Seed Succession Financing
Posted in Practice Management
Tuesday, March 1. 2016
Live Oak Bank is now in the business of financing the first stage of successors buying into their advisory firms.
Jason Carroll, managing director of investment advisory lending at Live Oak Bank (headquartered in Wilmington, NC; www.liveoakbank.com), has made it his mission to facilitate successful successions at independent advisory firms: that is, the transfer of ownership from the founders to the next generation of advisors. In the past month, his firm has started taking one of the biggest obstacles off the table.
“Just 30% of advisory firms today have a succession plan in place,” Carroll says. “We’re going around the country with presentations on how to encourage juniors to buy in. At the same time,” he adds, “we’re rolling out our new Live Oak Partial Equity Buy-In Program, which is designed to finance the first stages of the purchase.”
Live Oak Bank is an unusual entity, to say the least. Where most banks look for tangible collateral when they lend money, Live Oak Bank lends on cash flow to companies (like advisory firms) which have little to no collateral. The bank specializes in financing succession transactions in specific niches—independent pharmacists and veterinarians, and since 2013, firms in the advisory space.
In the past, the loans were all guaranteed by the U.S. Small Business Administration. Because of the black-and-white language of the SBA rules, these transactions had to be for $5 million or less, with a maximum term of 10 years, and had to be allocated to the final stage of a succession buy-in. The SBA mandates that the selling advisor could not continue to be an owner after the loan, or manage the day-to-day operations or otherwise control the company. (Owners could, however, continue to work at the firm, typically in a client-facing advisory or rainmaker capacity.) There was, until now, no provision for the bank to finance the early stage successor buy-ins.
So far, the company has lent $264 million to advisory firms under the SBA program—with, Carroll says with more than a hint of pride, zero defaults. But from inception, he has wanted the bank to help advisors get started on the path to succession, by financing the earlier rounds of internal buy-ins. That, of course, means lending its own capital without the SBA guarantees.
In fact, this was the most common feedback we received when this newsletter profiled Live Oak Bank in April 2014. Advisors wanted their successors to start buying them out, but
1) they didn’t want to exit ownership right away, and
2) the successors didn’t have the money to buy that first 10-15% of the company.
Until this year, Live Oak Bank didn’t have a solution for that first couple of tranches. What changed? “We rang the bell and went public on the Nasdaq exchange on July 23 of last year,” says Carroll. “It put a lot of money on our balance sheet.” The partial equity buy-in loan program received approval shortly thereafter and is being rolled out as you read this.
How does it work? Live Oak Bank will finance your succession plan in stages. In the first stage, successors might receive financing to buy 10% of the company per year, moving closer to the 50% ownership line but almost certainly not crossing it. “The first generation probably isn’t going to want to give up 51% control until there’s a final succession deal in place,” Carroll explains. “So let’s say the loans are for 10% in each of the first four years.”
Each loan is for a 5-year term, but they will amortize over 7 years, which makes the payments more affordable for the successors.
Then the owner and second generation reaches an agreement for the remaining 60% of the firm to be purchased under the provisions of the SBA-guaranteed loan program. This loan will typically pay off any remaining balances on the earlier loans.
The rates will be the same for the earlier (nonguaranteed) and the final (SBA) loans, and will be based on the size of the amount borrowed. “We don’t make commissions here, so it works exactly the reverse of what you might think,” Carroll explains. “Everything is based on prime, which is currently 3.5%. The lowest rate will be prime plus 2%, up to a high of prime plus 2.75%, and the smaller loans will carry a higher rate.”
Why? “It costs us just as much to underwrite a $100,000 loan as it does one for $5 million,” Carroll explains. “To offset our underwriting costs, we have to bake in a little higher rate for the smaller loans.”
How does that underwriting work? As mentioned earlier, Live Oak Bank lends on cash flow rather than collateral, so underwriting is really an analysis of two things: the creditworthiness of the second-generation borrowers, and the financial health of the firm they’re buying.
Start with the borrowers. “They have to show they’re a responsible financial advisor in two aspects,” Carroll explains: “One, that their personal credit and their personal financial statement is okay. Two: that they’re in good standing with the SEC—and FINRA, if that’s applicable.”
He adds that Live Oak Bank’s underwriters recognize the financial challenges facing a professional who might be 35-45 years old. “If they’re anything like me,” Carroll says, “they have a mortgage, a HELOC, a couple of car payments, and maybe they’ve finally climbed out from under their student debt. They don’t have a million bucks to buy into the firm, which is why they’re coming to us. We don’t expect them to have that.”
Underwriting the firm requires a sophistication in the advisory business that your bank down the street will not possess. “Our main question is: Can the firm afford itself?” says Carroll. “If the successors were to say, hey, I want to buy out the whole thing; the seller is done—from an internal succession, without that seller’s salary, can they afford it based on the cash flow of the firm itself?”
Carroll says that the sweet spot for his firm is advisory firms with between $100 million and $1 billion in AUM, but they are better described by the internal facts on the ground: founding advisors who have identified their successors and are ready for them to start buying ownership, but the firm has grown so quickly that the next generation is having trouble affording the first couple of purchases.
If they can just get that first 10% of the firm in the hands of the next generation, everything else becomes a lot easier; the profit distributions help pay interest on the loan.
“The founder is saying, ‘I like this arrangement because I don’t have to leave for five years,’” says Carroll. “They can start the process with this next generation advisor who has been saying, please let me buy in, but when they run the numbers, he doesn’t have enough money.”
Carroll says that Live Oak Bank’s biggest competition, when it comes to financing successions, is the sellers themselves, who may negotiate a 10% return on their loans to the next generation. This forces the bank to stay competitive. “It’s why we have to stay at that 5.5% level,” he says. “And because it is a business loan, you’re writing off your business interest on your taxes. So, net, the successors are coming in at 3.5%.”
Of course, the bank also offers working capital loans, to address the not-uncommon situation where the successor generation wants to invest in the firm they’re buying into, and the founder responds that this future investment would be coming out of his distribution, to improve the value of a firm he won’t be owning.
Carrol hopes that the availability of outside financing will help move the needle on all those succession plans that aren’t happening currently. And, interestingly, he’s finding that some owners have changed their minds about retiring only when somebody finds their lifeless body slumped over the desk in their office. “Some of the founders we talk to, when the find out what we’re offering, they’ll say, hey, where’s my ejection button?” he says. “I’ve already identified my successors, and I’m ready to get started on retirement. Can I accelerate it?”