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forthcoming, key players (and the best move fastest) tend to vote with their
feet, making new combinations with like-minded individuals or firms when
differences become too severe or too prolonged.
Professional services firms range in size from the sole practitioner to the
multinational megafirm. Resources on managing the business abound for en-
trepreneurs and for the largest firms in virtually every profession but not for
the mid-size firm. Therefore, we have chosen to focus our attention on mid-
size firms employing multiple professionals in, or with near-term expecta-
tions of, ownership and (potentially) a more junior group with ownership
aspirations. We also address the issues associated with growth through ac-
quisition and the need to create ownership structures f lexible and scalable
enough to facilitate growth.


Why This Topic Is Important
Structure is often a major contributing factor in how well staff perform and
get along in the professional services firm. A structure that is not appropri-
ate can:

1. Lead to stakeholder (owners, employees, suppliers, customers) disaf-
fection
2. Impede corporate development and growth, including the raising of
capital
3. Limit exit strategy options
4. Result in inordinate, and unnecessary, liability being assumed by the
principals

After structure, equity must be allocated and compensation plans must be
designed and aligned to reinforce the business objectives of the firm while
recognizing the individual contributions of each principal and professional
employee. Allocation of initial ownership interests is critical, and the ground
should be laid to prepare the firm for future growth by setting scalable stan-
dards as early as possible in the firm™s life. Equally important is to think of
future ownership participation when the founder makes the first allocation
of ownership interest to key professionals at a later date. Fairness and con-
stancy are two elements of this process that will save the company from
needless problems down the road. The decisions made must be documented
to ensure orderly transitions. They include, but may not be limited to (de-
pending on the structure chosen and various federal and state statutes and
industry requirements for professional service licensure and ownership):
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Partnership and Governance Structures

1. Equity agreements between the principals, providing for:
a. A definition of the ownership interests of each principal
b. Terms under which ownership can be transferred, including re-
strictions
2. A mutually agreed on valuation approach and an ongoing valuation
schedule
3. Employment and noncompete agreements for all principals and key
employees, including provisions for termination

Firms failing to adequately separate equity and performance issues run
the risk of eventual failure. Falling prey to the notion that the owner gets his
or her compensation through the profit of the firm is faulty. Firm profit is
only one element of compensation. In addition, there is the need to provide
fair pay, perks, and benefits to principals as well as employees. Particularly in
the early days of an enterprise, failure to account for performance, whether
money is actually paid or merely accrued (and the taxes paid), can lead to
major problems at a later time.
Compensation issues include base salaries, incentives, leverage items (com-
missions or gain sharing fees), bonuses, “sweat equity,” options/warrants, gen-
erally accepted employee benefits packages, and executive perks.
Once structure, equity, and compensation for performance are estab-
lished, the decision management aspect of the firm needs to be established.
Who makes decisions and how decisions are made can make the difference
in whether a firm survives or fails. The decision-making and management
process need not be complicated, but principals must strive for clarity and
fairness or an exodus of the best people will soon begin. This chapter re-
views several models, noting their strengths and weaknesses.


Ways to Organize: An Overview
There are many ways to structure the professional services firm. But before
a structure is chosen, some strategic issues have to be considered:

1. The scope of the business (local, national, or international)
2. The nature of the business (type of practice/industry)
3. Risk and personal liability considerations
4. Tax treatment
5. Capital needs and availability
6. Succession
7. Attracting and retaining talent

While there are a wide variety of ways to structure a business, the most
popular are: subchapter C corporations, subchapter S corporations, and
56 Managing and Governing the Professional Services Firm

limited liability company (LLC) models. Some smaller firms are sole pro-
prietorships, and some firms, particularly in the legal arena, are still part-
nerships but the unlimited liability issue and the potential challenges of
equitable distribution work against these models. Moreover, professional li-
censing or industry codes prohibit ownership in a firm by professionals
from other disciplines; sole proprietorships and partnerships are not f lexi-
ble enough to accommodate growth with such restrictions. Exhibit 3.1 (pp.
63“ 64) summarizes the advantages and disadvantages of each form.


Sole Proprietorship
Sole proprietorships are generally unattractive for a professional services
firm of any size. While easy and cheap to start, usually requiring only the fil-
ing of a local business license, sole proprietorships provide little or no f lexi-
bility for growth.

Advantages
1. Start-up costs are inexpensive.
2. Income and expenses of the business f low through directly to the
owner.
3. As an extension of the individual, there are no business income tax is-
sues.
4. This form works best for smaller, low-risk personal service and some
retail businesses.

Disadvantages
1. Personal liability is unlimited for all claims and judgments against the
business.
2. It is difficult to bring in others to accommodate growth.
3. Loan capacity is limited to personal loans and personal net worth, plus
the value of accumulated assets.
4. Income sheltering and favorable tax treatment options are not gener-
ally available.
5. Exit strategies are limited.


Partnerships
Partnerships, whether limited or general, are legal entities in their own
right. Partnerships can be formed by individuals, companies, or individuals
and companies. A partnership can sign contracts, hold property, and file
suit in its own name. Partnerships are dissolved on the death or insolvency
57
Partnership and Governance Structures

of one of the partners, and all partners have unlimited liability for partner-
ship actions irrespective of initiating partner. Most states have minimal
requirements for the creation of general partnerships, while limited part-
nerships typically require only the filing of a one-page certificate of lim-
ited partnership.

