Independent financial service practices that are set up as entities (C-corporation, S-corporation, or a Limited Liability Company) have some powerful advantages over a basic sole proprietorship model.
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A sole proprietorship dies with its owner. Any advisory agreements between a client and a sole proprietor come to an end. A corporation, or a limited liability company, however, can outlive the founding owner and offer a platform on which to build a business of enduring and transferable value.
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, and through a variety of channels (stock options, equity compensation, gifting strategies, direct sales, ISOP’s, etc.). For example, a founding owner can set up an internal ownership track and sell 10% of the company to a key employee or a son or daughter, financing that sale over a period of five to maybe seven years. As a result, a founding owner can create and develop actual partners to rely on to build the company and to provide continuity in the event of his or her temporary or permanent disability or sudden death.
Stock sales are the norm when implementing an internal ownership track or even a complete transition to an internal buyer (think employee, partner, son or daughter). A common mistake many advisor make is to try to sell 100% of the advisory practice at one time on the eve of retirement, rather than to properly build this solution into the business by virtue of an internal ownership track that creates a gradual, incremental buy-in opportunity of stock ten years or more ahead of time, along with a gradual change of control for contract assignment purposes.
In an entity structure, retiring owners can also sell a majority interest in their business, perhaps to a key employee, son or daughter, but remain a minority owner, holding on to 30% or 40% of the company, and shifting into more of a “rainmaker” role upon retirement. The ability to retain ongoing ownership is beneficial because it helps maintain continuity in a slow, gradual and professional 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.
The gradual pace offered by an incremental stock transition provides peace of mind to the exiting owner, succeeding owner, staff members and, most importantly, the clients, who can witness the succession planning process occurring over the length of their advisor’s career.
It’s relevant to note that the use of entities is not permitted by all broker-dealers, and the position of the SEC/FINRA on this issue is certainly not clear – custodians don’t have issues with this strategy. That said, I’ve only run into two or three broker-dealers that don’t permit the use of entities. To be safe, if you’re with a broker-dealer, check with your compliance department. Remember, 99% of all independent broker-dealers and custodians now allow you to set up entity structures – just do it right. In a highly regulated industry, Legal Zoom is not the answer.