More RIA buyers are offering equity. Here's what sellers should know

When financial advisors sell a registered investment advisory firm, they are increasingly likely to change from the majority owner of their business into a shareholder of the buying company.

Equity swaps comprise a growing share of the purchase price mix in wealth management transactions, alongside that popular and eye-popping asset — cash — and contingency payments. Amid the continuing industry consolidation, several hundreds of RIAs and other wealth management firms change hands each year. The offers of equity in the buying firm shock some sellers, who may be caught off guard by the notion of receiving 10% to 20% of the deal price in the form of stock in the acquiring company, according to Mark Wilhelm, a partner at the Troutman Pepper Hamilton Sanders law firm who advises companies in M&A deals. 

The incoming equity poses tax implications for many advisory practice sellers, as well as a profound shift from running their own small business to having to understand various classes of equity and the voting rights associated with them, Wilhelm noted in an interview.

READ MORE: 25 tax tips for RIA M&A deals and other small business sales 

Although some buyers view their shares as "sacred" and don't provide any equity, others see offering equity as a requirement since it's a method of "making it cheaper to do the deal" in a time of high interest rates and a means to keep the seller literally "invested in the business" for the future, he said. If they take equity in the buying firm, the sellers often morph from a limited liability corporation established by a three- to five-page document into a private equity-backed agreement running 120 pages or more, according to Wilhelm.

"They've been used to for years and years and years being the sole owners" at firms where "whatever they say goes," he said. "A lot of that comes as a surprise to people selling their business who have typically experienced relatively simple structures."

The higher cost of financing due to current interest rates has prompted buyers to move "away from the cash-heavy, high-certainty deal structures that defined 2019-2021" to a time of "shared risk and upside" and a greater portion of equity consideration, according to the latest annual "RIA Deal Room" report by management consulting and transaction advisory firm Advisor Growth Strategies. While "cash remained a popular tool to de-risk potential sellers" last year, the buyers deployed liquid assets "more discerningly in 2023," the report said. 

The average percentage of equity offered in deals made by a group of acquirers surveyed by the firm has climbed by 10 percentage points to 31% in the past three years, while the level of cash has dropped to 64% from 77%.

"Deal-structuring has shifted in the aggregate to focus more on partnership mentalities — meaningful cash combined with sharing risk and upside through equity consideration," according to the report. 

READ MORE: 7 insider RIA M&A trends, from mini-mega to equity-culture revolution

"Down payments, retention consideration, equity and earnouts or earn-more incentives are the headline-grabbing metrics," it continued. "Transaction consideration and structure are critical because a seller-specific market is forming that includes what a current majority ownership group negotiates with the next generation to encourage retention and upside in a transaction. This trend is only becoming more acute as selling firms reconcile the present with the future in a transaction. The topic of next-generation incentives in a transaction serves as a warning to RIAs that fail to consider long-term incentives. Plan now or pay later."

In terms of taxes, that lower share amount of incoming cash could slash part of the hit from Uncle Sam. However, the sellers may get the equity from the buyer in the form of "a taxable rollover" that provides cash that they use to buy the shares, Wilhelm noted. Sellers tend to choose that type of transaction when Congress or a presidential administration is pushing for new policies that could bring higher taxes in future years than under the current rules, he said.

The other option is a tax-deferred rollover with a structure resembling a 1031 exchange — a deal in which the parties swap similar assets using criteria that are subject to IRS regulations about "like-kind" transactions. That process gets much more complicated in RIA transactions because, technically speaking, the advisory practice is usually selling its assets to the buyer's holding company rather than spinning off its equity to the acquiring firm. In that case, the deal agreements must translate the assets in the selling firm into equity from the underlying operating business of the seller.

"You don't pay taxes on it until some event down the road," Wilhelm said. "The question is, how do you reflect that in your legal documents in order to get to that desired outcome under the current tax laws?"

READ MORE: Recruiting case highlights perils of equity deals

For prospective sellers, the tax- and business-related impacts of equity swaps illustrate why it's important to have an auction process that gives them an opportunity to be "talking to a bunch of different buyers" about the deal structure, he added. That means, if they hope to defer some of the taxes, asking potential buyers "about whether that's something that's available is a good thing," Wilhelm said. By the same token, the potential sellers can examine their own RIA.

"What I would suggest is that they talk to an accountant beforehand to make sure that whatever entity structure they have right now will accommodate that," he said.