Creating Compensation Plan

8/6/2019 Creating Compensation Plan

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MARKET KNOWLEDGE TOOLS

INDUSTRY REPORT

Best Management Practices:

Creating an Effective Compensation Plan


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Table of Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

The Key Lessons of Best Managed Firms . . . . . . . . . . . . . . . . . . . . . . . . . . 3

The Link Between Strategy and Compensation . . . . . . . . . . . . . . . . . . . . . 4

Partner/Owner Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Adding New Partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Setting and Evaluating Employee Base Compensation . . . . . . . . . . . . . . 16

Structuring an Employee Incentive Plan . . . . . . . . . . . . . . . . . . . . . . . . . 18

Benefit Packages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23


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Firms must structure their compensation and incentive

plans in ways that generate real value to employees across

the entire practice.

Introduction

Compensation practices have become a vital concern for advisors

in recent years, as the extended market downturn has erodedadvisory firms revenues, and profits. In that challenging

environment, advisors looking to maintain the success

they enjoyed during the 1990s have been forced to

examine and better manage their cost structures.

This paper is designed to define a standard of excellence andhighlight best management practices by examining the managerial

methods of the top 10% of independent fee-based advisory firms(the Best Managed Firms) who have been identified as such from

the 2003 FPA Compensation and Staffing Study(see sidebar formethodology). Advisors who incorporate the proven strategies ofthe Best Managed Firms will be well positioned to fully leveragefuture business opportunities and achieve the highest level ofsuccess in the years ahead.

Principals from these Best Managed Firms were interviewed in

order to identify the specific compensation practices thatcontribute to their success. This report presents the managementinsight of the principals interviewed and combines their bestpractices in a comprehensive series of key lessons that otherowners/managers of advisory firms can use to create their ownhighly effective compensation methodologies.

Compensation planning serves as an advisory firms primary tool

for attracting, motivating and retaining its most importantstrategic assetsuperior staff. In order to achieve the strongestreturn on their investment in employees, firms must structure theircompensation and incentive plans in ways that generate real value

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Methodology

The Best Managed Firms were

selected from among the 243

participants in the 2003 FPA

Compensation and StaffingStudy, based on a composite

score consisting of:

Ranking by pre-tax profit

per owner

Professional leverage

demonstrated by use of

non-owner professionals

and support staff

Ranking by revenue per

professional

Ranking by revenue per client

Career path as demonstrated

by introduction of new

owners/partners to the firm


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to employees across the entire practice. Without an optimal compensation

strategy, advisory firms will find it increasingly difficult to build and maintainthe level of human capital that is vital for success going forward.

Whats more, compensation will play a key role as owners formulate theirbusiness succession and exit strategy plans. Even owners who are years ordecades away from transferring ownership of their practices must beginpreparing for that eventual transfer by attracting and grooming one or moresuccessors.

The message is clear: Advisors looking to strengthen their current financialhealth and plan effectively for the future should evaluate their methods ofcompensation, and use the best practices of their highly successful peers as aroadmap to enhance their own compensation methods.

These Best Managed Firms exhibit higher levels of profitability than theoverall fee-based advisor community. As the graph to the left reveals, BestManaged Firms have an average pretax income per owner of $412,428

approximately $171,400 more than that of all other fee-based firms. Clearly,these top firms operate in ways that enable them to enjoy a significantcompetitive advantage.

These criteria go beyond an examination of current profitability, however, toinclude an evaluation of the long-term value that the owners are generating

for their firms. Thus, the Best Managed Firms

exhibit not only impressive current financialperformance, but also the business structuresnecessary to produce a strong return oninvestment and maximum transferable valueover time.

2

$500,000

$400,000

$300,000

$200,000

$100,000

$-Best Managed

FirmsAll Other

Fee Based Firms

$412,428$412,428

$241,026$241,026

Average Pretax Income Per Owner

Best Managed Firms and

All Other Fee Based Firms 2002


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The Key Lessons of Best Managed Firms

Extensive interviews with the Best Managed Firms reveal a group

that is very diverse in the services offered, client markets targeted,geographic location and composition of staff.

However, the following four key compensation principles are present in everysingle firm.

Institutionalized compensation practices. Every aspect of compensation,from how base salaries are determined to how bonuses are paid, isinstitutionalized i.e. determined based on a well-planned system thatreflects the firms strategy and each employees contribution. A highly

structured approach allows Best Managed Firms to establish equity incompensation, avoid the dependence on personal relationships that makesit difficult for a firm to grow, and ultimately create a system that canembrace many new employees.

Well-defined roles and responsibilities, starting with the owners. BestManaged Firms have written job descriptions, match descriptions withskills, and seek to add skills and talents when needed. In contrast, otherfirms typically adapt their needs around the current skill-set of a smallgroup of existing employees.

Focus on employees and employee development. Best Managed Firmsconsider their human capital to be their most important asset and makeevery effort to retain and further develop it. Best Managed Firms not onlyoffer financial incentives for their employees to increase their expertise,but also systematically provide opportunities to take on greaterresponsibilities and gain valuable experience in client management andbusiness development.

Reward all aspects of a firms activities. Best Managed Firms are growingby 15% to 20% a year, yet they never lose sight of the importance of client

retention and the impact all employees have on the client experience. As aresult, these firms seek to reward all employees for their contribution tomaintaining superior client service.

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Best Managed Firms consider their human capital

to be their most important asset.


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The Link Between Strategy and Compensation

Best Managed Firms differentiate themselves by approaching

compensation in a fundamentally different way than mostbusinesses. Specifically, Best Managed Firms design their staffing and

compensation plans by first developing a business strategy that takes

into account their long-term financial goals, types of clients or niche

targeted, new business initiatives, partnerships and other issues. Only

then do these firms look to add the talent and skills necessary to

execute on their strategies and enhance their competitive positions.

