Thinking of starting a limited liability corporation? If so, you're not alone. About 80 percent to 90 percent of new practices choose that form of business structure, according to Philip Palaveev, senior consultant at Moss Adams, a Seattle accounting firm specializing in financial advisors, thanks to their tax and other advantages.

But, just because everyone's doing it, doesn't mean LLCs are foolproof. In fact, like any type of business arrangement, they're rife with pitfalls. “They're tricky,” says Stuart Silverman, president of Fusion Financial Group in Elmsford, N.Y., which provides marketing, consulting and broker/dealer services to 125 advisories. He recalls a three-person partnership with two high-flying producers and one ne'er-do-well, who seldom even showed up at the office. The partners in the LLC had created a complicated revenue-sharing formula to divvy up the profits, but it did not anticipate the nonperformance of one player. Eventually, they dissolved the LLC and formed a new one — with two partners.

The message: Enter into an LLC, by all means. But do so with your eyes wide open and don't expect that a solid legal structure will protect you against the human factors that make or break a partnership. While you can't guarantee that your venture will succeed, you can go a long way toward preventing it from imploding or, worse, landing you in court. “I think partnerships are wonderful, if structured fairly,” says Silverman.

Financial advisors — and other small professional-services operations — are drawn to the LLC structure for many reasons. But foremost among these are the tax advantages: LLCs allow owners to pass through their earnings as personal income. that eliminates the corporate tax on earnings that so-called C corporations pay. S corporations also allow owners to pass through earnings as personal income, but they are less flexible than LLCs when it comes to restrictions on the type of stock they can distribute and the number of shareholders.

So, LLCs seem to have all the advantages. But they are also tricky to live with. The first delicate area has to do with deciding how the money is divvied up. Many advisors go into partnerships for the simple purpose of achieving economies of scale. Typically, they keep the fees they make from the clients they serve and put a certain percentage into a collectible pot for fixed expenses. The result can be a significant reduction in costs for each advisor.

Scott Schwartz, of SAS Financial Advisors in San Mateo, Calif., says his expenses have gone down as much as 30 percent since taking on a partner two years ago. Even if you intend to have a different arrangement down the line, some experts advise that you start out with this mine/ours approach, until you're really sure the partnership can work.

On the other hand, other advisors prefer sharing revenues right way. When he took on a partner three years ago, David Berman, of Berman McAleer in Baltimore, rejected what he calls “the eat-what-you-kill arrangement” in favor of sharing revenues 50-50 immediately.

“I was willing to risk losing some revenue in exchange for the comfort of knowing I wasn't hanging out there by myself,” says Berman. The bet has paid off. Revenues are up about 85 percent over the last three years.

Berman's arrangement is pretty simple. In other cases, advisors share revenues, but use a considerably more complex formula.

“We probably have 75 partnerships set up and each one is different, depending on the skill level of the advisor and other factors,” says Silverman. He points to one partnership in which the individual who brings in a referral gets 25 percent of revenues for that client, the person who works with the account gets 25 percent and a certain percentage goes into a joint pot for expenses. Then, the rest is shared 50-50 between the partners.

Bones to Pick

Another source of contention is how decisions are to be made, especially if there are disagreements. Do all owners have to reach decisions unanimously, or do those with a bigger stake hold more sway? That's a particularly vexing issue when it concerns selling shares of the company.

One common solution is to require that any partner interested in selling his or her stake first offer those units to the other owners before looking elsewhere. Other places take a different tack. Joseph Ventura, a partner in William Tell Financial Services in Latham, N.Y., says his firm stipulates that any partner with majority ownership has to have at least one other partner agree with him for an issue to pass. They also have specific steps for how to run meetings, mandating standard Robert's Rules of order, as well as a secret ballot if there's an impasse.

Of course, decisions are especially hard when there are two equal partners. Palaveev points to a two-person firm in which one partner wants to retire and sell his part of the practice to someone the other owner doesn't like. After months of butting heads, they've decided the only solution is to dissolve the partnership completely.

