Q160 – How Do I Repay A Forgivable Loan To Move To The RIA Model?

…

Also available as podcast (Episode #160)

Apple  |  Android  |  Spotify  |  Amazon  |  Audible

How Do I Repay A Forgivable Loan To Move To The RIA Model?

TL;DR – When an advisor is recruited to a wirehouse (or similar type broker/dealer) an “upfront check” is generally involved. These are often referred to as “forgivable loans.” While seemingly lucrative, there are, of course, always strings attached. If circumstances warrant the advisor leaving that firm before the forgivable period ends, there is an expectation that some of that upfront check must be repaid. In this episode of the Transition To RIA question & answer series, I explain logistically what occurs with such upfront checks, and how repayment generally occurs.

Host:

Brad Wales founded Transition To RIA in 2020 after nearly 20 years of prior industry experience, including direct RIA related roles in Compliance, Finance and Business Development. He has an MBA and has held the 4, 7, 24, 63 & 65 licenses. He has been quoted or featured in 100+ industry articles including in the Wall Street Journal, Barron’s, and most every other major industry publication. He is well known for his RIA video explanatory series, and Kitces named his podcast as a “Top Podcast for Financial Advisors.”

Found This Video Helpful?

Want to understand what a transition to the RIA model would look like for your practice?  Schedule a Discovery call to learn more.

While You’re Here

Consider also downloading the FREE WHITEPAPER: “Steps To Take Now If You Anticipate Transitioning Your Practice To The RIA Model Anytime Within The Next 10 Years.”

Full Transcription Of Video:

How do I repay a forgivable loan to move to the RIA model? That is today’s question on the Transition To RIA question and answer series. It is episode #160.

Hi, I’m Brad Wales with Transition To RIA where we help you understand everything there is to know about why and how to transition your practice to the RIA model.

If you’re not already there, head to TransitionToRIA.com where you’ll find this entire series in video format, podcast format. There are articles, there are whitepapers. There’s a Vendor Profile Series. All kinds of things to help you better understand the model.

Again, TransitionToRIA.com.

On today’s episode, we’re talking about something that often comes up with, particularly wirehouse, advisors that have an outstanding forgivable loan. And how that often has advisors thinking it would prevent them from making a transition.

So, the question is are there any options for that that can be considered? That’s what we’re going to get into on this episode.

For starters, let’s define what a forgivable loan is to make sure we’re all talking about the same thing.

These are sometimes also referred to as loan-bonuses. Or you’ll hear them called an upfront bonus, or an upfront check, a transition check.

In its most basic form, let’s say an advisor has historically been at one wirehouse and they at some point have moved to another wirehouse, and as part of that they’ve received some large upfront “check” for doing that. That check is typically what’s essentially being referred to as a forgivable loan scenario.

In that example, that advisor, that team that has received that check has committed to stay at that firm for a period of time. You’re in theory locked in place and you can’t make a move prior to that.

But keep in mind functionally what is happening.

With most of those upfront checks you receive the cash on day one – or however administratively quickly they can get it to you. And you now might be committing to an 8, 9, 10 year, I’ve even seen longer, commitment period.

And in part because these checks keep getting bigger, there are often back-end components to these checks as well.

As the recipient, you receive the cash outlay perhaps on day one. But your tax obligation is spread out over the life of the commitment period, so you actually have essentially phantom income that you get W2‘d on over the lifetime of the period.

For the wirehouse itself, while they have to come up with the cash on the front end from a cash flow perspective to give you that cash, they expense it themselves over all those years. The reason is because functionally what is happening is on day one they are loaning you that money.

Let’s use an example with simple numbers. Oftentimes these numbers can get much bigger, but let’s use very simple numbers.

Consider if the wirehouse has given you one million dollars for joining them. That is the “upfront check.” That million dollars goes in your pocket and is not taxed on day one, and is not fully taxed in year one.

The reason is because technically they’ve loaned you that money, and a loan is not a taxable event. If you go borrow money from somewhere, that alone does not create income.

So, now you have this one million dollars. And let’s assume the arrangement came with a 10-year commitment period.

What happens each year is you’re repaying that loan. This is often done on a quarterly basis. But the wirehouse says to you… “If you are still with our firm – back years ago there were more nuances to it, it’s a little more simplified nowadays – but if you are still at our firm when each of those quarterly loan payments are due, we’re going to give you a bonus that just so happens to match the principal payment on the loan, and then there is a de minimis amount of interest typically associated with these as well. We’re going to give you that bonus payment which balances out the loan payment.”

