Acquisitions as an Exit Strategy in Indian Law Firms

For most businesses in India as elsewhere, acquisitions are seen as a tool to further growth and diversification. For law firms as well, acquisitions are often seen as a method by which the acquiring firm is able to venture into new practice areas while achieving cost synergies brought on by the increased scale of operation. However, recently businesses in India have begun to look at acquisitions as a form of ‘exit strategy,’ or a method by which entrepreneurs are able to sell off their investment in a business that they founded. Thus, acquisitions have also begun to function as a form of exit planning for founders who are looking to retire in the near future.

This type of strategic acquisition becomes especially relevant in the context of law firms which have been started and managed by an individual or a group of individuals who would like to see that the firm continues to flourish even after their exit. For such founders, passing on the ownership to a suitable acquirer appears to be a far more favourable option than dissolution or liquidation of the business that they helped start.

This article seeks to analyse the feasibility of such strategic acquisitions for founders of law firms in India. It focusses further on the steps to be taken in order to begin the acquisition process and looks at the advantages that such acquisitions seek to offer.

Feasibility for Indian law firms

In India, law firms can be divided into two categories on the basis of their business structure and scale of operation. The first category comprises large full-service law firms, most of which are structured as limited liability partnerships. In such firms there is a clear succession plan in place, with the retirement of a senior partner resulting in a junior partner’s being promoted to take the retiring partner’s place. For such firms, acquisitions for the purpose of exiting are less feasible due to their size and scale of operation, nor are they required since such firms already have some form of exit planning in place.

Strategic acquisitions become more relevant for the second category of law firms in India, which are largely family-run businesses, smaller in size and often structured as sole proprietorships. Such law firms sometimes find a vacuum being created in the succession space when the founder is aging and wants to retire. For such firms, acquisitions form a feasible exit strategy as these firms are usually involved in niche practice areas which makes them a good acquisition target for larger law firms seeking to diversify. While an acquisition results in the founder giving up his control of the firm, often founders continue to work in the capacity of mentors even after acquisition, using their association with the firm to ensure the smooth transfer of clients as well as to maintain employee morale after the acquisition. They may continue in advisory roles for the specific practice area in which the acquired firm was specialised, using their years of industry experience to cultivate new leadership and management skills.

Preparing for the Acquisition

Once a firm decides to adopt this exit strategy, several steps must be taken before venturing further, in order to ensure that the acquisition is successful and founders are able to easily exit the firm.

1. The first step in this regard is to search for an acquirer that best suits the firm’s strategic goals. It is necessary to determine which law firm would be the best acquirer – ideally one that has similar management ethics as the target firm, so as to ensure efficiency in operation even after the acquisition.
2. It is also necessary, once certain possible acquirers have been identified, to evaluate and improve the existing systems and policies within the target firm as well as create a comprehensive profile of the firm’s areas of expertise, in order to make the firm more appealing to the acquirer.
3. Since structuring of the acquisition would be largely dependent on market trends, it is also necessary to carry out an in-depth market analysis of recent market trends.
4. Correct valuation of the firm’s assets should be undertaken before the process of acquisition can be started. This will include determining the value of the firm’s fixed assets, liquid assets, and goodwill, as well as human capital.
5. A thoroughly undertaken Conflict Check is another critical aspect which comes into play while considering a merger.

Since each firm remains unique in the manner in which business is carried out, as well as other management practices, it is not possible to pinpoint an exact plan that must be followed before approaching the acquirer. The strategy adopted would depend on the acquirer and the target’s objectives and goals as well as the time frame available.

Advantages of Acquisition as an Exit Strategy

Selling the business of a law firm to a market competitor has a substantial advantage for persons who are looking to give up complete ownership control over the firm, as this allows for the fastest method of achieving maximum liquidity. For the founder of a law firm looking to retire, therefore, such a sale would be an ideal exit option. Smaller firms which are involved in niche practice areas also form the best targets for larger law firms seeking to consolidate the acquired business and diversify their practices. An acquisition by a competitor could also result in increased valuation of the firm if the target is a well known firm in the specific practice area in which it specialises, since the price of the business would be what it is perceived to be.

Conclusion

In a country like India, acquisitions form an appropriate exit strategy for law firms in the country which are structured as small, niche, family-run businesses. In addition, acquisitions in general have the known advantages of increasing the value of the company and making operations more efficient by increasing their scale.

However, for law firms in particular, it is also important to remember that acquisitions risk making clients nervous, which might lead to loss of business. Thus when a founder wishes to completely give up his ownership control over the firm, an acquisition might be the step forward, if carried out cautiously after adopting a plan that takes into consideration the unique position of the target firm, allowing the firm to embrace a deal best suited to its needs.