Compensation decisions at Best Managed Firms are driven primarily by theprevailing compensation paid by the national and local markets for such skillsand reinforced further by incentive compensation packages that link a firmsgoals with each individuals goals. Best Managed Firms also tie compensationto performance evaluations, to help ensure that goals are set and clearlycommunicated and that the firm rewards behavior consistent with its

strategic objectives.

Interviews reveal that Best Managed Firms hold three primary beliefs thatguide their compensation programs.

Strategy determines staffing. Best Managed Firms carefully assess their

skill-sets and determine which skills they lack and need to develop in lightof where they are taking their businesses. This helps ensure that allpartners and staff truly add value to the firm and contribute fully to its

most important business goals. Technical expertise, business developmentskills and operational experience are cornerstones of the Best ManagedFirms strategies, and they recruit accordingly to create a portfolio of skills

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Best Managed Firms tie compensation to performance

evaluations, to help ensure that goals are set and clearly

communicated and that the firm rewards behavior

consistent with its strategic objectives.


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that allows them to be successful. They acquire these skills in the market

or by financially incenting existing employees to develop them. TheMonitor Group, Inc. believes that, Brands are created, they dont justhappen. This firm has made an effort to not only build its own brand but

also the brands of its employees by systematically enhancing their skillsand exposure.

Premium prices for premium talent. Best Managed Firms recognize thatpremium compensation helps them to attract and retain superior staff at

every level of the organization. Not all firms will need to set their basecompensation in the upper quartile of the compensation surveys as the BestManaged Firms do. But if a firms strategy is built upon technical expertiseand relies on a superior service offering to target high-net-worth investors,recruiting premium talent at a premium price is likely a requirement.

Incentive compensation provides the strongest link between the firmsstrategic goals and employee behavior. Strategic goals should translateinto assigned responsibilities and measurable outcomes. Once goals are

set, Best Managed Firms tie them to the performance evaluation of theiremployees and use them to provide the foundation for an incentivecompensation plan. The process often starts with the compensation of thepartners, as discussed below.

Partner/Owner Compensation

In a private firm fully controlled by a small group of owners, defining

a structure for owner compensation may not seem important. In fact,

oftentimes many investment advisory firms consider partner

compensation whatever is left after expenses are paid.

Unfortunately, this type of haphazard approach does not serve the bestinterests of the firm, its owners or its employees. The experience of Best

Managed Firms suggests that there are a number of important reasons toconsider a more structured approach.

The need for formal structureThe structure of owner compensation is a crucial decision because it sets thetone for the compensation methodology of the entire firm. Employees taketheir cues from the attitudes and actions of top personnel. Therefore, by

implementing a formal compensation plan for owners, firms send powerfulmessages to all employees that the owners a) do not receive discretionary

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amounts of money but instead are paid based on industry norms and their

functions in the firm, and b) are subject to performance evaluations thatimpact their compensation. These messages reinforce the goal of linkingcompensation to strategy, and demonstrate that the same compensation logic

applies to both owners and employees.

Whats more, as a firm grows, its ownership will inevitably expand beyond thefounding partner(s). Structured compensation for the owner group becomesa critical factor in a firms ability to bring in new owners in a fair and

equitable manner, and continue to incent their further development.

A firms growth also increases the complexity of the owner groupsresponsibilities, which often requires partners to specialize in particular areas ofthe practice. Inevitably, one or more of the partners will have to relinquish clientresponsibilities to devote a significant portion of their time to firm management.In addition, one of the partners often becomes a full-time business developer (orRainmaker) with little or no client management responsibilities. Clearly, thetraditional system of compensating partners for the revenue each brings to the

firm breaks down in an environment characterized by more complex andspecialized roles. What becomes required is a structured system that rewards allcritical functions and reflects their importance in a firms overall success.

Industry experts argue that the value of an advisory business is ultimatelydriven by the reward for ownership and not the compensation for working inthe practice. Best Managed Firms, therefore, design structured compensation

plans that measure reward for ownership separate from the reward for labor.This is important from a business management perspective, for the owners toevaluate their return on investment, and as partners consider their eventualexit from the firm. A separate system to reward ownership helps ensure thatowners are fairly compensated for the financial risk they take as investors intheir firms and for exposure to liability. Furthermore, measuring a separatereward for labor (i.e. base compensation) of the partners is the first steptoward identifying the free cash flow that the partners will one day transition.Lastly, there are already a number of Best Managed Firms that have non-working owners (retired advisors or external investors), and the number of

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What becomes required is a structured system that rewards

all critical functions and reflects their importance in a firms

overall success.


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such firms is likely to grow as many advisory firms are sold or transition their

ownership. In the presence of an external investor who shares in theprofitability of the firm, implementing a discretionary partner compensationsystem becomes impossible.

A successful partner/owner compensation systemA common system for partner/owner compensation is shared by a number of theBest Managed Firms, including Burt Associates, Gamble Jones Morphy & Bent,and Kochis Fitz Tracy Fitzhugh & Gott. These firms all incorporate a three-tieredapproach consisting of:

Base Salary. This is compensation that owners receive for their primary

function in the firm (Advisor, Portfolio Manager, CEO, etc.). Most BestManaged Firms establish base compensation by referencing industry studies

as well as consulting with their peers in formal or informal study groups.

Owner Incentive Pool. The firms set aside a bonus pool funded by firmprofitability, and use this pool to reward partner performance and theadditional responsibilities that partners undertake (such as overseeing theimplementation of a new client information system, taking the firm

through an audit, etc.). Partners share in this pool based on a pointsystem driven by contributions that can be unique to their position andthat reflect individual goals.

