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Key elements of a succession plan

As registered investment advisory firms continue to mature and evolve, one of the most important things RIA founders must consider is the need to establish a cohesive succession plan.

Charles Schwab's 2013 RIA Benchmarking Study showed that many of the largest RIAs have documented a plan and have conducted a formal valuation of their firm. However, the study also revealed there are still many advisory firms that have not yet completed this very important task that helps to ensure the continuity of their firm.

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The benefits are vital to all stakeholders, whether they be the founder, the employees or the clients who have placed their trust with the firm. When they're ready to transition, RIA owners are uniquely positioned to capitalize on the value of the firms they've built.

Advisors I talk to are focused on ensuring that the businesses they've built will endure—they want to create a lasting legacy. They also realize the RIA business model uniquely positions them to monetize the value of their firm when they are ready to transition.

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It's for that reason that I encourage advisors to think through five key considerations necessary to create a successful plan. These elements will benefit RIA firm owners, whether their goal is internal succession, external succession or a combination of both.

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1. Create a clear vision. An initial challenge advisors face when developing a plan is actually understanding where to start. There must be a willingness to look closely at personal and professional goals, and an ability to look impartially at the value of their firm.

Rather than asking what a successful succession plan looks like, a better question for founding principals to ask themselves is: What does a successful transition look like—for me? Getting to that answer requires personal reflection and careful consideration. Setting personal, professional and firm-related goals will help create a clear vision for the advisor and the firm, as well as an improved peace of mind for employees and clients.

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2. Determine valuation. There are many approaches to determining a firm's value. But cash flow is the common denominator used to establish fair value. Unlike assets under management or revenue, cash flow is the best indicator of RIA profitability and overall operating efficiency. Prospective buyers want to see dependable and predictable flows, both current and future.

Quality of cash flow matters, too. Buyers typically pay a multiple (or measure of equity or firm value relative to revenue or earnings that it generates) based on the quality of cash flow and its growth rate. RIAs will fetch top dollar for such things as a stable client base; revenues that are overwhelmingly from a recurring, fee-based business; a track record of growth and strong margins; and a core group of professionals who are committed and incentivized to operate the firm as the founders reduce their responsibilities and ownership stake.

Many firm owners want to retain a degree of control in a transition, which can also impact valuations. It's worth considering bringing in a valuation specialist or transaction intermediary to review the mix of goals, revenue streams, expense structure, legal structure, finances, clients and other available information.

A specialist can help ensure that a fair and realistic firm valuation is achieved. While there are many approaches to valuation, attributes that are always considered include risk, scalability, growth and cash-flow quality.

3. Maximize value. Buyers place a high value on business continuity—assurances that clients and key employees will remain in place once the firm begins its transition.

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Clients who can easily follow disengaged staff out the door are an obvious risk to a successful transition. This risk can be mitigated by hiring RIA professionals who are a good long-term fit and by creating a compensation strategy with incentives that help employees share in the firm's success. Creating a structure that allows key employees to participate in ownership is a powerful value driver for the RIA business model.

Firm value is also enhanced by institutionalizing client relationships—which means ensuring that clients are connected to the firm rather than to an individual advisor. Additionally, firms can reduce risk and maximize value by documenting all processes, including compliance procedures and contingency plans. Firms that demonstrate systematized business practices will yield higher valuations than those without this level of transparency.

4. Maximize scale. Efficiency is another key value driver. It's worth exploring ways to facilitate growth without adding overhead. Not only do strong margins benefit owners in the short term but they can also serve as a platform for future firm growth—always appealing to prospective buyers. But there's an important distinction to be made here: While efficient operation is desirable, being lean to the detriment of staff workload and compromised client service is not.

Buyers aren't necessarily seeking a bargain, but they do want lower transaction costs per unit of revenue. Efficiencies can be created, for example, by automating workflows to streamline operations and by creating a segmented service offering that fits the revenue profile of each client segment. Creating proportionally lower costs will equate to higher margins.

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"The succession planning process can take as many as five to 10 years to establish and implement—and there's just one chance to get it right."

5. Demonstrate consistent growth. Buyers will pay a premium for firms that are rigorous about new business development and that have an effective client-growth strategy. The most sought-after firms have multitiered growth strategies that utilize client referrals, "centers of influence" and marketing and public relations programs to capture revenue opportunities from a number of different channels. (So-called centers of influence are business partners and other professionals, such as accountants and attorneys, who can influence your ideal client to consider hiring you.) These firms have well-documented business development compensation and incentive plans in place for the entire staff, to ensure that everyone has a vested interest in the firm's growth.

Read MoreAttention, investors: Succession plans matter

Today's RIA owners have spent their careers building firms on a foundation of successful relationships and trust. Establishing a succession plan that secures their firm's legacy beyond their individual transition is critical not just to their firm and their clients but also to the long-term success of the next generation of leadership. The succession-planning process can take as many as five to 10 years to establish and implement—and there's just one chance to get it right.

Understanding the many factors that influence a succession plan is the first step. Advisors who take the long view, addressing their risks, scalability, growth and cash flow, will see their efforts pay dividends when the time to transition arrives.

—By Nick Georgis, vice president of business consulting and field experience for Schwab Advisor Services

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