Advantages
1. Start-up costs are inexpensive.
2. It is easy to establish with two or more entities.
3. Limited registration is required.
4. Partnerships are their own legal entities.
5. Tax treatment is favorable because income and expense f low through
to partners.
6. Limited partners™ liability is normally restricted to their investment
(they can become liable if actively involved in the business).
7. Limited partner income is not subject to self-employment tax.

Disadvantages
1. General partners have unlimited liability.
2. Creditors of a general partner can pursue the partnership and force its
liquidation.
3. The partnership normally ends when one partner dies or becomes
bankrupt (other partners elect to continue under some circumstances).
4. Adding new partners generally requires consent of all existing partners.
5. Limited partnerships have been attractive to passive investors but
pose problems for investors (angel investors, venture capitalists, equity
funds) who wish to assume an active role in the company.
6. Valuing partnership interests can be complicated.

Limitations of a Partnership

A good example of organizational structure impeding growth is the case
of a construction management firm. The firm, a partnership, employed 7
principals (senior and junior partners) plus about 15 others and was man-
aging about $35 million in construction contracts.
Due to the nature of partnerships (unlimited liability of all named
partners for any and all partnership liabilities) and bonding require-
ments (the need for hard assets to secure bonds), taking on larger proj-
ects was problematic. Many bonds required personal guarantees from
the principals and were often secured by their homes. This led to varia-
tions in opinion among the partnership about acceptable levels of risk
and pursuit parameters for new projects.
58 Managing and Governing the Professional Services Firm

Within nine months, the firm, with the help of an outside adviser, be-
came a corporation. Bank financing for projects was secured. A valuation
formula for the company was established, and one partner was bought
out. The remaining principals grew the firm to more than $100 million
in sales, eventually selling it to a larger company.



Limited Liability Companies
The LLC is a relatively new organizational structure developed to overcome
some of the shortcomings of the limited partnership. All members of an LLC
are essentially treated as limited partners in relation to liability issues, but
with a difference. Creditors of individual LLC members cannot pursue the
entity; bankruptcy (bankruptcy and assignments for the benefits of creditors
terminates membership) or the death of a member does not necessarily force
its dissolution. A well-thought-out operating agreement explaining all rights
and remedies is critical to the LLC™s success.

Advantages
1. LLCs can be created by one or two members (individuals, corpora-
tions, other LLCs) depending on state law.
2. Most states require the filing of a single-page certificate of formation.
3. Members enjoy limited liability status but may be involved in the
business.
4. Members have protection from creditors of individual members.
5. Members have interests, rather than shares, which are more scalable
in accommodating internal growth.
6. LLCs may not offer options.
7. Flexible handling of ownership interests, distribution rights, voting
rights, income distributions, losses, credits, and deductions can be al-
located to members.
8. LLCs can be easily converted to the corporate form.

Disadvantages
1. Adding new members requires the agreement and consent of all exist-
ing members (unless provided for in the operating agreement).
2. LLCs are not true corporations and lack case law to support a full
range of activities.
3. Interests do not provide for awarding of employee options or stock.
4. LLCs may restrict investment options if outside capital is sought, except
in cases of foreign investment where the LLC is a familiar structure.
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Partnership and Governance Structures

Subchapter S Corporation
A popular structure for many professional services firms is the subchapter S
corporation (S-Corp). The S-Corp has been in existence for many years, and
its corporate structure provides well-defined case law in support of the
rights of officers, directors, and shareholders. In addition, it allows income
and losses to pass through to the individual shareholders. The S-Corp follows
the corporate form of the subchapter C corporation (C-Corp) in many ways
but without the imposition of a second level of taxation. It has, however,
some restrictions such as limitations on the number of shareholders and re-
strictions on who can own shares. Some of these restrictions have been eased
by recent legislation.
For example, S-Corps are no longer limited to 35 shareholders. Under the
new regulations, that number has been increased to 75. Stock ownership has
also been relaxed. Currently, other corporations can own shares, as can pen-
sion plans, stock bonus plans, and profit sharing plans. The new regulations
also allow S-Corps to provide stock incentives to employees.
Some restrictions still remain, including restrictions on employee benefits
allowable to large shareholders. The S-Corp may still have only one class of
stock. Foreign investors are not permitted. Only small business corporations
are allowed to elect S-Corp status. While conversion to a C-Corp is possible,
conversion to an LLC requires that the corporation be dissolved, leading to
potentially adverse tax implications.


Advantages
1. S-Corps have a proven corporate structure.
2. S-Corps have a favorable tax treatment similar to partnerships.
3. Liability protection and regulations as in the corporate form apply.
4. Regulations were recently liberalized.
a. S-Corps can now have up to 75 shareholders.
b. Ownership is now open to other corporations and nonprofits.
c. S-Corps can own subsidiaries.
d. S-Corps can provide stock incentives to employees.

Disadvantages
1. Only one class of stock is allowed.
2. S-Corps are available only to qualified small business corporations.
3. Foreign investors are not permitted.
4. The form restricts investment options.
5. Employee benefits are limited for large shareholders.
6. Conversion options to LLC may trigger unwanted tax implications.
60 Managing and Governing the Professional Services Firm

Scalability Is an Issue in S-Corp Succession Plans
The founding principal in an architectural firm had, over the years, sold
a small percentage of ownership to his second-in-command, a person
several years his junior, with the understanding that he might eventually
purchase more shares. In time, the firm identified another potential
owner. He was hired with the express understanding that he would be
able to purchase shares pending a one-year trial period. As the year was

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