tion and adverse tax effects
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
Maximum flexibility on classes
shareholder meetings, voting issues,
of shares, liquidation prefer-
etc.
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
Partnership and Governance Structures
65
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 reinvestment in the firm. Shares to family members can also pass from one generation 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 financed 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 (contractually promised sharing in either a change in control or in the establishment 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. Vesting 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 valuation 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 representation of that investment. A fair return should be expected on that investment. The firm should also be careful not to adopt a practice of declaring bonuses that too closely coincide with the salary or shareholder equity percentages of the major shareholders. The IRS sometimes determines that bonus programs that track key executive salaries and stockholdings too closely are really undisclosed dividends. For a quick rule of thumb on industry averages, firm leaders should consider asking their banker for information on their type of firm from their industry research teams. Other benchmarking information
66
Managing and Governing the Professional Services Firm
can be found in the Annual Statements Study, published periodically by banking industry trade group Robert Morris Associates.3
Compensation
Compensation is not only about money. In a professional services firm, where the most valued assets of the business walk out the door every day, it’s also about recognition and stability. The elements of compensation create a balance that affords the professional and his or her support staff the peace of mind to focus on the creative work of the firm, thereby enhancing performance (see Exhibit 3.2).
Because there are typically few hard assets, sufficient cash f low is critical in maintaining organizational dynamics. In firms where cash f low is a problem, productivity is adversely impacted almost immediately.
Targeted lifestyle income
(professional)
$ ___________
Incentive
Commission
+
+
Base pay
+
Bonus
Options
+
+
+
Standard firm benefits package
+
Professional group perks
+
Leadership perks
+
Options (stock, shadow equity)
Exhibit 3.2
Typical Compensation Options for Professional Services Firms
Partnership and Governance Structures
67
Firms should focus on a targeted lifestyle income range for all employees.
This comprehensive look at compensation permits great f lexibility in the allocation of benefits (typical cafeteria plans) and in the development of risk management initiatives, such as self-insurance, that the firm may wish to pursue.
Firms should also be aware that ongoing, uncritical offers of benefits could turn those benefits from a competitive tool into a potential liability.
The subject of compensation, benefits, and staff retention are covered in detail in Chapters 9 and 10.
When a Benefit Becomes an Obligation
All compensation issues should be reviewed on a regular basis and modified periodically to prevent the potential risk of a benefit turning into a “condition of employment.” Conditions of employment have been the
grist of many court cases and can be construed to occur when com-
panies award the same benefits consistently, and without review or alteration, for many years. When, in hard times, a company suddenly
begins to cut back on such benefits, and employees have sued, the
courts have often supported the employees’ claim that the “benefit” had become “a condition of employment.”
Compensation, or pay for performance, is typically composed of:
1. Base salary
2. Bonus
3. Incentive plan and gain sharing programs (Items that can be subjected to leverage)
4. Options
5. Commissions
6. Employee benefits
a. Health, wellness, and lifestyle benefits
b. Long-term benefits
7. Professional group perks
8. Leadership perks
Regardless of what elements are included in the compensation package, it is important to identify a targeted income level for each principal and employee. Base pay, depending on the nature of the professional’s work (e.g., business development versus staff auditing) and the amount of, and leverage potential for, incentive pay usually ranges from 40 percent to 80 percent of total compensation and should be based on comparative wages within the firm’s geographic region or industry. Numerous sources for comparative
68
Managing and Governing the Professional Services Firm
salaries exist, including the U.S. Department of Labor ’s Bureau of Labor Statistics,4 various online sources,5 and local development agencies6 that track wages as part of their services in attracting companies to a locality.
These sources can also provide extensive lifestyle cost information, including prevailing information concerning employee benefits programs.
Bonuses for senior level and other professionals and staff may be established by employment contract, by firm history, or by industry practice.
Bonuses are usually discretionary and should be used only to reward extraordinary performance that has been identified and documented. Bonuses are typically paid from profits and represent a share of excess profits before taxes (if a C-Corp), shareholder dividends, reinvestment objectives, and any extraordinary reserves have been paid.
Incentive plans and gain-sharing programs are targeted programs de-
signed to promote a limited objective or to spur short-term objectives. These programs will lose some of their potency if they become de facto awards.
These plans are often funded as a percentage of gross income for specific lines of business, accounts, or overall revenue gains. Risk /reward calculations (or leverage) are key to developing and administering effective incentive and gain-sharing programs.
Options represent rewards given to promising professionals within the firm whom firm principals view as next generation leaders. Options usually offer equity participation at a fixed price to eligible participants. Participants can exercise their options with their own monies or, in some instances, can be underwritten by the firm as a form of sweat equity. The value of options f loats with the fortunes of the firm, and participants should receive continuing updates on the value of the firm and their options. Shares associated with options programs are usually restricted and may have additional antidumping provisions.
Commissions are normally available only to firm members involved in corporate development and /or sales, although many firms have a finder ’s fee program that extends to all employees who refer new business to the firm.
Commission plans proliferate, and plan terms vary by industry and by locality. Principals should consider a few things in establishing any commission program: Commissions should almost never be paid on gross billings (structure them on net income numbers), and commissions should be keyed to net collected revenues. While employees, including principals, want to be paid commissions in a timely manner, either reserving a portion of the commission or delaying the commission until funds are received is recommended.
Charge-backs should never be handled as lump sum transactions. If it is necessary to charge back a commission, do it over a period of time.