performance is achieved when everyones contributions are factored into assessing organizational success. More likely, several professionals cooperate to achieve the desired result. When cooperation is lacking and results are not 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 entrepreneurs 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 midsize firms employing multiple professionals in, or with near-term expectations of, ownership and (potentially) a more junior group with ownership aspirations. We also address the issues associated with growth through acquisition and the need to create ownership structures flexible 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 appropriate can:

1. Lead to stakeholder (owners, employees, suppliers, customers) disaffection

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 standards as early as possible in the firms 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 constancy 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 (depending on the structure chosen and various federal and state statutes and industry requirements for professional service licensure and ownership):

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 restrictions

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 (commissions or gain sharing fees), bonuses, sweat equity, options/warrants, generally accepted employee benefits packages, and executive perks.

Once structure, equity, and compensation for performance are established, 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 reviews 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

limited liability company (LLC) models. Some smaller firms are sole proprietorships, and some firms, particularly in the legal arena, are still partnerships but the unlimited liability issue and the potential challenges of equitable distribution work against these models. Moreover, professional licensing or industry codes prohibit ownership in a firm by professionals from other disciplines; sole proprietorships and partnerships are not flexible 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 filing of a local business license, sole proprietorships provide little or no flexibility for growth.

Advantages

1. Start-up costs are inexpensive.

2. Income and expenses of the business flow through directly to the owner.

3. As an extension of the individual, there are no business income tax issues.

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 bus iness.

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 generally 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