formula that will be used to calculate the distributions. If the retention provisions are met, then all of the proceeds will be delivered to the seller. If the claw-back provision is triggered, then the seller receives the adjusted amount and the balance is usually applied to the buyer’s loan.

Do all lenders allow for an earn-out structure?

As long as the projected earn-out terms cash flows, most conventional lenders are fine with earn-out structures. From a lender’s perspective, earn-outs protects their borrower from a downside turn in market or higher than anticipated attrition. It also provides for an exceptionally low LTV, while still being in first lien position with the earn out promissory note subordinated to the lender. However, the bank will typically require that the earn-out be subordinated to the bank's loan.

Does the SBA prohibit earn-out structures?

Yes, earn-out structures are not allowed in SBA loans. If it looks like or smells like a “revenue share” arrangement, the SBA lender won’t approve the purchase agreement.

Does an earn-out have to be subordinated?

Typically, yes.

Do earn-out have complicated legal and tax considerations?

Earn-out structures need to be carefully considered and constructed. There are serious tax implications if the earn out is conditioned on future services by the seller (viewed as compensation and taxed as regular income) instead of a deferred purchase price payment (taxed as capital gains). Borrowers should use experienced professionals with specific expertise in advisor acquisition agreements and terms, but even more so when earn out structures are being used.

What if the seller is retiring during the earn-out term?

If the seller is going to retire during the earn out term then the lender’s lawyer reviewing the deal will want to make sure this is accounted for in the purchase agreement language. Depending on the advisor’s model and affiliation, different rules apply to a buyer paying part of the revenue the practice earns to an unlicensed individual.

Does my custodian and/or IBD have eaarn-out rules?

Custodians typically allow for this by the seller qualifying as a “solicitor” allowing for ongoing payments when not licensed and simply disclosed to clients during the transition process. While most independent broker dealers (IBDs) are “earn-out friendly” there are IBDs who are not. Some broker dealers have strict compliance rules around ongoing revenue share between affiliated advisors with unlicensed individuals.

Advisor acquisition earn-out structures are typically always embedded into the purchase agreement as a future payment of purchase price. Even so, some IBDs dismiss the purchase agreement language and take the stand that if it looks and smells like a revenue sharing arrangement then it should be treated like one. Advisors should check with their broker dealer and custodian early in the process to determine and account for their earn out requirements when the advisor is retiring during the earn out term.

What if the seller is continuing to work throughout the earn-out term?

While most IBDs allow for it, there are IBDs who will not allow the advisor buyer to pay the selling advisor directly through earn out payments, even if licensed. Some IBDs will require that a team ID rep code be established with the IBD paying 60% of compensation to buyer’s rep code and 40% to the seller’s rep code for example.

What is FINRA Rule 2040 about?

Rule 2040 Applies to Advisors Selling Their Practice and Giving Up Their License.

When a licensed financial advisor decides to sell their practice and retire, they need to navigate the regulatory landscape to ensure they receive their fair share of the sale proceeds. FINRA Rule 2040 provides a framework that allows for such a transition, ensuring compliance with federal securities laws while facilitating ongoing compensation for retired advisors, provided certain conditions are met.

Under Rule 2040, a retiring registered representative can continue to receive commissions from accounts held for continuing customers. This is permissible provided there is a bona fide contract established while the advisor was still registered, detailing the terms of the ongoing payments. The contract must explicitly forbid the retired advisor from soliciting new business, opening new accounts, or servicing existing accounts generating the ongoing commissions. This ensures that the retired advisor's activities remain in compliance with applicable federal securities laws and FINRA rules.

For the arrangement to be valid, the advisor must cease their association with the member and leave the securities industry. Still, the contract can stipulate provisions for continuing payments even in the event of the advisor's death, directing these payments to a designated beneficiary or the advisor’s estate.

https://www.finra.org/rules-guidance/rulebooks/finra-rules/2040