Legal Update: Succession Strategy
Succession is one of the underlying biggest challenges for law firms, no matter your size. The perception is that succession planning appears to be easier for the larger firms, but getting the right talent in the right place at the right time is what everyone struggles with at times.
This is often why mergers and acquisitions activity is becoming such a talking point, as it could be the perfect solution to a difficult challenge or an opportunity for growth, depending on whether you are selling or buying.
What are my succession strategy choices?
From the outset, everyone has a choice, so it is only a matter of how palatable the choices are. The flow diagram below shows what your options are. It starts with one simple question – do I have an internal option? – as this is the question that gives you the most choices. If there are no internal options, then you are forced to go externally or close.
An internal option may give you an immediate perception that it is going to be far easier. However, this really depends on whether you are looking for value. It is important to define value which, in most internal cases, would be an amount over and above the accumulation of capital and undrawn profits in the business, best known as goodwill.
Traditionally, the legal profession very rarely talked about goodwill, let alone actually received it – a partner in a partnership was a custodian for the business, and hopefully during their working life received a good return for that and left the business in a better shape than when they came to it.
With the opening up of the legal sector to outside investors and increased competition, the concept of goodwill is now used more and more when transferring businesses from one generation to another. However, it does not always actually resulting in a payment for exiting partners.
When looking at internal options, it is important to remember that this is an internal market and not an external market. Headline-grabbing numbers of values of businesses being bought and sold, although interesting, cannot fully drive how an internal market would work.
The ultimate success of a succession strategy has to be the ability for the ongoing practice to continue. It ensures it is affordable for the new people coming in while, simultaneously, ensuring that retiring owners receive a fair reflection, albeit a reduced amount in comparison to what is in the marketplace at that time.
All too often, the conversations on succession focus on valuations and what an individual is worth, but a well-thought-out succession strategy does not just revolve around paying out an amount of money to that individual but also ensuring that their workflow continues. The measure of a well-executed succession strategy is when the business carries on as if that person was never there! This may sound harsh, but, in reality, it should be what all owners are aiming for.
How do I treat value?
If conversations have progressed to the point where an additional sum of money is to be paid to a retiring individual, the next step is to consider how that should be treated. Naturally, a retiring individual will want a capital payment as that currently has a better tax rate payable on it. However, the remaining owners would prefer to make a payment that allows them to get tax relief straightaway.
Trying to establish how the payment should be classified can cause issues but, as the fundamental point is that the business must continue, it should be affordable for the remaining partners whilst, at the same time, having some reflection on the impact of the retiring individual. There are many ways to structure a retirement payment, and advice should be taken early on if this is to be acceptable to all parties.
Management buy-out (MBO)
MBOs are often seen outside of the legal world, where a senior management team buys out the owners and then carries on the business. The concept can work within legal firms, as this would consist of a collection of individuals (be it owners or new people coming in) who do not necessarily need to be solicitors, providing the structure is that of an alternative business structure (ABS).
Conceptually, an MBO can be done in a traditional partnership, a limited liability partnership, or as a company. It can often trigger the conversion to a limited company status, especially where payments of goodwill are being paid and treated as capital in order for the new owners to get some form of tax relief straightaway.
Whether the transaction is treated as a formal, MBO is not necessarily relevant, as the underlying concern in any structuring of a transaction is affordability. Like many MBOs outside of the legal profession, before really seeing any increase in return themselves, the senior management team will spend a considerable amount of time post-deal paying either the debt that has been created on buying out the owners or paying direct to the owners over an agreed period of time.
The hope with an MBO is that the subsequent owners will then sell out to another third party. It is always important to consider what the ultimate exit would be and whether this would work, bearing in mind the legal market as it is at the moment and the future potential for more consolidation.
Are there any alternatives?
Internally, yes. An alternative option to an MBO is an employee ownership trust (EOT). The popularity of this type of arrangement continues to grow, but not necessarily with a complete understanding of how this could work. The whole concept of an EOT is worthy of a separate article as, although, on the face of it, it appears to deal with all the issues of succession planning without a thorough understanding of how it works and what the business needs to be focussed on, it is not necessarily the answer to everyone’s prayers when looking at exiting their business.
What are my alternative options if I cannot sell internally?
If the internal route is not available, the two options are to either close the practice or sell to a third party.
For most professionals, closure is the one to be avoided. Not only does it trigger run-off insurance and all of the issues that the profession is currently experiencing beyond the 6-year traditional coverage, but also the cost of redundancy, closure of offices, file storage and more. It is not an option to be undertaken lightly but, in certain circumstances, you are forced to do so as a result of not getting professional indemnity renewal.
Of course, closure cannot be avoided by everyone, but a business should be able to avoid this if succession planning becomes a big priority within the overall strategic plans for the business long term.
How easy is it to sell to a third party?
The external option is often seen as more complicated than the internal option, as there is less control over the process. In some cases, it can be extremely easy if all parties are clear about their intentions, there is good communication about how it would work, and some of the thornier issues are resolved early on in negotiations. For others, selling to a third party is extremely difficult, depending on how it is structured and the ongoing relationship between both parties.
In so many cases, the seller will often stay with the business for a while after the sale to help with the handover. For this reason, it is important to start a business relationship on the right foot and ensure negotiations do not become bitter, as this does not bode well for working together in the future.
Will I get value for my business?
Value means different things to different people. Naturally, value is assumed to be goodwill as defined already in this article, but for others, it could be a guaranteed level of income for a period of time, the fact they have secured successor practice (detailed advice is required on this as the rules are extremely complicated), or the opportunity to work in a bigger organisation for the greater good and, therefore, increase in value and income over a longer period of time.
Understanding what you perceive as value and what you want, and being realistic about this, are the fundamental points that a seller needs to sort out with their advisers before negotiations go too far, as it helps crystallise potential issues which could destroy deals right at the last moment.
Headlines of the latest acquisitions, news of new entrants into the market and continuous updates of performance of listed law firms do give the perception that there is potentially more value in law firms than there was before. However, true value only comes from understanding what your unique selling points are and what benefit your business has to an acquirer. Understand that, and you are able to develop an opportunity for yourself to get some value over and above your investment in your firm.
There will always be an option for law firms in terms of how to deal with their practice once they have made a decision that they no longer want to trade independently. The options are dependent on how well you plan for your succession. Your succession strategy starts the moment you become an owner and not the moment you decide to sell. Often at that point, it is too late for you to have the opportunity to make the best choices and maximise value.
Value as a concept has many different interpretations. Understanding what value means to you and what your business has that others are looking for can create something over and above just merely becoming successor practice. Thinking outside the box is key to any negotiations, as this will ensure you get the best value for your business. Additionally, taking advice early on will avoid a deal falling over, save you both time and money and set you up for a smoother process.