Synthetic Equity Is Getting a Real Look From RIAs

Justin Nichols, managing principal at CGN Advisors in Manhattan, Kan., and his two partners were looking for ways last year to give employees access to the firm’s growth without the “complexities” of making them owners or asking them to pony up what would be steep buy-ins.
With the help of a consultant, they decided to set up a program to provide so-called “synthetic” or “phantom” equity, in which employees are guaranteed a share of the firm’s growth at a future date or around a triggering event, such as a sale of the firm, a founder leaving or the firm merging with another RIA. Similar to a deferred compensation program, such as when publicly traded companies issue restricted shares, the setup can also provide a pathway for a younger advisor to eventually put accrued equity toward purchasing a stake in the firm.
“We have a bunch of great employees, and we really want to retain them,” Nichols said. “This was another tool in the toolkit to retain and even attract talent in the long term.”
According to Nichols, the competition for RIA talent in Manhattan, Kan., is no joke. The firm of 16 people with about $1.6 billion in client assets is located about 45 minutes from Overland Park, Kan., home to mega-RIAs including Creative Planning and Mariner.
David Grau, CEO and founder of Succession Resource Group, worked with CGN on the program. The succession consultant said he has been advising on synthetic equity structures for larger RIA firms for years but that it has more recently moved downstream to smaller RIAs.
“Now, we’re working with five and 10-person teams, and they’re doing phantom equity,” he said. “They’re contemplating these equity structures that, 10 years ago, would have made their eyes roll into the backs of their heads.”
Grau said the landscape has shifted to a place where advisors understand there is value in their firms that they can sell. However, giving ownership stakes, and often voting rights, is not always a fit, particularly if the owners don’t feel ready to cede those things to younger advisors. He said it can also go the other direction, by which a younger advisor doesn’t feel ready to put up a large share of cash to buy in but wants that opportunity in the future.
“Talk about your quintessential golden handcuffs,” Grau said. “In an industry where we are all fighting to attract and retain great young talent, you can build a phantom equity plan where they can start to accrue $10,000, $20,000 or $30,000 worth of an equity balance.”
The owners can also set the vesting schedule for the equity, meaning it can be flexible in terms of how long it will be illiquid for employees and when it will become a liquid asset. There are also clauses for payouts should an RIA sell to a private equity firm or some other triggering event occur.
To be fair, Grau and other consultants are interested in these setups as well because they are complicated and require guidance. However, other consultancies reiterated that they have seen growth in interest and uptake for these types of deferred ownership programs as the RIA market has matured and continues to see waves of capital driving competition for talent.
Eric Leeper, CFO and principal with consultancy FP Transitions, said synthetic equity is still in its “relative infancy.” However, it is increasingly being used to solve RIA compensation structures that have historically been based on “eat what you kill,” where the advisor is often responsible for business development and serving clients.
Today, Leeper sees two factors changing the efficacy of that model. One is that larger RIAs are running more like businesses—with advisors still wanting to be compensated well for their work—and new advisors, on the other hand, prioritizing financial planning and working with clients over business development.
“There’s a major issue that the industry has with the division of the role of the advisor being a planner and the advisor being a salesperson,” he said.
Advisories must set up structures such as bonuses or deferred compensation to move away from the “eat what you kill” model. The synthetic equity model can provide a middle ground while both owners and advisors prepare for real ownership.
“You have an issue of affordability for next-generation talent at the company,” Leeper said. “This is where we really started to lean into synthetic equity.”
Leeper said that equity is almost always based on a percentage. For example, a contract might offer 5% of company profits so long as the advisor is a member of the firm in good standing.
To design the equity, however, a firm may target a capital value of, for instance, $100,000 five years out and calculate the percentage that would most likely get them to that amount.
Leeper also noted the employees could gain a tax advantage from the setup, as synthetic equity is not taxed on issuance as company stock or capital ownership would be.
The model, however, does come with some complexity. Synthetic equity structures are regulated under the Internal Revenue Service’s 409A, or nonqualified deferred compensation, which requires specific plan documentation and compliance oversight.
On the positive side, Leeper noted, it does not show up as a “contingent liability” on the balance sheet of the issuing firm, as it would if it were a defined benefit or guaranteed payout. That can be particularly attractive for a firm that, at some point, may be looking to sell and wants to show buyers a strong bottom line.
Brandon Kawal, partner with Advisor Growth Strategies, said his firm has worked with about 24 clients on synthetic equity programs over the past year. He ties the current interest in the structure partly to the aggregators backed by private equity money going after advisor talent at independent RIAs.
“Compensation, and then ways of getting people equitized, has gone way up in importance (for RIAs) because you have these team members that you suspect—and are probably right—are being solicited to leave for higher money,” he said. “Somebody is always going to be willing to pay more, so what else can you do to make it super attractive.”
Given the current market, RIA founders may see synthetic equity as a “bridge strategy” for owners that gives team members access to the firm’s growth upside, Kawal said. When the time for succession comes, those employees will have stakes built up.
He also noted that the synthetic equity offering could attract non-advisor employees as the RIA industry seeks to bring in talent in other areas, such as tax, estate or legal expertise.
Meanwhile, the setup will require outside experts as well.
“There’s going to be a cost to it, so you have to have a lot of conviction around the ‘why,’” Kawal said.
For RIA owner Nichols in Manhattan, Kan., the synthetic equity conversation also pushed other general ownership conversations ahead. It led, in part, to the team moving ahead with actual ownership for some employees and making the synthetic equity structure part of its future strategy.
“We really want to make this (phantom equity) option part of the story when we are hiring and when we are recruiting,” Nichols said. “We want people to understand this can be a pretty nice that they can participate in the growth and ultimately the value of the firm.”
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