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With the rapid proliferation of ancillary businesses in recent years, many law firms have faced the question of whether to undertake such activities, followed by the challenges of structuring and operating these new enterprise. The core rationale for an ancillary business is to provide clients with multidisciplinary services that are more efficient and cost-effective, from the clients’ standpoint, than trying to assemble the expertise they need on an ad hoc basis. Clients may prefer to work with lawyers and their related ancillary businesses because they offer a different, and often better, approach to complex problems. Pragmatic reasons for a law firm to establish ancillary businesses include enhancing core practice areas and solidifying client relationships, competing more effectively with accounting firms and other law firms, attracting nonlawyer professionals, generating client referrals, and increasing revenues and profits. Given the growing pressure on the financial margins of most law firms and the significant increase in competition from other types of service providers, it is not surprising that many firms are looking beyond the traditional practice of law for ways to protect and expand their client relationships and to enhance their financial returns. Ancillary businesses are an increasingly popular business strategy that are likely to be a permanent feature of the legal marketplace. The experience of many firms demonstrates that the success of an ancillary business often depends on the care with which key decisions are made at the outset as to corporate form and structure and operational issues. CORPORATE FORM The appropriate form for a particular business will turn on such factors as how the law firm’s ownership interests are to be held, tax considerations, concerns about “upstream” liability, the level of control desired by the firm, and the contemplated exit strategy. The actual structure of the enterprise can, of course, take many forms: corporation, limited liability company, professional corporation, general partnership, limited partnership, or limited liability partnership. Ownership. Will the ancillary business be a wholly owned subsidiary of the law firm or will ownership be shared with one or more other investors or equity holders? If it will be shared ownership, the law firm may wish to limit its own liability for the acts of its co-owners by avoiding a general partnership arrangement. If the co-owners are to be key employees of the new venture, a limited partnership approach might be advantageous, with the employees as general partners and the firm retaining the status of a limited partner. In either case, the firm will need to decide how its ownership interests in the venture should be held. One option is to have the interests held as an asset of the law firm itself, with dividend payments or other distributions paid directly to the firm and recognized as revenue (or more likely “other revenue”) on the firm’s financial statements. Another alternative is for the firm to create a separate partnership (or other entity) at the time the ancillary business is created, with the ownership interests of law firm partners or shareholders in that new entity in the same proportions as their ownership interests in the law firm itself. The profits (or losses) of the ancillary business would then flow through to the partners or shareholders of the new entity without passing through the law firm at all. Each approach has its benefits and drawbacks. A separate partnership may be desirable where the new venture requires a significant capital infusion from the law firm � a contribution that would, obviously, fall more heavily on those partners holding larger ownership interests in the firm. That approach could, however, create a disincentive for younger partners in the firm to continue their support of the venture over time, a disincentive that would be reduced if (as in the first option) the changing ownership interests in the law firm were always effectively represented in the ancillary business. Tax Considerations. The principal tax consideration is, of course, whether the new entity should be structured to avoid the double taxation of earnings that occurs if a business is organized as a corporation. From a strictly tax standpoint, there would appear to be little reason to choose the corporate form, particularly since other equally attractive options � like limited partnerships or limited liability companies � are readily available in most jurisdictions. There may, however, be other reasons to opt for the corporate approach, the most prominent being a concern about potential liability. Potential Liability. Most law firms want to limit their potential risk exposure arising from their separate ventures. Obviously, the risk of such “upstream” liability will be greater for some types of ventures than for others. A law firm considering an investment banking business or a construction management subsidiary, for example, might rationally have more concern about potential liability than a firm contemplating a lobbying or economic consulting business. Where the risk of upstream liability is particularly high, a firm is probably well-advised to avoid partnership arrangements (even limited partnerships) and opt for the formal protections of the corporate form, either as a standard business corporation or (depending on the law of the jurisdiction) as a limited liability company. Control Issues. Another key consideration in structuring an