A note for today – Law Firm Succession
The White Paper below is written as a knowledge piece on law firm succession planning. 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 within the White Paper and accelerates the need for Law Firms to address the issues below, such as ensuring that:
- People are trained and mentored to manage the business, should senior management be unavailable staff can work anywhere. They don’t have to be in the office, recruitment must take advantage of the desire from the workforce for more flexible working hours
- IT is robust, backed up and able to support the business, even if not hosted on-site
- Property needs are assessed. Do we need that many desks on-site?
- The firm is financially stable enough to withstand financial shocks and finally
- There is a disaster recovery plan in place and that is tested frequently, so you know the business can continue, even in the most unusual of circumstances.
We hope you appreciate the ideas within the White Paper and look forward to helping you with those challenges, whether in the current emergency or once some version of normality has returned.
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. This can lead to a failure to successfully pass the business on and a failure to realise the capital value in the firm – or their share of it.
There are many firms, with older partners, perhaps sole traders, with capital tied up in their business, who eventually decide it is time to retire, look up from their desk and then look around vainly for someone to pay them out: only to find that no one is prepared to do so.
We refer to a sole trader to illustrate the point but it can apply to any firm where there has not been any new blood into the business for several years.
For some firms, especially the larger ones, perhaps those in the top 200 by turnover, there are sufficient people coming through to provide a pool of talent, that can take on the challenges of equity: but those firms must still manage the process and get those people ready if there is to be a successful handover.
In recent years, the sole trader and partnership models have steadily declined and largely been replaced by the Limited Company structure, as illustrated in the table below.
|Sole Trader||Partnership||Limited Company||Limited Liability Partnership||Other||Total|
What we are seeing is the retirement of an increasing number of “traditional” sole practitioners and their businesses being aggregated into new entities. To some extent this has been accelerated by the complexities caused by increased regulation of the profession. It has – put simply – become too much for a small ‘one-man-band’ to handle. This process will accelerate due to the demographics of the profession, as illustrated shortly.
These retirements, with businesses being taken over by or converted to other legal vehicles, also have implications for the way in which succession will be managed. Banks view these entities differently and there are taxation issues that will need to be considered in full when managing succession.
In this in-depth guide, we deal with the likely stumbling blocks to a successful succession and hopefully signpost ways of addressing them. Those issues are right across the board in law firms. Some people will initially only consider this a people issue, i.e. who is able to take over? While that is obviously a vital consideration, there are many factors at play here, including premises, IT security, PII and claims, finance, etc.
Each succession is a jigsaw and each one is different. Planning for succession is very similar to planning for a merger. You need to get the firm ready and make it attractive. This takes time and requires the owners to put in that time.
The key message is to think through all of the potential issues and start planning early!
Protecting your core operating model
Both sellers and buyers need to be alive to vulnerabilities within the firm, and some are less obvious than others. While there might be plenty of awareness of the risks of, say, integrating IT systems in the event of a post-acquisition merger, what about the loss of highly skilled, hard to replace personnel? Take the example of cashiers.
We’re at a tipping point in the profession where demographics and technological change are driving a growing wave of retirements. It is such a pivotal role in a practice that unless well planned for, it can be hugely disruptive – not a situation that any new owner would welcome, especially when they thought they were done with succession planning!
So how do you mitigate the risk? Not everyone will have the luxury of a solid deputy able to step up. Then there’s the challenge of finding a quality replacement when there’s a dwindling pool of talent out there? You could be a long time looking. The reality is that firms are having to think differently about how they protect their core operating model. And where once people looked to outsourced services to drive efficiencies and economies, now increasingly they are being valued at an even more fundamental level – guaranteeing the supply of required expertise. And protections are there across the board, not just third-party suppliers to compensate for our disappearing cashiers, but equivalent services in secretarial and transcription, IT infrastructure and applications and HR and payroll.
The lesson here is that succession planning doesn’t just stop at retiring partners. Moving to outsource with the right providers can help modernise and protect the practice, affording a stronger stance for the seller and a more desirable proposition for the buyer.
This has to be the hardest part of the jigsaw to find. When looking for someone to take over the business, it is important to ensure that they are bought into the process early on. Just as you need to plan early, they also need time to learn how to run a firm. That means learning how to manage people, understand and manage its finances, what it is to be an entrepreneur and finding work. It is taken as read that they have the technical ability. These characteristics are not easily found in everyone.