From a cash flow perspective, there’s not really any money moving at that point because, in essence, you would be paying a loan, but at the same time, they’re giving you a bonus, and so it essentially washes out.

Now, what it does mean for you is that’s where that phantom income comes from because you are receiving those “bonuses” during those periods. They report that as income to you on your W2 at the end of the year.

Hence you will pay tax on the one million dollars, but it’s spread out over time because you’re taxed on those bonus payments as they occur over time and as that loan is paid down.

Now, the reason I go into all that is to understand what happens if you leave before you’ve reached, again in this example, that 10-year point.

Let’s say we’re exactly halfway through and so you’re five years into it. If you were to leave, that outstanding loan obligation still sits there. And that is a loan that you took and that you’ve already received, and that money needs to be paid back.

However, because you’re leaving their firm, you are no longer going to get the bonus payments going forward that were offsetting those loan payments.

At that point, the outstanding loan balance is the dollar amount that you still owe back. Which you’re not really “owing it back,” it’s just you still have a loan balance to pay.

If you kept the original upfront money in your pocket, obviously you just pay the remaining amount back. Or if you’ve already used the money for other means, you must come up with some way to pay that loan back.

So, just from a semantic standpoint, understand what’s occurring. If you leave before the end of the period, in most of these circumstances, you’re just repaying the outstanding loan balance.

With that backstory, I want to get into some semantics of it and then also ways to potentially pay it back.

First, and this is an important one, they will want that money back.

There are almost no circumstance where they are just going to forget about it, or not remember to follow up with you, or just say… “Wow, you’ve been a great advisor to us, or a great person, or a great team player, we’re just going to let it go.”

No, if there’s a balance they are going to want their money back.

Now to extend on that, and it doesn’t happen too often, but every so often you’ll see some industry article out there, a news article about some advisor, some team that is attempting to fight their old firm and not pay it back.

The argument they usually try to make is that when they were given the loan initially, promises were made about what would happen if they joined the firm. That might involve resources promised, that might be support, that might be optionality of ways to work with clients.

And now, after the fact, the advisor alleges those promises weren’t fulfilled, or those promises weren’t kept. And so as a result, and the argument usually goes, they damaged their practice.

And often, they not only argue they shouldn’t have to pay the remaining loan balance, they countersue to try to get even more money essentially back.

In almost every instance, those do not work out.

I’m sure there have been some very unique circumstances where perhaps an advisor team prevailed. So I don’t want to say in absolute terms that it never works out, but realistically speaking, if you’re thinking… “I can get out of repaying this money by complaining about promises not being kept,” that generally does not work out.

That’s also a big reason I think it’s crazy that advisors and teams join firms that essentially put themselves in this 10-year, let alone 11, 12, 13, 14, 15 year environment, where are promises that were made to you when they promised you this check, are they going to be delivered, let alone maintained over the entire 10-year period or 15-year period?

As an example, assume you take a check with a 10-year commitment. As part of your initial due diligence on that firm before you made the move, you looked into what the economics were, what the payout was, and how that would look for your practice.

Well, guess what? There’s no commitment that they won’t change the payout over the 10-year period, let alone say a 15-year period.

You’re taking some check, you’re committing yourself to this 10-year period, and you have no idea if they’re going to change the payout three years from now.

Or perhaps you’re joining because you really like the branch manager. Well, who’s to say how long that branch manager sticks around? Are they going to stick around all 10 years or 15 years?

I think it’s crazy when advisors, teams are taking these huge checks for these long commitment periods and somehow assume that not only are all the promises that were made to them going to be maintained, but that things aren’t going to perhaps negatively change for them over such a long period of time.

You’re basically stuck. If they change the payout, you can complain about it all you want. You can say that’s not what it was when I agreed to join. Well, your only recourse is to leave.

Now, there are maybe reasons you should be leaving, and maybe that’s one of the reasons you should be leaving. But short of you leaving, you’re generally going to be stuck with whatever changes come your way.

I could keep lamenting about that and ranting about that, but I don’t want to go too far down that path.

Just be aware, they are going to want their money back, and in almost every circumstance, you are going to owe it back. Again, not the full amount, not what you were paid up front, just whatever the remaining balance is as of the time you leave.

Next, they typically will want that money back quickly.

It’s not to say they want it back within two hours of you leaving. Sure, they would I guess they would want it back that quick, but realistically speaking they realize that’s not going to happen.

But this is not some exercise where you can get it to them within six months of leaving. They are going to want their money back in a relatively short period of time.

