Referral Agreements and Joint Ventures - Business Management for Financial Advisers

Financial advisers love joint ventures and referral agreements. They perceive them as low-cost, low-risk ways to expand their business. But by definition, joint ventures and referral agreements are designed to be short-lived: either they work extraordinarily well, and the larger advisory firm, CPA firm, or bank swallows the smaller advisory firm up whole, or they fail abysmally.

Joint ventures and referral agreements should not be confused with building one’s referral network or developing informal alliances. In a referral agreement, whether it’s a formal joint venture or not, two parties formally combine their strengths to shore up each other’s weaknesses and systematically capture more business.

A CPA firm, for example, may want a referral agreement with a financial-advisory firm so that it can deliver financial advice to its clients; or a financial adviser may seek a joint venture with a law firm to make legal advice and document preparation readily available to its clients. Usually one of the entities generates new business and the other provides expert services. Ideally the parties to the agreement would bring both strengths to the table, but that’s rarely the case.

The referral-agreement model works best when both parties share in the risk and return, have an explicit commitment to each other to support the initiative, and have a clear vision of what they’re trying to accomplish with the model. These arrangements fail when the relationship becomes one-sided, when success is measured simply in terms of short-term financial results, or when there is no clear strategic framework for why the agreement should work.

As with any new strategy, when considering a referral agreement, you must first clarify how this method of sale will build on the strengths of each firm, differentiate your firm from those competing for the same type of clients, be responsive to a specific market, and match your definition of success. For example, you may be an adviser specializing in very high-net-worth individuals with complex financial needs, especially in the tax management and estate-planning areas.

To further extend your brand and deepen your relationship with clients, you might align with an accounting firm or a law firm that has that expertise and make those services part of your core offering to your clients. The challenge for you is to define what your firm is offering and distinguish it from what’s offered by every other firm in your market, including accounting or law firms.

Can you package these strengths in a way that makes their delivery more cost effective, or efficient, or integrated than what’s currently available in the market? Is the proposition a compelling one for your target clients? Can you realistically project business through such an affiliation? And is the agreement the most effective way to allocate your resources?Once you’re clear about the type of client you’re going to pursue and serve through the referral agreement, you’ll need to define the functions each party will perform and determine who is accountable for each one.

This requires being clear about the protocols for how clients will be handled throughout—from introduction, to intake, to document collection, to providing the service, to billing and collecting the fees. Who will be accountable for each step? What will the final product or service look like? How will you ensure quality control? How will you report back to the other parties on what is happening with specific clients? How will you resolve conflicts? How will you distribute the proceeds?

In joint ventures and referral agreements each side of the relationship should also have someone whose mission is to manage that relationship. Each party essentially becomes the other’s client, and the relationship cannot be taken lightly. Some structured approach to communication must be in place, as well as a process for regularly examining what’s working and what isn’t. Be clear about the measurable objectives.

How will you define success? Will it be the acquisition of new clients? Greater profitability? Greater share of wallet? As you lay out the plan, it will become easier to develop a financial model that can help you evaluate whether a referral agreement is a logical business decision. For example, to increase assets and attract more clients, many advisers make the mistake of overpaying for referrals they receive from other professionals.

That’s why it’s essential to understand the economics of your own business. One adviser, for example, asked us to provide guidelines on the compensation structure for a joint venture he planned to set up with a CPA firm. The plan called for the CPA firm to refer its clients to the advisory firm through a joint venture, which would expand the adviser’s offering and bring in incremental revenue.

According to the accountant, the rule of thumb for the industry was a 25 percent payout on all revenues in perpetuity. Like all rules of thumb, this one took on a life of its own—whether or not it was logical or in the best interest of the firm providing the professional services.

We tried to help this adviser understand that a referral fee is part of direct expense, not part of overhead—in other words, a cost of goods sold. We believe that advisory firms should try to keep their direct expenses at around 40 percent, and they will need to pay for referrals or joint venture fees out of this amount. Direct sales and professional service outside of the joint venture or referral agreement are also direct expenses.

So if, as in this example, an adviser pays 25 percent of total revenue from a client to the joint venture partner in perpetuity, that leaves only 15 percent to pay for the analysis, consulting, and implementation of the client’s plan. This may be acceptable the first year, but it certainly is not acceptable in subsequent years because eventually the client bonds with the adviser and puts more demands on the firm.

The “salesperson” provides only the introduction, not the ongoing services that give rise to all the future costs. If the referral source requires some sort of trailing fee to provide legitimate leads, then the advisory firm needs to limit the payout to an amount it can afford. It’s hard to justify more than a 10 percent ongoing trail (perhaps with 20–25 percent up front); in fact, 5 percent may be more appropriate and ideally for three to five years, not into perpetuity.

If you pay a high referral fee in perpetuity, eventually you will have to ask if it’s prudent to try to build your business around the low value clients these referrals become. Imagine the dilemma.

Do you return the calls from the full-fee clients first or the calls from the clients for whom you’ve discounted your fees under the referral agreement? Do you provide the same degree of service to clients from the joint relationship? Which clients are you most concerned about losing? At some point, as your firm reaches capacity, you might, in fact, hope to lose some of those clients, because the “haircut” on them is so much larger than on clients you attracted through other means. Ultimately that outcome is not in the bestinterests of the client or the venture.

In many cases, for the same amount of effort, advisers could get high-value clients and not have to add overhead to support lower-margin business. The only exception to this is if they use the “unique sales method” strategy, in which most of their business comes from such a conduit. That way, they have a low-cost, efficient means of serving and supporting those clients. In other words, they build a service-delivery model around the economics of the relationship.

If your firm is using a joint venture or referral agreement to generate incremental business and that agreement is not integral to your firm’s overall vision and strategy, the arrangement is probably not a good idea. Eventually you’ll find that managing the relationship siphons off your time and you risk acquiring less-valuable business.

Over time, that type of model will seriously erode your margins and your interests. Joint ventures and referral agreements can work, but only if the business purpose, the economics, and the commitment are right for your business.


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