Bigger vs Better: Should your firm merge?

First, see if it can answer “yes” to one essential question.

So law firm mergers are back in the news again, to the continued fascination of the legal press. For every combination that’s completed and announced, you can count on several others bubbling under in conversations within executive committees and at luncheon gatherings of senior partners, so there likely will be more such deals announced throughout the balance of the year.

It’s not clear that “mergers” are the best word to describe many of these transactions. Some of them involve global behemoths swallowing up comparatively modest firms in desired regions, resembling not so much a business deal as the annexation of territory. Others are billed as marriages of equals, but with so many of these merged firms maintaining their own profit pools, they seem like marriages where the spouses have no joint bank account and keep separate residences.

The common thread among all these deals, however, is that the merging firms go to great lengths to publicize the impressive size of the new entity, the huge number of lawyers, offices, and jurisdictions it will boast. It’s the kind of tactic you could understand if, say, two ice-cream dealers merged and could now deliver 70 flavours in one location, rather than 30 and 40 in separate stores as before. More volume and greater selection are obvious customer benefits in that kind of market.

It’s more difficult to make out clear customer benefits from law firm mergers. There’s an unspoken assumption that more lawyers in more offices in more locations is self-evidently a good thing, a competitive advantage and a client service. And maybe there are tactical benefits to be gained, especially around marketing strength, talent acquisition, and the like.

Yet I can count on the fingers of no hands the number of corporate clients I’ve overheard wishing their law firms were bigger and farther-flung. To the contrary, many clients greet news of a merger with a certain exasperation, having to turn their minds to identifying and resolving potential conflicts, or to awaiting the inevitable rate increases from the new entity.

Any law firm that’s considering a merger or acquisition should ask itself one question — the same question, really, that it should raise whenever any foundational or strategic decision is in play: “Would this make our firm more effective?” It’s a powerful question, because it forces the firm to focus its attention on its fundamental business purpose.

The point of any business is to serve its customers. For a law firm, that translates into helping clients in its chosen markets achieve their goals by addressing their legal challenges and opportunities. A law firm should be considered successful only to the extent it helps clients achieve their law-related objectives. Would a merger allow the firm to accomplish this mission more effectively? And if so, how?

Effectiveness, remember, is defined from the perspective of the client, not the firm. Clients consider a firm effective if it anticipates and meets their legal needs in the context of their business realities, demonstrates real commitment to procedural improvements that increase quality while reducing cost, provides reliability and competitiveness around pricing, and keeps lines of communication buzzing and productive. Mergers, by themselves, aren’t going to move the needle very far on any of those criteria.

Mergers might very well deliver competitive advantages, although I’d love to see a study that contrasted those advantages with the costs of merger, which are manifold and substantial. But potential mergers ought to be scrutinized primarily with specific reference to how they will enhance the firm’s effectiveness in its chosen markets, rather than with vague assurances that “global clients want one-stop shopping.”

Size alone is no longer a significant differentiator for law firms. Increased profitability does not correlate strongly with increased size, nor does talent retention, realization rates, client satisfaction, or a host of other measurable criteria with which firms should be closely concerned. There is little evidence that becoming bigger means your firm becomes better. If you’re unsure about this, feel free to call up a few key clients and ask them what they think about your merger plans. Their responses should be illuminating.

The Price of Acquisitions: Assessing and Managing the Real Cost

The term “acquisition” is used quite often to describe the manner in which law firms bring in experienced lawyers.  Sometimes firms describe the hiring of lateral partners as an acquisition and bringing in groups of lawyers or a whole practice group from another law firm is viewed as an acquisition.  When the consolidation of two law firms is referred to as an “acquisition” it typically signals that one firm is larger than the other and will dominate the transaction.  This means that the “acquired” firm is merging into the name, compensation system and legal entity of another firm.  The successor of the consolidated two firms usually looks more like the “acquiring” firm than a blend of the two firms.

But rarely are any of these “acquisition” transactions where a purchase price is paid.  Indeed, law firm mergers and lateral hires are traditionally cast as “cash neutral” events. Typically, all parties are considered to be bringing an equal amount of value on a prorated basis into the new firm and the management of most firms would be horrified at the concept of actually paying to acquire another firm.  With mergers, this means that when the respective net worth of the two merging law firms is spun back to the lowest common denominator (per equity partner or per percent of ownership) the value of the two firms is roughly equal.

But law firm mergers are rarely as equal as they are designed to be and the result is that, in reality, one firm is frequently – but sometimes unknowingly – paying a substantial price to acquire (or be acquired by) the other.  This is an issue because, as law firms are involved in more and more mergers, particularly a series of mergers with smaller firms, the impact on the combined capitalization of the successor firm can be significant.  In fact, differences in the respective value of merger partners in the hundreds of thousand and, perhaps, even millions routinely get swept aside in the eagerness to do a deal and, perhaps, because even some astute business lawyers don’t quite grasp the concept of law firm capitalization.