The current generation of retirees are predominantly male. The graph below, shows the demographic split of men, (left-hand-side) and women, (right-hand side), in the workforce and compares the latest data to the data from 2008, (black line). You can see that the age profile of men has – more or less – remained static. It also shows that there is a large number of men over 70, who still have practising certificates. On the right-hand side, there has been a marked increase in the number of women in the profession with practising certificates. As those women age and assuming they remain in the profession, they will eventually be in the majority in every age bracket.
This is an important point to bear in mind for succession planning: the potential successors nowadays are increasingly likely to be female rather than male. And that has implications for the way you search for the successor and the offer that is put on the table.
To maximise the chance of successfully passing their business on, the current equity owner must make the offer equally attractive to male and female candidates. This may result in more part-time partners or more flexible or ‘agile’ working practices being offered through your IT systems.
The cheapest way of ensuring a successful handover to the next equity owner is to ‘grow’ them from within. This has the advantage that they know the firm, its staff, and clients and the way it works. A formal programme of education and providing them with exposure to the issues that they will experience in owning and managing the firm, will ensure that they are ready to take on the responsibility when the time is right. It may also provide them with the opportunity to realise that taking on the risks of equity ownership is not for them. It is better to train a small number of staff to be potential equity owners and allow some of them to realise that they are not suited to entrepreneurial existence, than not to train them and have nobody ready to take over from you in due course.
All this takes time. There may be a couple of false starts. However, if you don’t prepare some staff for the opportunity, you may be left with the other possibility of hawking your firm around the local competition or to one of the many consolidating firms that are currently acquiring firms cheaply because the owners are left with no choice.
Larger firms obviously have the ability to develop people from post-qualification and take them right through to equity ownership. This will be through a process of giving them supervisory experience, followed by team or department management responsibility. All of this should be alongside training in the necessary skills to manage the firm, such as people management, project management, quality improvement, risk management and personal management and skills training, (e.g. resilience, time management, business development, and so on).
As with the smaller firms, some people will fall by the wayside but those with the commitment to the firm and who demonstrate the requisite ability will be ready to take on the mantle.
Finally, in terms of growing your own successor, we are aware that anecdotally, fewer people these days want to take on the risks of equity ownership. They are not looking for a long-term career with the same firm but want to have a more portfolio-style career or change careers a couple of times in their lives, perhaps with travel breaks in between. So, while there are more people with practising certificates now than ever before, it is not a given that there will be plenty ready to take on the equity that is offered. Part of the training must be an honest explanation of the risks and rewards of equity. Every firm that is honest with its staff about the offer on the table will be more highly regarded than any that hide the downsides while overplaying the upsides.
The other option is to find people from outside. This may be by private conversations with other firms or by asking a headhunter to find someone for you. The former may be cheaper and may provide you with a known entity taking on your business but will not provide the largest pool of potential talent. For example, if you know the partners in another local firm and talk to them, they can only decide if they would be interested; they are unlikely to speak for others within their firm or others outside their firm.
Using a headhunter will be more likely to identify individuals within their firm who are interested in progressing but being held back. They may well be interested in taking on your business. Only a headhunter, who perhaps already has a list of candidates for equity, or knows other firms who would be interested in your business, would be able to identify and approach those candidates for you. They have the great advantage of approaching individuals anonymously, so your retirement intentions remain secret – until a Non-Disclosure Agreement can be signed.
Remediating relationship risk
For buyers and sellers, the devil is always in the detail and that’s why we have due diligence. But there are emerging considerations that are adding to the scope of due diligence – and adding to the pressure to get it right.
When a partner exits, it’s not just a lifetime’s knowledge and experience that goes with them. It can also be key client relationships. It is one of the singular characteristics of law firms that clients tend to have relationships with individuals rather than the firm, and so when that individual leaves there is a heightened risk that the client will leave with them. Obviously that risk is somewhat mitigated in a retirement scenario but even so any change can increase the chances of a client considering their options. But, and it’s a big but, how do you know just how important that one-to-one relationship was?
The exiting partner might talk it up but where’s the evidence? Perhaps there was an influential relationship once but now the power base is with others, a different lawyer and a different client contact? And just how many links are there between a firm and a client, are there several partners in different practice areas with their own connections? If the senior partner, say, was to leave, would the relationship collapse or would it stay strong on the back of a web of multiple interactions. And if the senior partner wasn’t the real power broker, who is?
