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coming to an end, many issues were left unresolved. No valuation for-
mula had been agreed to by the founder and the candidate, nor had there
been any discussion with the second-in-command relative to a new valu-
ation and its impact on his shares. Moreover, the founder had made a de-
cision as part of his personal succession plan to begin a process of
divesting his shares to new shareholders as able candidates were identi-
fied and invited to join the practice. A scalable and equitable valuation
and stock transfer procedure was needed, along with updates to all the
corporate documentation. In addition, provisions needed to be made for
nonarchitects (designers and specialty engineers) who could not, under
American Institute of Architects (AIA) rules, participate in direct own-
ership of an architectural firm. Finally, options governing the sale of ad-
ditional shares to current shareholders and potential dilution issues
needed to be addressed. Within a year, these programs were in place just
in time for the acquisition of a competing firm and the absorption of a
new equity owner in the company.

Subchapter C Corporation
The C-Corp is the organizational structure most adaptable to growth. For
principals wishing to give the firm maximum advantage in managing rapid
growth, attracting investors, providing incentives to key employees, possibly
forming an Employee Stock Ownership Plan (ESOP), or wanting to go pub-
lic,1 this is the structure to adopt. There are no limitations on the number of
shareholders or subsidiaries, and there is ample case law to provide guidance
in protecting both majority and minority shareholders.2 Despite the normal-
ization of corporate law across America, both Delaware and Nevada still
enjoy reputations as corporate havens for maximum legal f lexibility.
C-Corps provide maximum tax benefit for employee benefits with up to
$50,000 in individual benefits deductible. Various classes of stock can be is-
sued on terms favorable to even the pickiest institutional investor or venture
capitalist, including provisions for preferred stock options and preferential
liquidation rights. The form is also the best choice for owners considering
ownership succession.
The biggest downside is the double taxation issue. Unlike other forms of
organizational structure, the C-Corp is a taxable entity”which means own-
ers pay taxes at both the corporate and personal level. Similarly, losses do not
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Partnership and Governance Structures

pass through to the individual investors. Many professional services firms ad-
dress these challenges by “managing the bottom line,” but this practice has
limitations, and principals must be careful not to run afoul of IRS rules re-
stricting, and possibly penalizing, this practice when taken to excess (using
excessive compensation guidelines and personal holding company penalties as
their tools).
An additional challenge also being seen more today has emerged as some
attorneys have initiated novel (fraudulent conveyance) strategies to “pierce
the corporate veil.” Actions usually follow Racketeer Inf luenced and Cor-
rupt Organizations (RICO) or Employee Retirement Income Security
(ERISA) violations, charges of corporate fraud or malfeasance on the part of
key shareholders or officers, are related to creditor disputes, and /or are the
product of equitable distribution actions in marital dissolutions. Because
fraud statutes are often very broad, some plaintiff attorneys use the statutes
to “discover” hidden assets or challenge “valuation” approaches.

Advantages
1. The C-Corp has maximum f lexibility for growth and expansion.
2. Liability protection and regulations as in the corporate form apply.
3. Companies can convert from S-Corp and LLC.
4. Number of shareholders or subsidiaries are not limited.
5. There are no limitations on who may own shares.
6. Multiple classes of stock and other securities are allowed, along with
f lexible rights and preferences.
7. This form is not restricted to small business companies.
8. Ample case law exists to defend rights of all involved parties.
9. This is the most attractive form for institutional investors.
10. Stock options are available for employees.
11. Maximum employee benefit deductibility is provided.
12. The C-Corp is the best structure for eventual IPO and /or succession
strategy.

Disadvantages
1. There is a potential for double taxation (on corporate income and divi-
dend income).
2. Corporate income and loss cannot be used on a personal level.
3. C-Corp structure requires more formality to be in conformance with
legal requirements (failure to conform may become problematic if
firm leaders are challenged by dissident shareholders, creditors, es-
tranged spouses or disaffected employees). Conformance requires reg-
ular board and shareholder meetings, preparation and maintenance of
formal corporate minutes, maintaining records of resolutions, and
62 Managing and Governing the Professional Services Firm

some arm™s length restraint regarding personal distributions to key
shareholders.
4. There are limits on the amount of earnings that can be retained in
closely held companies as well as limits on executive compensation lev-
els (before unreasonable compensation and personal holding company
penalties are pursued).



Equity and Compensation
It sometimes appears that there are nearly an infinite number of ways to di-
vide equity and establish creative compensation plans. The most popular and
accepted plans separate equity and return on equity from job performance.
Firms that fail to make this separation and /or cloud compensation issues
often experience high turnover and spotty overall firm performance.

Equity
Equity can be allocated in many ways. It can be gifted or awarded, pur-
chased or sold, earned or inherited. Provided the firm has taken the time to
establish an ongoing valuation procedure and engages in strategic planning,
most processes proceed slowly and peacefully.
The most basic need when dealing with equity in the firm is to determine
if those who currently own it want to retain it, give or gift it to a relative, use
it to retain the best firm talent, sell it to an individual, or even dispose of it
by initiating an ESOP.
With the largest shareholders™ intent in mind and a valuation formula in
place, serious consideration can be given to how best to use expanded equity
participation as a strategic tool.
In increasing the pool of shareholders, the leadership should always be
sure to restrict the shareholder ™s ability to freely resell firm shares. The firm
should have the right of first refusal for all outstanding shares at the time of
a shareholder ™s separation or death (shares are often repurchased over a pe-
riod of time”often 5 years for a friendly parting and 7 to 10 years when
asked to leave). This is usually accomplished by adding a legend to each stock
certificate detailing the procedure for selling shares.
Stock can be gifted, earned, or awarded based on the operational perfor-
mance or profitability of the firm and the roles played in achieving those re-
sults by those being gifted. So called sweat equity programs are defined
within this scope and represent a way to acquire excellent talent at what
amounts to discounted prices. All stock awards should be commensurate
with results over and above a predetermined base level of performance.
Shares to be allocated to new and prospective owners in such programs are
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Partnership and Governance Structures