Owner Profit Pool. The remaining profits are then distributed based on

the proportionate ownership of the firm.

This three-tiered approach is optimal for a number of reasons: It rewardslabor contribution and ownership separately. It recognizes that partners, just

like employees, should be subject to performance evaluations for theirprofessional responsibilities. It also encourages partners to enhance their skill-sets by being involved in different aspects of firm management, rather thanfocus exclusively on business development or client management. Perhapsmost importantly, this approach puts the focus of all the owners exactlywhere it should beon overall firm success.

The chart on page 8 shows how this compensation system can be applied to

base salaries and various profit/bonus pools, using the hypothetical exampleof ABC Financial. In this case, the partner incentive pool represents 40% offirm profits, while another 40% of the profits are distributed to partnersbased on their proportionate ownership. An additional 10% is allocated to abonus pool for employees, and 10% is retained.

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Five key owner compensation decisionsWhen designing or re-evaluating owner compensation, Best Managed Firmsanswer five key questions:

Who owns the clients and who owns the revenue?

What are the roles and functions performed by the owners and how doesthe firm value them?

What is the proportion of variable versus fixed compensation in ownercompensation?

What is the balance between ownership and job contribution? What percentage of profits will be distributed versus retained?

Who owns the clients and who owns the revenue?All the Best Managed Firms have made the critical choice to institutionalizeclient ownership. This means they have created a business culture and systems

in which client service responsibilities belong not to one advisor, but to theentire staff. Accordingly, almost all the firms chose not to track revenue to aparticular professional, and focus instead on team service. This decision tonot track revenue by professional essentially implies that the firms do not useindividual revenue generated as the primary driver for owner compensation a system that is still very common in the industry. The benefits of such a

team-based approach include higher profitability, greater efficiencies, betterclient service and a stronger value for the business over the long-term.

What are the roles and functions performed by the owners and how does thefirm value them?

Inside the Best Managed Firms, owners are typically involved with businessdevelopment, high-level client management, firm management andcompliance/policy. Historically, the business development function hasreceived the highest financial rewards. However, many Best Managed Firms

now recognize that client management and retention is as important to theircontinued success as new business development, and reward the twofunctions equally. Conversely, firm management responsibilities historicallyhave been discounted in compensation, but Best Managed Firms understandthat without leadership and management excellence, firm performance andgrowth will suffer. Consequently, a number of owners inside Best ManagedFirms have become full-time CEOs.

What is the proportion of variable versus fixed compensation in ownercompensation?As suggested in the chart on page 8, owners of Best Managed Firms typicallyreceive a large percentage of their income from variable forms of compen-sation. The positions that owners typically have inside the firms (CEO, COO,Rainmaker, etc.) lend themselves naturally to variable compensation, becausethese positions have an extremely strong impact on the business. The addedbenefit of variable compensation is that it subjects partners to a system of

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evaluation that is driven by their specific goals. This reinforces the best

practice of tying compensation to overall business strategy, and ensures thatall partners are focused on the job of building a strong practice.

What is the balance between ownership and job contribution?Determining the portion of profits that should be distributed based onpercentage of ownership versus job contribution is a policy decision uniqueto every firm. That said, there must be a balance between the two factors.Distributing profits largely or entirely based on ownership does not

adequately compensate young partners (who typically have smaller ownershippercentages than older partners) and discourages them from working as hardas they can for the firm. In a firm that does not track personal revenue, apurely ownership-driven system may become inequitable in terms of whodoes the work and who gets the money. However, a system that distributesprofits primarily based on job contribution often fails to reward seniorpartners for the additional financial risk they incur. In most cases, therefore,Best Managed Firms that use a contribution bonus pool choose a 50% splitbetween the two factors.

That said, many of the smaller Best Managed Firms those with two orthree owners of equal status and percentage ownership still use a system ofequal base salaries and equal profit distribution. Such a trust system canfunction very well in a smaller firm where owners have worked together for along time. In fact, attempting to establish a formal system in such anenvironment can be detrimental, as it may raise suspicions among the other

partners. This method of compensation effectively declares that partners trusteach other to contribute equally, and that they do not expect any conflicts ordisputes. However, smaller firms using a trust system will likely find itineffective if they admit new partners beyond the founding group, and willneed to institute a formal structure as that occurs.

What percentage of profits will be distributed vs. retained?Most Best Managed Firms have a system for determining retention ofprofits. The owners recognize the need to ensure the financial stability oftheir firms as well as capitalize their growth, and take steps to prevent

distributing all the cash at the end of the year. Typically, owners will go

through a budgeting process to determine their firms capital needs for thenext year and set aside that amount. Budros & Ruhlin, Inc., for example,prepares a budget and a financial forecast each year and shares it with eachpartner to determine the availability of capital for distribution. In addition,several firms also retain a quarters worth of expenses as a safety cushionagainst unforeseen declines in revenue.

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Adding New Partners

The issue of new partners and their subsequent effect on firms

compensation policies is becoming increasingly important tomany advisory practices. For example, all of this years Best

Managed Firms have either recently admitted a new owner into

the practice or are contemplating such a change in the near future.

This trend is largely the result of the aggressive growth goals that BestManaged Firms set for themselves. Because Best Managed Firms typicallytarget 15% to 20% annual revenue growth, they require more professionals tobe involved in the mission-critical activities that will fuel such growthincluding business development and client relationship management.

Therefore, the motivation, development and retention of key professionalemployees becomes particularly important to these firms, and ownershipstakes are increasingly being seen as both drivers for employees and a logicalbusiness-building strategy for existing owners.

Business succession concerns are also driving the recent ownership changes.Most of the Best Managed Firms were founded in the early 1990s byprofessionals who already had 10 to 15 years of experience in the industry.