Perhaps the greatest source of friction has to do with how hard everyone is working.

“When one partner isn't pulling his weight or performing well, that's a hot button,” says William Abrams, an attorney with Abrams Garfinkel Margolis Bergson in New York City. The only time Ventura, for example, faced an issue so contentious that the partners had to use a secret ballot was when they were angry about one owner who didn't seem to be working hard enough. They decided that anyone who didn't put in a 40-hour week would have his or her wages docked. In fact, according to Abrams, such resentments are the No. 1 cause of partnership litigation.

Even if there's no lawsuit, the fallout from such disagreements can be pretty bad. Dennis Barba Jr., a financial advisor with Raymond James Associates in Cleveland, who also teaches entrepreneurship at various schools in his area, remembers a $750,000 producer, who agreed to bring two $300,000 reps into his practice, figuring that together they'd turn the business into a nonstop money machine. Unfortunately, over the next few years, he continued a furious marketing campaign to keep growing the practice, while his partners did almost nothing to develop new business. Realizing he'd made a mistake, he bought out the two advisors' share of the LLC — for a sum so large, that Barba “had to take a bank loan out just to get rid of them.”

LLC Harmony

One key to making it work is for the right people to team up together. Trouble is, advisors often don't put in the time and effort needed to make that assessment. Instead, they join forces thinking they know each other well, when they don't. “They worked together, played golf together — but that doesn't mean they can go into business together,” says Barba.

One tack is to team up temporarily, without tying the knot formally. “They should do a dry run, to see if they can tolerate each other on a daily basis,” says Kirby Horan, senior analyst at Cerulli Associates in Boston. Schwartz, for one, spent over a year looking for someone to partner with. After he met his match at an industry convention, they went out to lunch three or four times, then decided to work cooperatively, running seminars and other marketing campaigns together. After several months, they realized they liked each other's style and set up a formal partnership.

You also can seek professional matchmaking help. Berman and his potential partner worked with a business consultant, who helped them iron out such issues as how to manage their merged staffs, since one partner was a control freak, and the other a lot more hands-off. The consultant helped them figure out how to accommodate to each other's style. But they also consulted a therapist, who talked about how each man could address his particular idiosyncrasies and develop a better working relationship.

Probably the most important way to avoid problems is by writing an airtight partnership agreement. That means anticipating as thoroughly as possible the potential snafus and writing ways to deal with them in the contract. “People think, oh, we'll figure it out as we go along,” says Horan. “But it doesn't work that way.” Include everything from what each person's responsibilities will be to how decisions will be made and what happens if partners want to disband. Of course, you also need to institute buy/sell agreements that stipulate formulas to use if one partner dies, becomes disabled or retires.

The other cardinal rule relates to the matter of communication. You have to establish regular avenues for discussion. After their business grew too big for them to regularly talk during the day, Stuart Horowitz and Andrew Stuart, partners in five-year-old Asset Management Group in Coral Springs, Fla., knew they had to do something different.

“It got to be that the only time we had to talk was 9 at night after we put the kids to bed,” Horowitz says. They established a Wednesday morning partnership meeting, also including the chief operations officer, with a set agenda for each time — cash flow, new clients, personnel issues, for example. As a result, the partners have shared information they would not have been able to otherwise — and it's resulted in a more efficient operation. Recently, when Stuart, who does more of the rainmaking, was so overloaded, he revealed he was considering hiring a new employee. But Horowitz, the main honcho for client relationships and administration, offered to use one of his staffers temporarily, to handle the excess work. They got through it, without having to pay for an additional staffer.

If only most marriages could operate that well.

FIVE REASONS PARTNERSHIPS FAIL

  1. Failure to codify decision-making processes.

  2. Uneven or inequitable division of labor among partners.

  3. Abbreviated “courtship” period leads to unforeseen personality clashes after partnership is formed.

  4. Lack of a formal system of communication.

  5. Sloppy partnership agreements.