In the third article of Phil Billingham’s series, he takes a look at one of the most commonly used exit strategies: the merging of businesses.

    While looking to merge your business as an exit strategy, there are pitfalls and common mistakes.

    As in all the articles in my series, taxation aspects have been ignored with just a focus on the mechanics.

    Let’s start off by being positive and looking at what we mean by mergers and why they work so well.

    From an exit strategy viewpoint, they work well where a firm has not been successful in growing an internal successor, but is perhaps too large to simply be swallowed up by another local small firm. I use the word ‘local’ quite deliberately. In many cases, it is likely you already know your future partner because the added value of merging between firms in the same area is often clearer than it would be with a firm from a distance away. Apart from logistics, distance can make it difficult to reduce costs meaningfully without losing all the staff and hence corporate memory of clients and the local market. Two local firms coming together can be an easier message to sell to clients and introducers.

    To profit and beyond

    About 20 years ago, I saw some interesting research in an American financial planning magazine, which examined the increased profitability of firms as they moved from being one-man bands, up to ten person firms.

    While an element of this increased profitability was due to shared costs of offices, admin and other overheads, there was actually a more profound reason than this. It revealed that as firms got larger, they started to work with larger ‘counterparty’ firms – accountants and solicitors, which, in turn, meant they were exposed to larger and more profitable cases.

    Individual advisers were also freed up to specialise, rather than having to be ‘all things to all men’, which again attracted more profitable cases.

    And they were also able to put systems in place to properly work the client base - and to market to attract new clients.

    Overall, these factors led to significantly higher profit ratios.

    But what has this information do with exit strategies? Well, on one level, the bigger the cake, the more there is for everyone. But the reality can often be much more than just ‘more dosh’, as the case study below reveals.

    Take advice where you can

    If we take a brief look at the regulatory and PI issues involved, the classic merger is firm A and firm B joining together to form ‘Newco’. (It’s always Newco!)

    The principals / shareholders in both firms agree appropriate shareholdings in Newco and transfer the clients and staff across.

    This leaves the FCA with the real consumer protection issue of who is responsible for past advice? They will want to see a sensible answer to this question and will be very clear that this cannot simply be a ‘phoenix’ operation to abdicate responsibility for past advice. There are no easy answers here, as, equally, the directors of Newco will be naturally reluctant to take responsibility for each other’s past advice.

    It’s a complex area, beyond the scope of a short article, but I will say it needs working out and getting good advice is always wise. Keep both your PI insurers and the FCA informed and on side. Proper mutual due diligence is also sensible. Yes, it slows the process down, and adds cost, but makes sense in the longer term.

    Due diligence will also give some idea about the cultural match. Culture is crudely defined as ‘what do you do when there are no rules?’

    It’s the way things are done. And because these things are rarely written down, they are almost invisible. And because they are unsaid, both firms assume that their way is the only ‘right’ way. And that leads to much more strain and conflict than the obvious issues of ‘which back office system have you got?’

    Let’s look at a case. As ever, details have been changed to protect the guilty …

    Role model

    Fred and John both ran small firms. They knew each other through PFS and IFP meetings, as well as local charity events. John’s firm had five staff, including two advisers, while Fred had just another adviser, and a part-time administrator.

    Fred was 55 and ready to retire. John was 45, and felt he had another 10 to 15 good years in him and was keen to build his business. Both firms were named after the principals.

    After long conversations, it was decided to join forces, and merge both firms into a new practice, to be known as ‘Newco Financial Planning’. They agreed that John would be the majority shareholder, and Fred would wind down. John would then buy out Fred’s shares over a period of time.

    The merger went ahead and for a while, everything seemed fine. After 12 months, things started to be a bit strained.

    Fred had found a new lease of life. Freed from the burden of running a firm and all the issues associated with that, he was actually doing more client work than he had for years. He now thought retirement was perhaps another five years away. Or more!

    Predictably, John had underestimated the management issues concerned with running the larger firm and was doing less client work than before. Equally predictably, he was unhappy with that.

    These changes in role contributed to a change in culture within the firm and the other advisers felt that they were being ‘managed’, in a way that they were not prior to the merger.

    Fred’s former adviser, Diane, felt that the new firm restrained how she worked and with Fred now ‘back in action’, felt she saw no immediate prospect of taking on his client base, which was her long-standing plan. She eventually left, taking a small but valuable client base, a few introducers, and set up locally in competition to Newco.

    The odd ‘historic’ complaint caused low-grade friction, as neither party was completely happy with what they saw, but nothing really horrible happened.

    Newco carried on, making a profit but not really living up to anyone’s expectations. Three years later, they were looking for a buyer.

    So, what went wrong?

    Actually, very little that was not completely foreseeable. Senior staff must be kept on side. Clients must be made clients of the firm, not the adviser. Roles must be clearly laid out. The objectives must be clear. Is this a strategic means of growing a business, or a true exit strategy? Scenarios should be explored, and tactics agreed, as far as possible, up front.

    It’s not complicated, it’s not new. It just needs thinking through.

    Mergers work – if they are properly managed!

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