ancillary business is deciding the level of control over the operations of the business that the law firm wishes � or may, for ethical reasons, be required � to retain. For example, does the firm want approval power (or perhaps, veto rights) over decisions by the ancillary business to hire officers or key employees or to determine their compensation, approve annual budgets, approve any proposed financing (either debt or equity), enter new lines of business, approve major contracts, change the name of the company, or enter into partnering or joint venture relationships with other companies? If so, should such power be exercised through the firm’s control of the board of the ancillary business or in some other fashion � for instance, through an operating agreement, a shareholders’ agreement, or veto rights over certain specific actions enumerated in a limited partnership agreement or other instrument? Of course, some forms of control may be inconsistent with the organizational format selected for the ancillary business. For example, in a limited partnership, general veto rights or wide-ranging approval powers may be inconsistent with the firm’s desire to retain the protections against liability generally afforded to a limited partner. Similarly, a firm-designated member of the board of an ancillary business who acts too blatantly to protect the interests of the law firm might find himself or herself at odds with the fiduciary duty owed by directors to the company they serve or at odds with other shareholders who aren’t associated with the firm. Another critical point to consider relates to ethical responsibilities. In some states, law firms are permitted to participate in ancillary businesses only if they ensure that the businesses conform to certain provisions of the local rules of practice governing lawyers. Rule 5.7 of the ABA’s Model Rules of Professional Conduct imposes a similar requirement, with a “safe harbor” exception if the ancillary business makes certain kinds of disclosure to its clients. Regardless of the organizational format selected for a particular ancillary business, the firm must retain sufficient controls over the business’s operations to ensure that the firm meets its ethical obligations. Exit Strategies. Having an “endgame” in mind will also help inform decisions as to structure and organizational format. For example, if the firm contemplates someday selling the ancillary business to a third party, it might take a different attitude toward equity participation by key employees than if it intends to retain the business for the long term. The same issue might also influence the firm’s decision on whether to hold its ownership interests as an asset of the firm, as opposed to transferring it to a shadow partnership of current partners or shareholders. Likewise, if the firm envisions a near-term public offering, it would probably select a standard business corporation format. OPERATIONAL ISSUES Once the basic corporate and organizational format of the ancillary business is decided, the firm needs to focus on operational issues. In most cases, the firm and ancillary business are likely to share at least some resources. Understandings concerning resource-sharing arrangements, together with other operational details, should be set out in a formal operating agreement. That agreement should specifically address the following issues: • The types of services that may be rendered to the clients of the ancillary business by legal personnel of the law firm, along with the procedures for disclosure, accounting, and timekeeping that will be used to make sure that legal services are not rendered through the ancillary entity and that clients are not confused about the kind of services they are receiving; • The circumstances under which the ancillary business may use other law firm resources, including nonlegal staff (secretaries, administrative assistants, receptionists, paralegals, file clerks, messengers, librarians), accounting services, marketing services, computer or other information systems, telephone or other communications systems, the library or other research facilities, file storage facilities, reception areas, conference rooms, etc.; • The basis on which the firm will charge the ancillary business for use of any or all of these services or facilities; • The extent to which the firm will provide investment capital, operating capital, or financial guarantees to the ancillary business; and • The operating procedures that the ancillary business will employ to keep the firm in compliance with the rules of practice in the jurisdiction or jurisdictions in which it operates. Establishing one or more ancillary businesses can be an attractive and profitable strategy for many law firms, particularly where those ancillary activities complement and expand core legal services already offered. Most firms, however, underestimate the resources and management time required to make their new ventures successful. Any firm contemplating an ancillary business should carefully consider all its options for structuring and operating the planned venture. Rushing into an ancillary business without thinking through these important decisions risks failure of the venture and may have serious consequences for the law firm itself. James W. Jones is a director of Hildebrandt International and a former managing partner of Arnold & Porter. Terri Pepper Gavulic is marketing director of Hildebrandt International and the company’s senior marketing consultant.

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