Typically, you should have already mapped out your plan for this. And oftentimes, as you’re departing, you even proactively point out to them how and when you intend on paying this money back. But they are going to want it in a relatively short period time.

And it’s not to say that they won’t be at least somewhat flexible, because even though they won’t necessarily be happy you’re leaving, and perhaps they feel you have non-solicits – that’s a whole different issue – but at the end of the day, they just want their money.

So if you said… “I can’t come up with it within 48 hours because I need to get it from the bank, but I can come up within seven days,” they’ll usually accommodate that.

Usually they’ll be realistic because again, at the end of the day, they just want their money and it’s not worth battling for them. But they’re not going to have patience if you try to ask for six months to pay it back.

Related, I’ve done an episode on when you need legal advice when making a transition. This is a perfect example where you will want legal advice if you have any sort of outstanding loan bonus arrangement.

Even if you feel you understand the terms, feel you understand what the implications could be if leave-in, feel you know what the process would be, there are specialty attorneys that this is what they do, help advisors make these sorts of transitions.

Some of them assist with hundreds of transitions a year. They know what the expectations are of your particular firm. Are they going to want it within seven days or 30 days, or how much of a timeline might you have?

It is an important step to get that legal advice. I can give you referrals for that. But you will want to get that buttoned up.

With that overview, then the question is: I know I need to repay it. So, how to repay it?

There are a couple of potential sources of funding for that.

First, from your own savings.

Hopefully you’ve kept some of the upfront money that you were given. Or you have some other means of liquidity, whether you have cash on hand or you could take a home equity loan perhaps.

So obviously your own liquidity, your own cash to pay it back is certainly one source of funding.

Next, if you’ve followed my episodes, there are multiple different pathways into the model. You should explore all pathways. Some of you might ultimately start your own RIA. Some of you will end up joining an RIA. And as I talk about often, there’s all different kinds of flavors of RIAs to join, so don’t have any preconceptions about what that entails.

In some of the cases where you’re joining an RIA, part of that is they can provide you with some, often referred to as “transition assistance,” which is some upfront money.

To set expectations, though, some RIAs don’t do any of that. You might wonder, well, how could they get away with not doing any? It’s because the economics they pass along to you going forward are so good, it literally doesn’t allow them to give you money just for joining them. And so in aggregate, that could still be more advantageous for you.

But of the ones that do give some money, just know it is very nominal compared to these crazy big numbers you hear from moving from one wirehouse to another wirehouse. So, to set expectations, it’s not going to be anywhere near those numbers.

Now, the trade-off is, and for all the reasons I talk about so often in these episodes, the benefits of being in the RIA model, the benefits of being in an independent model, and the benefits of maybe being at a particular RIA are oftentimes so much more advantageous that it makes up for foregoing some big check.

Not to disparage anyone, but if you go from one wirehouse to another wirehouse, you’ll generally get that big check. But are you gaining the flexibility and the better lifetime economics?

You can’t factor just the one-time check that you get. Instead look at the aggregate economics over the balance of your career. Typically it is always going to be better in the RIA space, both from current day income and then when you eventually sell your practice. You want to factor all of that in.

And oftentimes it makes sense even when receiving nothing upfront to join an RIA. The aggregate number is superior.

But of the ones that do give you some money, again, that’s another source of where it can perhaps be used to come up with funds to repay your outstanding balance.

Now, for those of you that end up starting your own RIA, one of the steps involved in that is to select a custodian to use. I’ve done several episodes on that. That’s a big part of my value proposition is helping you know which custodians are available to you, which are going to be a good fit for your practice, why you might choose one over the other.

Some, but not all, custodians will offer, depending on the size of your practice – I can help you understand expectations – will offer what they often refer to as “client benefits.” Where you, the RIA, are the client of theirs.

They say… “If you come use us as custodian, we will give you this amount of client benefit dollar amount to use as part of the transition.:

The reason I bring that up is: 1) Just so you’re aware that is something that happens; 2) That those client benefit dollars typically can only be spent on certain things like technology, and other hard costs of running the practice.

It is real money that you can use to invest in your business to offset costs you would otherwise have. But typically those funds will not just be given to you in cash where you could then use it to repay your forgivable loan balance.

So, just to set expectations, that capital might be part of the equation, but typically it’s not able to be used to repay a loan. So just something to be aware of.

Then the final source of funds I would note, and this is not necessarily every imaginable source, but there are specialty third-party lenders in the marketplace that specialize in this business.

