Challenges in Selling a Legal Practice

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By Sam Coupland | Jul 2, 2018

Generational change in the legal profession of Australia and New Zealand has led to discussion around the value of a legal practice – is there any, or is it just a myth?

Well managed, profitable, organised businesses with repeat customers are worth real money. It is not uncommon for small, successful firms to be purchased and sold. Many firms have retained goodwill in their balance sheet, sell interests to incoming partners, and buy them from retiring or departing partners. So what are firms worth?

If any business is to be valuable it must be profitable, organised, able to achieve replicable results through quality systems and have some degree of inimitability. In many respects law firms are not that different. There are, however, some aspects of law firms that make a sale difficult.

1. Internal Sale

Selling an interest in the firm to current employees is usually the safest bet. In effect their employment with the firm has been one long due-diligence process so they know what they are getting into. Many of the challenges of an external sale will have been answered: What is the culture like? How robust are the systems? How sticky are the clients?

The financial mechanic for bringing an employee into equity can be more flexible, and may involve a lockstep or some form of vendor financing.

Of course there are challenges with an internal sale. The most common complaint I hear from an incoming partner who is asked to pay for goodwill is that they are just purchasing what they already produce as an employee. The counter argument to this is, ‘But that is what you were being paid to do.’

Incumbent partners are the other impediment for an internal sale. By admitting a current employee to partnership, the profit pool will be diluted. This is most stark in a small firm where an interest is being purchased from the incumbents; for example, if there were two partners who sold an equal share to an employee, the shareholdings go from 50% each to 33% each. In this case, the relative decrease in percentage is quite large.

A firm with ten partners that sells an equal interest to an employee will see each partner’s share drop from 10% to 9.1%, a change which is quite manageable.

In each instance the method of bringing an internal partner through will determine the severity or otherwise of the financial impact.

2. External Sale

There is a genuine appetite for firms to grow through acquisition with some payment occurring, though this market is fairly discrete. Large firms will rarely (if ever) pay to acquire a firm: The deal they offer is the potential for higher earnings / profit share when a practice or firm is tucked into their structure. It is at the smaller end where dollars change hands.

I have been in the middle of many merger or sale discussions where, at the outset, it appeared like a marriage made in heaven – only for things to unravel down the track. Many of the problems that arose could have been worked around, but often one of the parties dug in their heels, scuttling the deal. The most common challenges I have seen are:

Failure to get the partnership on board: The larger the firm, the more people who need to be convinced that this sale or merger is a good idea. Discussions can be stymied for any number of reasons.

  • For the acquiring firm, an acquisition will most likely benefit some practice areas over others. Partners in the practice groups which won’t benefit, but will be asked to foot the bill for the acquisition, may object to this – even if the profit-share arrangements in the firm mean that they will also share in the spoils.
  • Everybody in the profession has a view (one that is not necessarily accurate) of other practices. Differences in perceived prestige of firms can see partners baulk at a deal. Similarly, a tough experience with a target firm who were on the other side of a matter which turned sour can leave a lasting negative impression.

Debt levels and capital contributions: All firms have different levels and appetites when it comes to debt. Partners in a no-debt firm often struggle to sign up to a practice where they will be taking on a liability that was not of their making.

Profitability due to structure: Many smaller firms achieve high profits because they run on the smell of an oily rag. When their gross fees are absorbed into a larger firm with higher fixed overheads, the resultant profit is not as solid. I have seen this a number of times when the smaller firm is attracted to a larger practice and the name it has in the market, only to be turned off by the reduction in their profit share from what they were enjoying when they were on their own.

Orphaned practice areas or offices: Law firms grow organically and as a result have practice areas or office locations that suit the firm in its current operations. An acquiring firm may not have need for, or may be strategically opposed to, operating in some areas of law or particular locations. For a deal to occur, the acquired firm will have to jettison a practice group or location. Often personal loyalty wins out.

Some of the above situations are insurmountable, but in most cases a deal can be struck. I suspect we will be seeing a lot more merger and sale activity in the profession over the next couple of years.