ENTITY ADVANTAGES DISADVANTAGES

Sole Proprietor No formation formalities Unlimited liability
No structure for investors
Not suitable if business has other
employees

Partnership-type tax treatment All income subject to self-employment
tax

General Part- Flexible management structure Unlimited liability
nership Recognized legal entity with Difficult to add new partners
right to contract Difficult to raise capital without
bringing in new partners
Requires 2 or more partners
Any partner can commit the others
Death of partner dissolves partnership

Partnership tax treatment

Limited Partner- Limited liability for limited part- Requires 2 or more partners
ship ners Requires general partner responsible
Ability to attract passive for all obligations
investors by making new limited Limited partners cannot actively par-
partners ticipate in management
Adding new partners may require
consent
Not attractive for institutional investors
No stock to use for options
Death of partner may affect continuity
depending on partnership agreement

Partnership tax treatment
Income to limited partners not
subject to self-employment tax

Limited Liability Flexible structure Body of law not well developed
Companied Can have different classes of No stock to use for options
stock, different rights and alloca- Not attractive structure for institu-
tions tional investors
Owners can be persons, corpora- Many states require 2 members (not
tions or other LLCs DE or NY)
Conversion to corporation easy Death of member may affect
Familiar structure for foreign continuity
investors (GmbH, SARL)

Exhibit 3.1 Selection of Entity”Summary
(continued)
64 Managing and Governing the Professional Services Firm

ENTITY ADVANTAGES DISADVANTAGES

Partnership tax treatment All income may be subject to self-
employment tax
Can convert to C corporation
without adverse tax affects

Subchapter S Security of corporate structure Can have only 75 shareholders
Corporation Well defined law on corporations Can have only 1 class of stock
Death of shareholder does not No foreign investors
affect continuity of company Only for qualified “small business cor-
Qualified tax exempt entities porations”
can be shareholders Not suitable for institutional investors
Can have corporations and LLCs Limited employee benefits to large
as subsidiaries shareholders

Partnership tax treatment Conversion to LLC requires liquida-
tion and adverse tax effects
Only salary (not profits) subject
to self-employment tax Issues on conversion to C corporation
Limited flexibility on allocations of
income, leases, credits, and deductions

Subchapter C Limited liability for shareholders More formalities”Board meetings,
Corporation shareholder meetings, voting issues,
Maximum flexibility on classes
etc.
of shares, liquidation prefer-
ences, voting rights
Preferred investment choice for
institutional investors
Suitable for initial public offering
Stocks options available
No limit on number or type of
shareholders
Well-defined law on corporations

Most favorable structure for Double taxation on dividends (but rate
employee benefit plans reduced to 15%)
Limits on how much of earnings can
be retained in closely held companies
Limits on level of salary to avoid divi-
dends of closely held companies
No pass through of net operating
losses to personal return

Exhibit 3.1 Continued
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Partnership and Governance Structures

often limited to the value of not more than one-third (collectively) of all
gains, but actual numbers can vary. The one-third share represents an equal
distribution of increased profitability or sales with the other two-thirds
being distributed equally”as profit to existing shareholders and as reinvest-
ment in the firm. Shares to family members can also pass from one genera-
tion to the next in family firms, depending on stock restrictions. In family
firms, before any shares are transferred, the impact of such distribution on
nonfamily members should be assessed.
Stock purchased, whether from founder ™s stock, shares of other large
shareholders, treasury stock, or stock from departed employees, is sold as it
becomes available. Pricing is based on the share valuation in place at the
time of sale. Stock purchases may be cash transactions, or they may be fi-
nanced over a period of years.

The Succession Leader
In some instances, particularly during a succession process, an interim
or bridge CEO or managing director may be engaged. This executive™s
contract will almost certainly involve either a share-based reward for
overseeing a successful transition or some form of shadow equity (con-
tractually promised sharing in either a change in control or in the estab-
lishment of a new ownership/leadership team) scheme. Most firms and
CEOs favor some small stock holding coupled with shadow equity. The
benefit of this preferred approach is that capital gains taxes are not due
on shadow equity until received (at some future point when the change
occurs), as opposed to an equity position that is taxed as received. Vest-
ing in a shadow equity plan does not constitute constructive receipt for
IRS purposes.

Whether to pay dividends is a C-Corp issue. Many owners consider that the
appreciation in a C-Corp firm™s shares, as demonstrated by the annual valua-
tion update, constitutes fair consideration. Any “profits” that can™t otherwise
be legally expensed are typically given to shareholders as bonus dollars. In the
S-Corp and LLC forms, profits pass through to the individual shareholder. For
those who take the “appreciation” route, it should be remembered that the
shareholders have invested in the company™s success. Their shares are the rep-
resentation of that investment. A fair return should be expected on that in-
vestment. The firm should also be careful not to adopt a practice of declaring
bonuses that too closely coincide with the salary or shareholder equity per-
centages of the major shareholders. The IRS sometimes determines that bonus
programs that track key executive salaries and stockholdings too closely are re-
ally undisclosed dividends. For a quick rule of thumb on industry averages,
firm leaders should consider asking their banker for information on their type

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