A note for today – the Law Firm Succession Series
The extract below is written as a knowledge piece. It is written with the medium to long-term issues facing the profession in mind.
In that context it does not – directly – take account of the issues raised by the current Covid-19 outbreak. The outbreak is undoubtedly damaging business and law firms are no exception. Certain areas of law will be hit harder than others, but undoubtedly, businesses will be dealing with the effect of this for potentially many years to come.
However, this only emphasises the issues raised in this article series and the resulting White Paper and accelerates the need for Law Firms to address the challenges.
We hope you appreciate the ideas within the Succession White Paper and look forward to helping you with those challenges, whether in the current emergency or once some version of normality has returned.
Look for our recent series of Covid-19 related articles to help your firm get back in shape.
So what do we know so far?
Law firms have a problem. There are too many owners that want to retire and too few people that are interested in taking over their business or share of their business and paying them out, so that they can do so. If you are a partner or owner looking to retire soon, then you need a plan to ensure that you have a successor or two ready, willing and able to take over the reins.
That all sounds very simple but if you drill deeper into the problem, there are many issues to address in passing on your business. Most owners focus upon the clients and the files. They are important – critically important. But there are many other areas around the business that can create difficulties for the retiring owner and are often overlooked when retirement beckons.
In Part One we looked at the changing sector structure and the implications for succession planning – the sole trader and partnership models have steadily declined and largely been replaced by the Limited Company. A focus was how to protect your core operating model – after all its not only lawyers who can retire after 20/30 years leaving a potentially huge knowledge gap.
The second instalment addressed the core issue of People – both to succeed you and protecting key relationships when staff move on. Oh, and the future of law looks Female according to the demographic data, have a look!
Read on for expert knowledge on our next dimension to succession planning – the Professional Indemnity Insurance factor. Love it or hate it no legal firm can exist without PII in place and it can pose fundamental problems for retirement and sucession planning options.
Professional Indemnity Insurance and Claims
Part of the risk of equity ownership is the risk of getting things wrong. There are two options to consider here. Have you got someone to hand over your business to or not? First, let’s assume you have and you are able to pass on your business to a successor, who will take over your files with all the inherent risks of doing so. Your claims record may have been exemplary but even in the unlikely situation where you will undertake a 100% review of those files, you are not guaranteed to find all of the potential risks and hence claims lurking in there. The risk of taking on those files would reflect in the price that anyone is prepared to pay for your business. This is especially true if they have not worked with you or your firm before. They would be more nervous about what is contained in your files if they have not seen your working methods, your attention to detail, contemporaneous file notes kept, CPD avidly undertaken and so forth.
In an ideal world, therefore, any successor would want to have been in the firm for a while, so they are more aware of what they could be exposed to. Therefore, you might want to introduce them to the clients, get them working on your files and learn for themselves where the risk areas are likely to lie and assess what level of risk they think they might be taking on. You can facilitate this by engaging them in an employed basis, so they are not – initially – taking on the risk: or if you are looking to pass the business on to another firm, you could have some form of association with that firm, where staff from the potential successor firm can work on your files, so again, they can assess the risk.
Any successor practice will need to liaise with their own PII brokers well before taking on any new firm. The work they do in reviewing your files, seeing your work and your processes will be hugely beneficial for them in helping them outline the risk to their brokers and ultimately to their underwriters. That in turn will determine – at least part – of the consideration they may pay for your business. The more risky it is, the less they will pay. So, it is in your interests to plan ahead and get good systems and processes in place now. That way, you will maximise what you eventually receive on retirement.
Secondly, the more negative situation is where there is no succession and no-one wants the business. In that case, the owner(s) will be forced to put the firm into insurance run-off. As most people know, this will require the owner of the firm to pay a further six years’ worth of PII cover in one tranche, to cover any future claims arising from those files. No one wants that – probably not even the underwriters! This is why planning to find someone to take on your business is critical but also understanding the PII successor practice rules too.
PI Insurance Insights
Successor practice rules make for a complex area and it’s essential that parties are fully conversant with them ahead of any retirement plan. That extends to insurance too and you need to be explicitly clear on the implications of each scenario.
The options are: a practice merges with another entity and is succeeded by that practice, that practice assume all of the past liabilities and no additional Insurance policy is required. Naturally when two firms merge the premium spend will increase but 1 plus 1 doesn’t always add up to 2, there could be some economies of scale possible. That said, if the claims performance is bad and the practice areas’ profile is altered it could mean that there are fewer options available for that profile of firm, therefore 1 plus 1 would now equal 3.
A practice could succeed another but not assume the past liabilities of the practice, if a run-off policy is purchased as the Minimum Terms and Conditions permit for a practice to make an election of run-off. This means that for a predetermined calculation, practices can maintain the brand and goodwill of a practice, without taking on the past liabilities of the previous leadership.
The problem with this option is that the cost of run-off can be expensive and indeed potentially prohibitive, particularly for those practices that have experienced losses or if they have significant annual PII spend, a high run-off rate or both.
In this scenario, the on-going premiums may be discounted as all of the past exposures of the practice the firm has succeeded would not be taken into account, only the on-going growth in fees from the practice areas undertaken so 1 plus 1 could now equal 1.2
The calculation of run-off will differ quite considerably from insurer to insurer; the norm is somewhere between 225% and 300% of the practice’s last annual premium, with the lowest being 150% and the highest currently is 350%. Negotiation might be possible on occasion but any reduction is likely to be quite modest and only possible if a practice has had a reasonable claims record and shown loyalty to its insurer with some longevity of relationship.
If a practice’s leader or for larger practices the leadership team are approaching retirement with no natural succession they obviously need to explore the alternatives, whether that’s looking for merger candidates or making some lateral hires to become the successor(s) of the practice. But those plans need to laid before it’s too late as their only other option upon closure of the practice is to pay their run-off premium – and provisions may have to be made to protect them and their assets personally in order to extend this beyond the six years too.
In Part Four our expert panel look at the role that Property and IT can take in a successful (or unsuccessful!) retirement plan and the types of security due diligence a prospective buyer may now want to conduct.
Thanks to all the Calico Succession expert contributors: