Financial Advisor Success Ep. 424

Executing A Successful Internal Succession Plan In The Private Equity Era Of Advisor M&A

Host: Michael Kitces
Guest: David Grau Jr., President of Succession Resource Group
Date: February 11, 2025

Main Theme & Purpose

Michael Kitces welcomes David Grau Jr., President of Succession Resource Group, to discuss the evolving landscape of succession planning for financial advisory firms, particularly the tension between internal succession strategies and the influx of private equity (PE) acquirers offering high deal multiples. The episode explores best practices for building sustainable internal succession plans, how founders and successors should prepare, and offers a nuanced look at PE deals—moving beyond headline valuations to the realities of terms, risks, and the value of legacy.

Key Discussion Points & Insights

1. The Evolution of Succession Planning (05:54–08:23)

• Succession planning cycles have shifted significantly: from lifestyle solo practices to ensemble firms, and now to more complex team-based organizations influenced by PE money.
• Firms are now growing to a scale where internal successors may struggle to afford them, but at the same time, PE aggregators have introduced a new set of choices and challenges.

“They usually end up being, you know, a little siloed at first. Eventually they'll shift gears and become more of an integrated ensemble … then they outgrow their successor’s ability to afford them.” – David Grau Jr. (05:54)

2. Understanding the Affordability Challenge (08:23–11:39)

• Historically, a practice selling for 2–2.5x revenue (or 7x earnings) was affordable if amortized over 7–10 years; successors balked less at the math and more at the size of personal risk.
• The main barrier is often risk aversion, not true unaffordability.

“What they really meant was ‘I just don’t want to take the risk of having a seven figure loan to buy a seven figure business.’…it was more of a risk tolerance issue than an actual ‘there’s no way to buy this’…” – Michael Kitces (08:23)

3. The Private Equity Effect (11:39–14:47)

• PE firms, with access to large pools of capital, pay higher multiples and can afford negative short-term cash flow for future rewards.
• But headline numbers hide complex (and sometimes onerous) terms regarding structure, tax outcomes, timelines, and contingent (future) payments.

“It isn’t the only thing in the top five… Even if it's number one, number two has got to be a close second is the terms. You've got the taxes, you've got the compensation, you've got the timeline…” – David Grau Jr. (12:30)

4. How PE Valuations Really Work (15:34–20:34)

• PE-backed deals often feature a low up-front cash payment (20–30%).
• The rest comes as stock in the acquiring firm, often valued at an inflated future multiple, plus significant earnout/contingent payments pegged to aggressive growth goals (15–20%+ per year).
• The actual “headline” valuation reported is seldom realized in cash.

“The only way you can make the values work that you’re seeing talked about out there with these outside aggregators and investors is to manipulate something else. And it generally is the terms.” – David Grau Jr. (12:30)

• On those deal terms:

  “The final... sometimes 20%... is kind of that earnout structure... where there’s growth targets... Relatively aggressive growth targets.” (18:25–20:34)

5. The Impact of PE Multiples on Internal Succession (22:14–25:18)

• High PE multiples create unrealistic expectations for internal succession candidates and founders, often derailing practical internal plans.
• Internal succession planning gives founders the chance to mentor, build legacy, and enjoy a steady transition—and can be financially comparable or better over time, especially across multiple tranches.

“It’s sabotaging a lot of firms’ ability to do internal succession planning by creating these unreasonable expectations…” – David Grau Jr. (22:14)

6. Adjusted Earnings in PE Deals (25:18–30:01)

• PE acquirers “normalize” (reduce) reported earnings by projecting required business investments post-acquisition—staffing, tech, compliance, etc.—shrinking the true EBITDA multiple being paid.
• Sellers often expect the buyer to adjust earnings up (removing owner perks), but PE buyers adjust them down for anticipated expenses.

“I’ve just never seen these firms do the normalization and have the profit figure go up. It always seems to go down…” – David Grau Jr. (28:31)

7. Economics of PE-Backed Acquisitions & Why They “Work” (30:55–34:13)

• By putting down low cash at closing and using stock/earnouts, PE firms leverage their money to acquire more firms, spread risk, and benefit from scale/synergies.
• The entire system is predicated on ongoing rapid growth—if growth stalls, payouts often don’t fully materialize for sellers.

8. Attrition as an Exit Strategy (38:18–44:36)

• Many advisors informally “retire through attrition,” gradually working less, retaining a shrinking book, and eventually selling what's left—often netting strong lifetime value.
• Founders can proactively “prune” books by selling C/D clients to newer advisors (who see them as ‘A’ clients), creating win-wins.

