Building a Foundation for Success

Sunday, June 06, 2010 16:14
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Building a Foundation for Success

Building a financial services practice that has enduring and transferable value should be the goal of every advisor. After all, the plans that you write and the investment strategies that you implement for your clients impact multiple generations – why not build a business that can deliver advice and services to all of the members of a family, and beyond your lifetime and your clients’ lifetimes.

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A simple way to build a business that can outlive you is to set up a formal, industry-specific entity such as a corporation or a limited liability company (“LLC”). One of the major advantages for owners who operate as an entity is the ability to transfer small, incremental ownership interests over an extended period of time. For example, a founding owner can set up an internal ownership track and sell 5% of the business to a key employee, or a son or daughter, financing that sale over a period of five years or more. As a result, founding owners create and develop “partners” to rely on in the event of temporary or permanent disability or sudden death – a continuity plan. Longer range succession planning options also enter into the picture.
 
Understand that setting up a corporation or an LLC has little to do with limiting your liability. As a former regulator and a securities attorney, I can tell you that you cannot limit your liability for negligent investment advice by incorporating. If you’re negligent, you’re liable, plain and simple. That’s what E&O insurance is for. I’m talking about building a stable and enduring business platform, for generations to come, and that is NOT a sole proprietorship.
 
An investment professional who operates as a corporation or LLC will contractually establish the client relationship through the entity, as opposed to the individual professional advisor. A client, for example, will sign an Investment Advisory Agreement with Capital Asset Management, Inc., rather than with Bob Jones, an individual and sole owner of the company. In the event of the owner’s retirement, death or disability, the contractual relationship can be maintained without interruption through the surviving and continuing shareholders of the advisory business. That’s part of the process of succession planning.
 
Setting up an entity underscores the basic idea that while people don’t live forever, an entity can, or at least for more than one generation. In contrast, a sole proprietorship can only transfer assets, making it impossible (or at least very difficult) to share ownership in the same company.
 
At this time in the independent financial services industry, LLC’s are the choice eight out of ten times. Unfortunately, too many attorneys and CPA’s are touting the benefits of this relatively new business model without fully understanding how it functions in this industry. They prefer an LLC’s flexibility over the more rigid rules and maintenance procedures of a corporation. Having owned and run an LLC and a corporation, side by side for the past 10+ years, I don’t agree that an LLC is the best model for today’s growing advisor.
 
LLC’s have some advantages, to be sure, but not in building smaller (less than $3 million in value) businesses with just a handful of owners. Consider that most LLC’s are set up as partnerships for tax purposes. Did you know that selling 1% of the LLC in an internal sale means that your key “employee” can no longer be handled on a W-2 basis? In a corporation, an employee can be an owner and an employee at the same time. Did you know that in an LLC or an S-corporation, owners cannot effectively borrow from the business (i.e., a shareholder loan), creating an obligatory note as opposed to compensation, as they can in a C-corporation? Did you know that when an LLC buys out a retiring owner, all of the payments are typically ordinary income reported on a K-1, not long term capital gains as in the sale and redemption of stock?
 
For these reasons and more, it is important to carefully consider which business platform to construct and build your advisory practice on. A mistake at the foundational level will have repercussions for the duration of your career. Most lawyers have never personally built a business of substantial size from scratch and have no understanding of the tax and regulatory intricacies of entity structuring in this unique industry.
 
In an entity based model, retiring owners can also sell a majority interest in their business, but remain a minority owner, holding on to 30% or 40% of the company. The ability to retain ongoing ownership is beneficial because it helps maintain continuity in the slow, gradual transition of client relationships from one generation of ownership to the next, and it reduces the initial cost of the controlling interest to an employee or son or daughter. Ongoing ownership also typically allows the exiting owner to retain an appreciating ownership interest.
 
Unlike the sale of assets, which is the process by which most third-party acquisitions take place, the control of an entity can be shifted, literally, 1% at a time. The gradual pace provides peace of mind to exiting owner, succeeding owner, staff members and the clients.

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