This group of owners is now approaching retirement age and contemplatingbusiness continuity and the best mechanisms for realizing the business valuethey have built during the past decade. The admission of new partners allowsthis older generation of owners to gradually transition the client relationshipsto the new generation, introduce them to referral sources, and give them thetime necessary to build their business management and development skills.

The optimal process for adding new partnersBased upon the experience of the Best Managed Firms, advisors shouldconsider the following optimal process for selecting and admitting newowners:

Decide if the firm is ready to add an owner

Design and communicate formal candidate evaluation criteria

Define the terms of the ownership agreement Design an appropriate financial structure for ownership transition

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Decide if the firm is ready to add an ownerOne key to successfully adding an owner is to ensure that the new owner willcreate value for the firm instead of diluting value. Certainly the decision toadd an owner can have financial consequences for existing owners in terms of

dilution of both income and ownership. In addition, the new owner candilute the decision making power of the existing owners. Even if new ownersare offered minority share, for example, they are likely to challenge purelydiscretionary decisions by majority owners.

To ensure that any new partner/owner adds value, its imperative to carefullyexamine three issues:

What is the target revenue per partner/owner that ensures an addition willnot be dilutive? The answer is usually a combination of the current incomeof the partners and the firms profit margin. In practice, Best ManagedFirms have between $700,000 and $1,000,000 in revenue per partner.

What is the firms current compensation structure and should the

structure change as a result of the new owner?

How are key decisions made and should the firm introduce formal waysof making such decisions?

Design and communicate formal criteria for evaluating partner candidatesFirms commonly offer ownership to a particular individual based on an

unstructured, subjective evaluation process. Such discretionary systems cansometimes be acceptable when a firm is considering only one viablecandidatebut most often they ignore important characteristics that existingowners should carefully assess.

For example, firms must recognize that being an owner entails a higher levelof responsibility than simply being a good professional, and shouldcorrespondingly expand their candidate evaluation process to cover areassuch as leadership and employee development/management. The idealprocess is independent of a particular candidate, comprehensive and

objective, and communicated to all employees rather than just the partner

candidates. Sharing the formal selection criteria with the rest of the staffeffectively tells other potential partner candidates the steps they must takeand the specific skills they must acquire in order to be considered for anyfuture ownership opportunities. This shows that the selection process is notarbitrary, and gives employees actionable steps they can take to furtherdevelop their professional abilities.

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The Best Managed Firms design formal, structured evaluation criteria that

assess each candidates:

Contribution to the firm. This can be measured using a combination of

metrics such as personal revenue, client relationships managed and newclient relationships developed, as well as other measures consistent withthe firms strategy and performance measurement system.

Professional skills. Owners should be setting an example for others in

terms of technical excellence. Accordingly, Best Managed Firms considerfactors such as a candidates degrees and designations, publications inindustry journals and public speaking, as well as technical excellence inthe advisory area of professional focus.

Employee management skills. Best Managed Firms recognize that thecandidates ability to develop and manage staff is critical for their newresponsibility as owner, and they incorporate this judgment into theirevaluations. Components of this assessment should include the number of

employees the candidate has managed in the past and their performance(turnover in staff managed, promotions of staff managed, etc.), and anevaluation of the individual by the employees. Any mentoringresponsibilities the candidate has undertaken should also be evaluated.

Personal characteristics.Every firm has a value system that goes beyond itsfinancials or investment policy. The firm therefore needs to ensure that new

owners adhere to and promote the values that are important to the firm.Sage Financial Groupbelieves that character evaluation is perhaps the singlemost important factor in the firms decision to admit new owners. Theseintangible characteristics, such as integrity and maturity, can be evaluatedsuccessfully by soliciting the insights of the candidates peers and managers.

Define the terms of the ownership agreementOwnership in a firm is significantly more complex than the simple right todraw from the profits. Best Managed Firms are therefore careful to define thespecific terms of any new ownership agreement. In particular, the industrys

most successful practices consider questions such as:

What percentage ownership will be offered? Depending on the firms legalform and the owners compensation arrangement, different components ofownership become important. At Best Managed Firms where ownershippercentage is the driving force behind profit distribution, up to 10% ofownership is usually offered to existing employees who become newpartners. This percentage is significant enough to be meaningful to the new

partner, but small enough to enable him/her to comfortably finance the

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Adding a New Partner

ABC Financial LLC

Scenario

4 Partners$3MM in Revenue16 EmployeesCurrent Income Per Partner: $361,325Current Profit Margin: $1,067,000 or 35.6%Bonus Pools: 50% of Operating Profit

1. When can the firm afford a new partner? To answer

this question, answer the following questions:

a. How much extra income is needed to preventdilution?

b. How much revenue is needed at current marginsto meet the requirements in (a.)?

2. Paul is the new partner candidate. He willpurchase equity as follows:

a. What percentage of ownership?

b. Existing shares or new shares? (Consult with

your CPA regarding tax issues.)

c. How are shares valued?

d. Paul gets a loan from the company to pay for

the shares (consult with your CPA on the taxconsequences). The loan is paid back in fiveinstallments from Paul's future income.

e. Example payment:

Calculations

In order for the new partner to make at least$200,000 (amount determined by the partners) andnot dilute income to other partners, the threshold is:

($200,000 Current Salary) / (Operating ProfitMargin After Bonus Pools) = ($200,000 $90,000)/ (17.8%) = ~$620,000.

The amount of incremental revenue that the firm shouldadd before adding a new partner is $620,000.

10% (decision made by existing partners)

New shares

A formal valuation determined the value of the firm to be$3.8 MM. The value of 10% of shares = $380,000.