“Retirement through attrition is the leading exit strategy for an industry full of professional planners. And it kills me, it hurts my heart.” – David Grau Jr. (40:41)

9. Who Should Choose an Internal Succession (45:13–47:21)

• Ideal for founders who want to develop and reward their team, preserve legacy, ensure continuity of client service, and potentially remain involved longer.
• Internal succession planning requires deliberate early planning—with defined job tracks, compensation models, and gradually increasing equity opportunities (phantom/shared/equity tranches).

10. Mechanics of Internal Succession Planning (48:44–58:06)

• Career Tracks: Formalize job descriptions/pay bands to enable predictable paths to partnership.
• First Tranches: Successors buy in at 1–5% (sometimes 10%), often company or seller-financed at first, then larger tranches with bank financing.
• Timeline: Full transition may take 7–10+ years via multiple tranches, with both founder and successors benefiting from firm growth between transactions.

“We have to approach these things—succession planning—as a series of events. I mean, frankly, almost as a mindset. It’s not a singular transaction…” – David Grau Jr. (55:14)

11. Valuing Internal Successions (58:06–69:12)

• Valuation Process: Get third-party formal valuations early and regularly.
• Discounts: Minority stakes usually get a 10–30% discount for lack of marketability/control, unless seller/company-financed (then likely not applied).
• Multiples: Internal deals typically transact at 6–12x EBITDA (average ~9x), depending on growth, team, scalability, and firm health.

“Internal succession should always be focused on earnings … buying in, the way that I’m going to service this debt is from the profitability that I will hopefully be receiving.” – David Grau Jr. (65:21)

12. Protecting Buyers & Practical Structures (70:09–73:32)

• Stretch notes tie successor payments to a % of distributed profits, buffering buyers in downturns.
• Bank financing increasingly common for larger tranches; banks require founder/company guarantees, ensuring continued operational and financial discipline.

13. What Makes Firms Attractive to Buyers (including PE) (67:08–69:12)

• Strong growth (>10–12%), scalable team, and investments in technology/process result in premium multiples—these factors benefit both internal and external exits.
• Founders who invest in business building, even if internal succession fails, net higher values from external buyers due to organizational maturity.

Notable Quotes & Memorable Moments

• On PE Terms & Valuations:

  "You are literally giving me the next 14 years of income… but once the adjustment is done, you’re not delivering to me a duffel bag full of cash…”
  – David Grau Jr. (17:48)

• On Internal Succession Mindset:

  “It’s more of an emphasis on the planning part of succession planning, as opposed to a singular transaction.”
  – David Grau Jr. (53:49)

• On Advising Successors:

  “For the successor—know you’re not ready. For the founder—know that they will never be ready! None of us are ready until we do it.”
  – David Grau Jr. (86:16)

• On Founders Deciding Not to Succession-Plan:

  "If you made the decision of how you want to exit purely based on financial motives as an Advisor listening. You should just work less each year, retire through attrition and ride this thing into the ground."
  – David Grau Jr. (38:18)

• On Timing:

  “If I’m hoping to exit in my early 60s and I’m not already starting the process in my early 40s, I may be behind.”
  – Michael Kitces (84:00)

Segment Timestamps

• [05:54] Succession planning cycles and the PE effect
• [08:23] Why affordability is more about risk tolerance
• [12:30] Headline PE multiples vs. the true deal terms
• [15:34] How typical PE-backed deal splits actually work
• [20:54] Growth expectations and their impact on contingency payments
• [25:37] The mechanics of “normalized" or adjusted earnings in PE deals
• [30:55] Why these high-multiple deals don’t blow up for PE acquirers
• [38:18] The “retire through attrition" phenomenon
• [45:13] The archetype of advisors who pursue internal successions
• [48:44] Practical steps for preparing an internal succession plan
• [58:06] How to value and structure internal equity tranches
• [65:21] Comparison of internal vs. external deal valuation metrics
• [70:09] Ways successors can protect themselves in early tranches
• [84:00] Backward-calculating the real timeline: why you need to start internal succession early
• [86:16] Advice for successors: "You're never ready, but be a sponge and work hard."

Takeaways & Action Steps

• Start Early: Begin succession planning and owner-track development at least 10–15 years ahead of your target exit.
• Valuation is Key: Obtain third-party valuations before any equity transactions; track value drivers and detractors as you go.
• Iterative Tranches: Structure internal successions as a series of gradual buy-ins (tranches), not a single transaction.
• Transparency for Successors: Offer clear job tracks and compensation models; introduce phantom equity before real equity.
• Don’t be Lured by Headlines: PE multiples may overstate realized value; examine terms and contingencies rigorously.

Closing Reflection

David Grau Jr. underscores that internal succession is both more challenging and more rewarding than most founders expect—offering the potential for greater total value, legacy, and satisfaction, if planned early and executed iteratively. The “easy button” of PE or attrition exists, but internal succession preserves continuity and culture in a way that's hard to value, but easy to regret losing if neglected.

For more podcast episodes and resources: www.kitces.com