Mapping lawyer/client touchpoints and analysing all the interactions between the client and the whole law firm can help generate amazing insights into client ownership – who in the firm has the strongest relationship with the client, who else in the firm is active with that client, who in the firm knows other people in the client, not just the principle contact.
All this type of intelligence can now be automatically harvested and presented so that those involved in any change of ownership can get a clear idea of ‘relationship risk’ at an early stage. If the data shows you are about to lose a rainmaker around whom a whole account revolves, then you can get ahead of the game and manage the transition, build new connections, effect a seamless handover, rather than just walking blindly into the abyss.
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.
Successor practice rules make for a complex area and it’s essential that parties are fully conversant with them ahead of any succession 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.
This is often overlooked when succession is being considered until it is almost too late and becomes a problem for the potential vendor and the acquirer.
Naturally, the property could be leased or owned. If it is leased, the remaining lease term is important. An acquirer does not want to be bound into an onerous lease, either in terms of length of the term, rent payable or other conditions: but on the flip side, the retiring party might consider that there is significant value in a long-term lease or one with unusually advantageous terms, such as a rent payable below current market rents. The retiring party will be the tenant and must make it sufficiently attractive to their successor to want to take over the lease. Otherwise, they will be stuck with the lease or may not be able to transfer the business at all. The expiry of the lease may itself be the trigger for retirement. The potential retiree must be aware of the lease issue and be ready to deal with this as part of the negotiations.
This situation is even more complicated if the premises are owned freehold by the retiring party(ies). They may well expect that the acquiring party will want to take over the premises. However, what if the firm has been using the premises rent-free? The retiring party, unless they are willing to sell the premises or are very generous, will expect to earn a rent. That will damage the profitability of the business and make it less attractive to any acquirer. In any event, the capital cost of acquiring the premises, alongside the value of the files, could well be prohibitive. And, in any event, in this age of open-plan and agile working, would the acquirer want those premises? They may be a millstone around the firm’s neck and preventing the firm from being as efficient as the best in the area. If the premises are to be sold, then the acquirer may ask for a discount on the capital cost of taking on the business, to reflect the increased rent that is likely to be payable once new premises have been found. All of this dents the potential pay-out to the retiring parties.
Once again, the main lesson is to plan ahead and have options available.
IT & Security issues
Anyone taking over the entire business will either continue to run it using the same hardware and software or, in a merger situation, will want to integrate it into their own IT.
In the former case, the only issues are to ensure that the purchaser acquires all the rights to use the IT, e.g. ensuring licences are transferred and do not remain in the name(s) of the retiring party(ies) and that the retiring party(ies) are locked out of the IT after retirement.
Where on succession, the business is being merged into another business, there is more work to do, in mapping all of the fields in the retiring party’s database into the acquiring party’s database. This is critically important to ensure a seamless transition for the firm(s) and clients and therefore, expert advice should be sought.
There are many potential IT issues, depending on how succession is facilitated and engaging help to ensure all issues are covered off will reduce the risks of things going wrong.
Putting a value on security
Buyers and sellers need to be aware that cyber-security is playing an increasingly prominent role in the M&A space. Amongst corporates there is already a body of research that is showing correlations between security posture and valuations, as well as influencing the selection of one target over another and causing offers to be withdrawn altogether.
The law firm that can demonstrate rigorous data handling procedures, no GDPR infractions or future data breach-related liabilities, documented assessment of its IT supply chain and a generally robust approach to IT system management is going to have a clear edge over another prospective target firm that can offer no such assurances during the due diligence phase. It strengthens the negotiating hand and can certainly help seal a better deal, and getting on the front foot in this way should be best practice.
But what if the seller has reason to be less bullish and the security stance is more opaque? That’s where as a buyer you need your due diligence to kick in. And what you must understand is that you have far more tools at your disposal now to assess, in quite forensic detail, the security health of your target. Services exist that analyse all outside visible IT-related assets – basically it’s like getting a hacker’s eye view of an organisation but in a totally legal and legitimate way.
It’s all about understanding as much as possible about an organisation and its cyber security credentials before you part with your money – rather than walking blind into a closet full of skeletons. It’s a tangible part of the calculation of value, and beyond that business owners are increasingly aware that strong cyber security practices are critical to reputation, brand and revenue growth.