Loan Amount / 5 = Annual Payment$380,000 / 5 = $76,000 Annual Principal PaymentUsually the loan will also have a market rate interest

Paul's Partner Salary = $110,000

Paul's Partner Bonus = $42,680Paul's Ownership Distribution = $53,350Paul's Total Income = $206,030

Less Annual Payment = $76,000Less Interest = variesRemaining Pre-tax Income = $130,030

An example of how a typical Best Managed Firm might bring on a new partner is shown below. The column on the leftdescribes a step-by-step process for a new partner admission at a hypothetical firm, ABC Financial, while the

column on the right details the financial calculations and other considerations used to arrive at the dollar amountsand other end results.


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purchase of that ownership in a reasonable amount of time using future

income. If the new partner comes from another firm and brings along abook of business, the ownership percentage is typically directly proportionalto the value of the new partners book relative to the firms book. Many firms

use the new partners revenue from his or her existing book of business toapproximate that value when determining the ownership stake.

At firms where job contribution is weighted more heavily in the distributionof profits, the actual percentage of ownership is less important than the fact

that the individual can now participate in the partner bonus pool.

How will the individuals responsibilities change after the purchase? Atmost Best Managed Firms, the new ownership does not constitute animmediate promotion to management responsibilities. However, over timethe new owner will have to assume such responsibilities, and the firm willneed a plan for introducing them to the management of the practice.

What benefits of ownership will be shared, and how? This question

addresses issues such as distribution of income, decision-making powerand the right to proceeds from the sale of the business. Several of the BestManaged Firms have income partners that is, partners who drawincome based on their personal revenue contribution to the firm but whodo not have voting power or the right to any proceeds from a sale. Incomepartners are often found in situations where the employee is contributingsignificantly to revenue but does not wish to commit financially to the

firm by becoming an owner.

Is ownership reversible, and how? There are cases even among BestManaged Firms in which new owners had to be terminated or chose toleave. Therefore, it is prudent to have provisions in place to effectively dealwith such situations and allow the remaining owners to repurchase theshares at a reasonable valuation.

Design an appropriate financial structure for ownership transitionBest Managed Firms employ a variety of approaches when structuring their

finances to facilitate a partial transfer of ownership to a new partner. These include:

Valuation. Best Managed Firms consult industry-specialized valuationfirms or use a simple multiple formula to establish valuation. When usinga formula, it is important to remember that the multiples applied areapplicable to the sale of the entire firm rather than a minority share, andshould therefore be discounted. Valuation experts can also help indetermining the appropriate discount.

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Financing . In most cases a new partner does not have the ability to

complete the purchase using cash. To facilitate this process, Best ManagedFirms typically offer financing, either in the form of a direct loan or byallowing the new partner to use future income to complete the purchase.

Best Managed Firms in such cases make a point of using financialforecasting, which helps ensure that there will be enough income to payback the loan or to fund the equity. Typical terms involve makingpayments for three to five years on a fixed schedule. Occasionally, theexisting owners (rather than the entity) may also take the note payable.

New shares versus existing shares. The decision to issue new shares orhave existing owners sell their shares is entirely one of personal financialplanning. The decision has important tax implications for the stocks basisfor the new owners. Depending on the legal entity and the use of theproceeds, this decision can also affect the tax treatment of the proceedsfor the existing owners.

A surprising number of firms in the industry have gifted ownership to

employees. This approach is counter-productive and carries severaldisadvantages. Gifting shares discounts the value of ownership and financiallydilutes the existing owners. Furthermore, it may limit the firms ability to selladditional shares to the new partner in the future. By giving away the first setof shares, the partner will be significantly less inclined to pay for anyadditional ownership going forward.

Setting and Evaluating Employee Base Compensation

The primary compensation method for nearly all non-owner

employees inside Best Managed Firms is a salary plus a bonus.

As a compensation philosophy, Best Managed Firms seek to compensate theiremployees in the upper quartile of the compensation surveys. They recognize thattheir success is driven by their ability to attract exceptionally skilled and motivated

people, and accordingly offer employees above-average compensation levels.

Best Managed Firms design and implement a highly structured and institution-alized system for setting employees base salaries and subsequently evaluatingsalary adjustments. Growth is ultimately the primary force motivating BestManaged Firms to institutionalize their employee compensation plans. HoyleCohen Wealth Management, for example, began its system of semi-annualsalary reviews following the merger of the two practices that created the firm.

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The highly-structured base compensation system used by Best ManagedFirms consists of four components:

Clear job description and responsibilities. The first step the firms take

when structuring compensation is to design a detailed map that explainsthe characteristics of the position, the required skills and theresponsibilities. For example, Capelli Financial Services, Inc., hasdeveloped a map of the service process that helps the principals establishthe roles and duties (i.e. the job descriptions) of each staff member.

Market-determined base compensation. The Best Managed Firmsconsult industry-specific studies to establish the foundation for anemployees salary. Most of the firms also consult local surveys and sourcessuch as Salary.com to obtain an estimate for the adjustment necessary toreflect their local geographic market.

Other important factors. After using the salary surveys to determine abase, Best Managed Firms consider other key factors that will impactemployees compensation, such as their experience, degrees anddesignations and prior/current job compensation.

Regular reviews and adjustments. Best Managed Firms review salariessemi-annually or annually, again by referencing external sources and byconsidering changes in the responsibilities and skill level of the employee.Best Managed Firms commonly use a cost of living adjustment tied to thereported inflation rate. In addition, most have a well-defined system formerit adjustments driven by:

Degrees and designations attained Employee evaluation (such as 360 degree) Tenure Additional responsibilities

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Income partners are often found where the employee is

contributing significantly to revenue but does not wish to

commit financially to the firm by becoming an owner.