They do loans to advisors for all kinds of purposes, whether it’s acquisitions or internal successions, all different kinds of things. A few of them will also offer to help with repaying outstanding forgivable loans.

What they will do is they’re essentially making a calculated bet. They look at your practice now, let’s say you’re at a wirehouse, and they will say, we expect from our due diligence, it’s reasonable that you’re going to move X amount of that over to your new location.

Now, for those that are not aware, these type of loans from these type of lenders, they generally use the cash flows of the practice as the collateral. So they’re basically making a calculated bet that they anticipate you to move at least X percent of your practice, and that going to generate at least this amount of cash flows, and so we are comfortable loaning you money (with the understanding you are going to use the funds to repay the forgivable loan balance.)

And so, as you can imagine, they must be conservative in how much they’re willing to lend, because they need to protect themselves because there’s some moving parts there. But just know that that option is potentially available to you to explore as well.

I’ll next leave you with two final thoughts.

Even with some of these options to repay it, even with all the reasons you perhaps should be making a transition, I still hear advisors say things like… “I only have two years, or perhaps three years left on my note. I’m just going to ride that out and then I’ll be free and clear and I don’t have to worry about repaying anything and then I’ll make the move.”

I understand that from a purely psychological standpoint where that can be appealing because the thought of having to repay money is not always something that gets you excited.

But I always say… “Let’s run the math.”

Let me give very basic numbers. I’m just making these numbers up, they are often much larger. But imagine if you had two years left on a forgivable loan, and each year you essentially still had $50,000 per year to pay back. That’s very simplified, because there’s interest, so it wouldn’t be exactly $50,000 each year. But for the sake of this argument, let’s say it’s give or take 50,000 each year.

If you were to leave at that two-year still-to-go mark, again, hypothetically, simple numbers, you have to pay back $100,000. And that’s painful to have to dig in your pocket to pay back $100,000.

But let’s say we run the numbers if you moved into the RIA model, and we map out realistically how much of your practice is going to move over, how long is that going to take, and then based on how you set up your practice, the devil’s in the details, but generally you’re always going to be better in the RIA model.

Now, quick sidebar, there’s no free lunch. Yes, the economics are generally always better, as is the flexibility with your practice, but there’s generally more responsibilities as well. That’s a whole different topic. I’ve done episodes on that, but I do want to at least acknowledge that. But the economics generally are better.

Back to our example, let’s say, again, simple numbers, that you would owe back $100,000 over the balance of that two years. And so you might think about sticking around at your current firm so you don’t have to do that.

Well, what happens if you mapped it out, and even after factoring in the delay in getting client accounts moved over, the delay in getting everything turned back on, but over that two years, let’s say because of those better economics, an extra $200,000 in income went into your pocket.

Well, yes, it’s not fun to pay $100,000 back, but if you make the move and can make an extra $200,000 over the same time period, you can do that math. You are going to be better off, even if you have to take half of that $200,000 to pay back you prior firm.

You just have to get over the mental aspect of having to “pay it back” because the economics are generally going to be better and you’re going to put more money in your pocket in aggregate if you just get on with it and make the move to the RIA space.

And then the second point I’ll leave you with, it’s worth understanding how this works. What would you owe back? How does that work from a legal perspective? How would the math look if you made the move to the RIA space?

Economics is just one of the things you need to understand as to whether the RIA model is a good fit for your practice. That’s a huge part of what I hope advisors and teams is understand all the benefits, all the advantages, but also all the responsibilities. I’m happy to have that conversation with you as well.

But you should at least run the math. Don’t just throw your hands up in the air and say… “I’ll just come back to this years later when my note is fully forgiven.”

There might be reasons to wait a couple years. There are a lot of different variables involved here. But it might make sense to get on with it and to make the move sooner than later. You must take the time to run those numbers. I’m happy to help you think all of that through.

Like I said at the top, my name is Brad Wales with Transition To RIA. Having these types of conversations is something I do with advisors all day long. I’m happy to have that conversation with you as well.

First things first, head to the website at TransitionToRIA.com where you’ll find this entire series in video format, podcast format. There are articles, there are whitepapers. There’s a Vendor Profile Series.

At the top of every page is a Contact link. Click on that and you can instantly and easily schedule time to have a one-on-one conversation with me, whether you want to talk about today’s topic or anything else RIA related. I’m happy to have that conversation with you.

Again, TransitionToRIA.com.

And with that, I hope you found value in today’s episode, and I’ll see you on the next one.

Want To Learn More?

Schedule a Discovery call and lets begin a conversation.