All of which means that an exiting owner needs to be aware that prospective buyers will be scrutinising more than the books and the business base. And if their security house is not in order, then they’re in for a tougher negotiation – or worse, no negotiation because there’s no more deal.
This is the ultimate issue. Buying into equity in a law firm is usually expensive. Over recent years, the values of capital accounts and undrawn profits left in firms to provide finance have increased. Values of well over £250,000 are common in multi-partnered firms. Sole traders can have smaller balances, depending on what is in their firm’s balance sheet. For example, if the premises are owned, held within and being sold with the business, the value of those premises will increase the capital to such an extent that it could make it almost impossible for a single person to acquire that firm.
To successfully transfer your business, you may need to split the part of the business that does the legal work, from any property-owning part. The property-owning part may need to be sold separately. That will make financing the legal part easier. Obviously, discussions will need to be had with your successor(s) about whether they would want to continue in the premises or move elsewhere.
A discussion with the bank about how to provide equity capital to the firm will usually be met positively but they will want to see things like business plans, cash flow projections, budgets and may want to discuss personal guarantees.
If you are selling, you can make the hand-over easier by introducing your successor as joint-equity owner first, taking a proportion of the equity: and then selling on the rest in stages or at a later date. Furthermore, staying as a consultant is a popular way of ensuring the goodwill in the firm is retained, notwithstanding that the equity has been transferred. Again, taxation and financial planning advice must be sought in these circumstances.
Save your energy
Deal advisors such as accountants don’t just have their respective expertise to bring to proceedings – they also have plenty of experience with a catalogue of ‘Lessons learned’ that they’ll only be too willing to share. Take this one: don’t take your foot off the gas at the critical moment. The basic premise here is that both sides expend so much energy in getting the deal over the line that they then collapse in that post-event euphoria, the adrenalin seeps away and tiredness and relief replace focus and momentum.
To be fair, most people are aware that the hard work begins after the ink is dry – after all, the business case that prompted the deal is just numbers and projections on a page, it needs the new entity to come together to actually deliver them. And those first weeks are critical, it’s no time to sit back. There are the obvious projects, from the integration of IT and finance systems, to the communications to staff, stakeholders and clients; but this is also a crucial time to lock in the next tier down.
Take the regional law firm whose ownership hinted to its next tier that there was possibly a buy-out opportunity for them as they themselves sought an exit. The three individuals in that next tier duly took some professional advice, advised the ownership of their interest and then….nothing. The first they knew about their future was when the firm’s owners announced their merger with Firm B some weeks later; they had not been consulted or been given any chance to move forward with their own offer. Being presented with a fait accompli was bad enough but then there was no effort in the immediate aftermath of the deal either to sit down with them, sort things out and lock them into the new partnership.
Less than three months in, they left and moved together to another firm, taking with them a client base large enough to take the shine off the projections – and striking an early and heavy blow to the prestige and standing of the merged organisation.
The takeaway here is to use your advisors, consultants and service providers so that they can take some of the weight off; let them do the detail, the heavy lifting, so you get to a good place with the numbers and the contracts and the project plans, and carry that impetus through to the execution post-signing. That way you leave yourself with the time and energy and perspective needed to look after your key people, ensuring not just a smooth transition but a firm foundation for future success.
There is a sea change in the profession. It has been gathering pace over the last few years and because of the increase in regulation, fewer people wanting to take on equity, being risk-averse as regards being in business, combined with the demographic changes already underway, the profession will face more consolidation and probably a continued reduction in the number of firms, despite an increase in the number of solicitors with practising certificates. We will have fewer – but larger – firms.
Some of the smaller mergers in recent years have taken place with little due diligence and the issues outlined above have come back to bite the new owner of the equity. That may be through a very large increase in the PII premium, significant claims being suffered, difficulties in integrating the IT and accounting, problems monitoring quality across all files and loss of key personnel. Even worse, some owners have had to suffer the PII run-off premiums of – often – nearly three times the annual premium.
Finally, every succession issue is unique. There is no template.
This is why proper planning is important, both for the potential retiree/vendor and for the successor owner/firm. It is almost identical to ensuring a firm is ready for a merger. That means that the firm must be run well by continually addressing the issues above. A well-run firm will have more value than a poorly run one. So, there’s your incentive!