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Structuring an Employee Incentive Plan

All of the Best Managed Firms reward their employees based on

performance and achievement, either through the use ofstructured incentive plans or discretionary bonuses. When

rewarding high-level positions, structured plans typically result in

a much more successful return on investment.

By contrast, discretionary bonuses for professional staff can fail to effectivelymotivate the desired employee behavior. Professional employees are,

therefore, unsure about why they receive a bonus and howthe amount is determined. They also lack a target goal thatcould serve to motivate their development within the firm.Whats more, discretionary bonuses quickly become anexpectation, and can severely impact morale if not givenout in a particular year.

That said, a discretionary bonus system is often effectivewhen used to reward lower-level positions that are clearlydefined and characterized by somewhat routineresponsibilities, and where performance relative toexpectations tends to deviate very little.

Seven Key Incentive Plan DecisionsTo design a successful incentive plan that reinforces and

rewards the desired behavior, all firms must consider sevencrucial factors. Although the Best Managed Firms oftendevelop a variety of responses, all have effectively solvedimportant issues related to: Incentive compensations role in an overall plan Eligibility and structure Primary driver of compensation Assessment and reward of desired behavior Triggers and incremental measures Team-based versus individual rewards Funding

Incentive compensations role in the overall compensation packageCompensation theory suggests that the more impact an individual has on theperformance of the organization, the higher their variable compensationpercentage should be. At Best Managed Firms, the positions that most oftenreceive variable compensation include CEO, COO, senior financial advisors,financial planners and portfolio managers. The table to the left displays theaverage percentage of incentive compensation relative to base salary insideBest Managed Firms by position.

18

Bonuses Inside

Best Managed FirmsBonus as %

of Base Salary

51.2%18.9%10.4%10.1%9.2%

19.8%8.5%

15.4%10.8%

33.6%6.7%8.4%3.3%7.4%9.1%4.1%

11.0%4.8%3.4%4.4%1.5%

Position

CEOCOOCFOHR DirectorComplianceFinancial PlannerInvestment AdvisorPortfolio ManagerTax/Estate Planner

RainmakerParaplannerTax PreparerTraderResearch AnalystClient ServiceCustomer SupportOffice ManagerNetwork AdminInternal AccountantAdmin AssistantReceptionist


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Eligibility and structureDepending on the diversity of positions inside the firm, management mayfind that there are distinct groups of positions that need to be rewardeddifferently. Typically, the division inside an advisory firm occurs between the

professional employees who have extensive client contact and impact onrevenue, and the back-office staff who have limited client contact.Accordingly, most Best Managed Firms offer structured incentivecompensation to their professionals but not to administrative staff.

That said, there are exceptions among the top firms. Several owners say thatultimately all employees have an impact on the client experience and should,therefore, be able to participate in the firms success.

Primary driver of compensationBest Managed Firms differ in their approaches to choosing a primary driverfor their incentive plans. While several firms prefer to tie incentivecompensation to base pay, others have open-ended plans that distribute acertain percentage of the firms profitability.

The rationale behind using a percentage of base pay can be found in all thefactors that should go into determining an employees salary. If the salarytruly reflects the marketable skills of the individual, their professionalcompetency, their level of responsibility in the firm, their experience, tenureand other factors that the firm considers important, it may be appropriate touse such a well-supported measure to determine the maximum amount of

incentive compensation an individual can earn.

The argument against using base salary as the primary driver is the fact thatbase salary caps the potential of the plan, potentially limiting its usefulnessas a motivational tool for employees. Best Managed Firms using no-cap,profitability-based plans can clearly emphasize the link between firmprofitability and the size of the reward. The ultimate choice, as always,depends on the strategy of the firm.

Assessment and reward of desired behaviorHistorically, the first metric rewarded in the service industry is revenue

generation. Although Best Managed Firms recognize the importance of revenueresponsibility, they make concerted efforts to also focus on a broader range ofbehavior-related metrics that are as important to a firms overall success, such as:

Client retention

Accomplishing pre-set goals that were determined during the latestperformance review

Performance review score

Achieving degrees and credentials

19


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Triggers and incremental measuresAn incentive plan usually has two types of measures: Triggersare measures thatmust be met in order for a plan to start paying. The most typical trigger is firmprofitability. In addition, many Best Managed Firms use a secondary trigger

designed around each individuals progress toward specific goals. Unliketriggers, which are on/off-type measures, Incrementsaffect the amountrather than the instance of payment. For example a plan may pay 10% of basesalary based on the achievement of five goals, each paying 2% of salary.

Some incentive plans are divided in half, and pay based on a combination ofcriteria. For example, FSAM, Inc. uses a system that is 50% based onachievement of individual goals and 50% based on firm-wide metrics such asnew clients, retention and assets.

One difference in the design of incentive plans among the Best ManagedFirms is the degree of willingness to make employees responsible for firmprofitability by either a) making it a trigger or b) tying the size of theincentive to the dollar profits available. Again, both sides have valid

arguments.

Team-based versus individual rewardsWhile all Best Managed Firms have a team-based client service approach,most do not treat teams as profit centers and, correspondingly, do not baseincentive compensation on team goals. The team component of most plans isrepresented by firm profitability as either a trigger or a source of funding.

FundingNearly all firms fund their plans with a percentage of profits, with the typicalpercentage being 10% to 15% of profits after owner compensation (beforedistributions). In some cases, a portion of the pool funds the qualified profitsharing plan.

That said, some firms have found creative funding mechanisms to furtherenhance their plans value. Cornerstone Advisors, for example, distributes apercent of all new client revenue to the bonus plan, giving back-office

employees a reason to be excited about new clients instead of seeing them as

additional work. Dowling & Yahnke, Inc. also uses a percentage of the clientrevenue to fund a bonus plan for the employees who service the accounts.

Ultimately, owners need to ask themselves how bonuses will be funded if theyare not based on firm profitability since it becomes possible to pay bonuseseven if the firm is having a loss year.

20


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21

Benefit Packages

The benefit packages offered by the Best Managed Firms reflect

both the size and the sophistication of these firms. Benefits thatare common among this group include:

Fully covered health insurance of the employee (however, covering theemployees family is not a common practice).

Dental plan.

Paid time off (PTO). Best Managed Firms have generous vacationpackages, sometimes as much as four weeks of PTO. Several firms

combine sick days, personal days and vacation into a single PTO blockthat employees can use at their discretion.

Minimum life and disability coverage. Retirement plans. Almost 50% of the Best Managed Firms have a 401(k)plan while the rest of the firms use SIMPLE or SEP plans. Most firms matchcontributions on a discretionary basis based on the profits of the firm.

Profit sharing plan. Nearly one third of the firms have a qualified planand share between 3% and 5% of profits.

Education expenses. Practically all firms reimburse employees forattaining degrees that benefit the firm (CFA, CFP, etc.). In most cases,employees become eligible for the reimbursement only after the degree ordesignation is successfully attained.

Conclusion

Advisors today operate in an environment characterized by

significant challenges such as increased competition and

reduced profitability and enormous opportunities including

the continued strong growth of the high-net-worth market.

To meet the challenges and fully exploit the opportunities, advisors shouldthoroughly examine all areas of their businesses that will drive their successgoing forward, and look to improve their processes and methodologies.

Of all the business structures in place at a firm, compensation is among themost important. Compensation is not only the biggest cost at most firms, butalso the most effective tool to attract, motivate and retain superior staff.


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22

Therefore, compensation becomes a deciding factor in determining a firmscurrent financial health and competitive position, as well as its creation oftransferable value over the long term.

In short, compensation affects every aspect of a practice and must bemanaged optimally. By examining and adopting the best practices of the mostsuccessful businesses in the industry, advisors can help ensure that theyachieve the maximum level of success in the months and years ahead.

The Best Managed FirmsAlphabetically by firm name

Accredited Investors, Inc. Edina, MNAll Star Financial Minneapolis, MN

Balasa Dinverno Foltz & Hoffman, LLC Schaumburg, IL

Bingham, Osborn & Scarborough, LLC San Francisco, CA

Budros & Ruhlin, Inc. Columbus, OH

Burt Associates, Inc. Rockville, MD

Capelli Financial Services, Inc. Bloomfield, MI

Compass Capital Management, Inc. Minneapolis, MN

Cornerstone Advisors, Inc. Bellevue, WA

DAL Investment Company San Francisco, CA

Dowling & Yahnke, Inc. San Diego, CA

Emerson Investment Management Boston, MA

FSAM, Inc. Houston, TX

Gamble, Jones, Morphy & Bent Pasadena, CA

Hoyle Cohen Wealth Management San Diego, CA

Hynes, Himmelreich, Glennon & Co. Darien, CT

Kochis Fitz Tracy Fitzhugh & Gott San Francisco, CA

LBMC Investment Advisors Brentwood, TN

Lee Financial Corporation Dallas, TX

Linscomb & Williams Houston, TX

Maul Capital Management, Inc. Las Vegas, NV

Nancy Abrams & Associates, LLC Beverly Hills, CAPlancorp, Inc. Chesterfield, MO

Regent Atlantic Capital, LLC Chatham, NH

Sage Financial Group Bala Cynwyd, PA

The Monitor Group Fairfax, VA

Tyee Asset Strategies, LLC Seattle, WA

Wealth Management Advisors, Inc. Leawood, KS


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23

Median Operational RatiosFee Based Firms1 By AUM Size and Best Managed Firms2

Assets Under Management

Revenue

Clients

Average Gross MarginAverage Operating Profit MarginAverage Pretax Income Per Owner

Staff Headcount

Principals3

Professionals4

Administrative and Support Staff5,6

Total Headcount (sum of above)

Clients Per Professional

Revenue Per Professional

AUM Per Professional

Revenue Per ClientAUM Per Active Client

EBITDA Per Client

$75,857,396

$600,018

138

57.1%12.0%23.8%

1.01.02.04.0

54

$271,561

$32,583,333

$4,441$527,248

$177

$25,000,000

$231,160

70

57.4%16.3%33.1%

1.00.00.01.0

51

$176,702

$17,897,099

$3,255$325,556

$126

Under $50 MM $50 $100 MM

$478,655,529

$2,817,318

342

58.6%20.9%10.6%

3.03.07.0

13.0

42

$407,464

$74,528,647

$8,334$1,336,156

$479

$150,000,000

$1,064,000

214

57.8%13.2%18.2%

2.02.04.08.0

50

$281,467

$35,250,000

$5,323$749,613

$167

$100 $250 MM

$450,000,000

$2,140,514

275

63.1%27.4%15.6%

2.03.06.0

11.0

39

$389,787

$58,502,273

$8,813$1,234,735

$786

Best Managed FirmsOver $250 MM

1 Based on 243 firms who are primarily or solely fee based.2 Best Managed Firms Top 10% Performing Firms based on composite criteria ranking of profitability, productivity, growth, and professional leverage.3 Principals Professionals/Owners with practice management and client responsibility.4 Professionals Investment advisors, financial planners, portfolio managers and business development specialists.5 Support Staff Paraplanners, tax preparers, research analysts and client service administrators.6 Administrative Staff Office managers, bookkeepers, internal accountants, information system specialists and receptionists.

Moss Adams LLP. Results from the 2003 FPA Compensation & Staffing Study.

Appendix


26/28

24

Average Common Sized Income Statement*

Fee Based Firms1 By AUM Size and Best Managed Firms2

85.1%

9.8%

2.7%

1.4%

1.0%

100.0%

23.4%

19.5%

42.9%

57.1%

17.6%

16.9%

3.6%

6.9%

45.1%

12.0%

-2.0%

10.0%

-1.2%

8.8%

8.9%

23.8%

44

78.4%

15.1%

2.7%

2.6%

1.2%

100.0%

19.8%

22.8%

42.6%

57.4%

13.9%

14.7%

3.9%

8.6%

41.1%

16.3%

-4.5%

11.8%

-1.6%

10.2%

9.2%

33.1%

112

Under $50 MM $50 $100 MM

85.6%

9.2%

0.7%

0.7%

3.8%

100.0%

28.4%

13.0%

41.4%

58.6%

15.1%

15.8%

2.5%

4.4%

37.7%

20.9%

-5.2%

15.8%

-0.8%

14.9%

15.6%

10.6%

40

78.7%

15.0%

2.2%

2.1%

2.0%

100.0%

23.3%

18.9%

42.2%

57.8%

20.5%

15.7%

3.2%

5.2%

44.6%

13.2%

-4.8%

8.4%

-0.1%

8.3%

9.7%

18.2%

47

$100 $250 MM

88.5%

8.4%

0.5%

0.6%

1.9%

100.0%

21.8%

15.1%

36.9%

63.1%

16.2%

12.7%

2.3%

4.4%

35.7%

27.4%

-8.3%

19.0%

-0.2%

18.8%

20.2%

15.6%

28

Best Managed FirmsOver $250 MM


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25

TotalCompensationB

estManagedFirms

MedianTotalCompensationiscalculatedasthemedianofthetotalsreported,notasthesumo

fthemediansofindividualc

ompensationcomponents.

Function

JobTitle

#Positions

%R

eceiving

aSalary

Median

Salary

%R

eceiving

a

Bonus

Median

Bonus

%R

eceiving

Commissions

A B C D E F G H I J K L M N O P Q R S T U

CEO

COO

CFO

HRDirec

tor

Comp

liance

Financ

ialPlanner

Inves

tmen

tAdvisor

Port

folioManager

Tax/

Es

tatePlanner

Ra

inma

ker

Parap

lanner

Tax

Preparer

Tra

der

Researc

hAna

lys

t

Clien

tServ

ice

Cus

tomer

Support

Office

Manager

Ne

twork

Adm

in

Interna

lAccoun

tan

t

Adm

inAss

istan

t

Recep

tion

ist

28

11 6 2 3 7

524

13 2 1

138 1 1

512

29

16

16

11

10

29

11

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

93%

100%

100%

100%

100%

100%

100%

100%

100%

50%

82%

67%

50%

67%

92%

50%

77%

50%

55%

79%

100%

80%

92%

79%

44%

56%

82%

90%

86%

55%

$201

,053

$132

,000

$74

,500

$90

,545

$65

,000

$85

,000

$156

,108

$110

,000

$78

,622

$120

,000

$44

,720

$59

,500

$45

,500

$69

,250

$44

,000

$36

,516

$50

,000

$62

,000

$44

,000

$36

,339

$33

,400

0%

0%

0%

0%

0%

1%

4%

8%

0%

9%

0%

0%

0%

0%

0%

0%

0%

0%

0%

0%

0%

$103

,000

$25

,000

$7

,750

$9

,126

$5

,987

$16

,800

$13

,240

$16

,893

$8

,528

$40

,288

$3

,014

$5

,000

$1

,500

$5

,147

$4

,000

$1

,500

$5

,500

$3

,000

$1

,500

$1

,600

$500

%R

eceiving

Ownership

Distribution

Median

Ownership

Distribution

Median

Total

43%

27%

17%

50%

33%

20%

25%

0%

0%

18%

0%

0%

0%

0%

7%

0%

0%

0%

0%

3%

0%

$88

,569

$55

,000

$3

,000

$7

,000

$7

,000

$45

,178

$12

,500

n/a

n/a

$300

,000

n/a

n/a

n/a

n/a

$44

,200

n/a

n/a

n/a

n/a

$32

,000

n/a

$366

,000

$160

,000

$92

,000

$98

,608

$72

,000

$104

,000

$162

,788

$110

,000

$82

,886

$216

,515

$47

,250

$64

,500

$47

,650

$73

,883

$52

,031

$38

,016

$59

,900

$66

,437

$45

,083

$39

,750

$33

,400

n/a

n/a

n/a

n/a

n/a

$

200

,000

$30

,000

$1

,515

n/a

$40

,000

n/a

n/a

n/a

n/a

n/a

n/a

n/a

n/a

n/a

n/a

n/a

Median

Com

missions

Full-timeEmployeesOnly


28/28

About MKTMarket Knowledge Tools

This industry report is part of the Market Knowledge Tools

(MKT) program, an ongoing series of reports from SchwabInstitutional designed to keep investment advisors on the forefront

of trends and competitive challenges facing the industry today.

Offered exclusively to Schwab Institutionals valued clients, MKT

delivers the kind of relevant and timely information needed for

future business planning. Through the synthesis and presentation

of primary and secondary research, this program offers research

reports, seminars, workshops, white papers, and guides prepared

specifically with independent investment advisors in mind.

Moss Adams LLP is not affiliated with

Schwab. The information in thispublication is not intended to provide

specific compliance, regulatory, or legal

advice. Please consult a compliancespecialist with reference to your specific

circumstances.

Schwab Institutional is a divisionof Charles Schwab & Co., Inc.

(Schwab)

2003 Charles Schwab & Co., Inc.All rights reserved.

Member SIPC

Creating Compensation Plan

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