The Value of a Law Firm
The value of any business is made up of four types of assets.  Fixed assets (the depreciated value of furniture, fixtures, computers and the like), liquid assets (cash, inventory, accounts receivable, etc.), Good Will (the value of businesses reputation, name recognition and client relationships) and what some call human capital (the revenue producing capability of a firm’s personnel and their know-how (in a law firm, its lawyers). The fixed assets and liquid assets show up on the firm’s cash basis balance sheet.  The subjective assets, Good Will and human capital, do not.

In some ways the process of merging would be easier if law firms were routinely purchased by an acquiring law firm.  There would then be a standard means of valuing a firm based on any of a number of procedures but typically ending in the purchase price that correlates to the way other business sales work — a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).  But with law firm mergers the vision is that both parties throw everything into a pot and assume that, unless there is some exceptional liability outstanding, the contribution of both firms will be prorated to their respective size.  Unfortunately, it doesn’t always work out that way.

Two features that are fairly unique to the practice of law in the United States have an interesting impact on the values placed on American law firms.
1. Cash Basis Accounting.  U.S. tax laws permit certain forms of business, including law firm partnerships and professional corporations, to report earnings on a cash basis.  This permits firms to be taxed on the amount of actual cash received from clients and disbursed to employees and vendors, as opposed to most corporate entities that are taxed on the amount billed to clients and billed from vendors (the accrual basis).   More significantly, tax laws generally require that firms file their taxes on the same basis as they use to keep their financial records.  And, even though the IRS has pretty consistently ruled that this does not prohibit firms from keeping their books on an accrual basis, many law firms fear being accused by their partners of financial shenanigans if the firm prepared financial reports on a different basis than their tax return.

2. Lawyer Employment Contracts.  Although courts consistently uphold non-compete agreements in every industry, including the medical profession, lawyers in the United States have traditionally been treated differently.  Under the Rules of Professional Conduct, it is argued, the clients’ right to choose their own counsel supersedes any form of non-compete agreement.  While there are a series of state court decisions that appear to be nibbling at a non-compete prohibition for lawyers, the non-enforceability of non-compete agreements is generally assumed in most law firm transactions.
Accordingly, if a law firm acquires another law firm, there is no guarantee that the acquiring firm will get anything beyond the physical assets together with the work in progress and accounts receivable.  So an acquisition based on past earnings would be irrelevant because there would be no assurance that the lawyers who accounted for the earnings wouldn’t walk across the street and start a new firm.

As a result, two of the assets that create value, Good Will and “the Recipe” are not included in the value that is considered in the merger of two law firms.  Since the cash basis of accounting causes firms to only look at things that involve cash, value is limited to specific assets and liabilities that can be precisely quantified.   This means that the two features that most drive law firms — the quality and expertise of their lawyers and their client base — are ignored in calculating the respective value of the two firms.

Since we don’t consider the subject non-cash assets in valuing a law firm, it makes it more important that we get the math right.  On a cash basis, the net equity of a law firm is equal to the assets minus the liabilities.  It’s that simple. [see figure 1].  As an equity partner, therefore, the value of my ownership of the firm is the net equity (assets minus liabilities) divided up by whatever means is determined by the partnership agreement.  While it could be equal distribution or some fixed capital percentage, in most firms the value is divided by the same percentage by which the profits are divided.

The Traditional Approach
The significance of law firm cash basis accounting is that it drives the way firms look at everything else, including the amounts equity partners pay in capital contributions. Historically, law firms were envisioned as places where lawyers were employed directly from law school and worked for a period of time as associates until they earned an opportunity to become a partner.  At that point, new partners either made a cash contribution to the firm’s working capital or it was deducted over a period of time as undistributed income. In most firms, the capital required of a new partner is a cash amount that is either a fixed dollar amount or in some way related to proportionate compensation (a percentage of cash earnings or a dollar amount based on a partner’s percentage of ownership).  In other firms, there is no capitalization required of partners and, instead, the firm’s capital comes from what is effectively retained earnings.

This system worked fine in the traditional firm because new partners were viewed as having paid a portion of their capital contribution through their years of work in the form of “sweat equity.”  But as firms began bringing lateral partners into their ranks and consolidating with other firms, a problem was created.  The actual prorated value of a firm owned by a partner is substantially different from the amount of the cash capital contribution.
Consider the following example:  Two lawyers, Moe and Curley, start a law firm.  They each chip in $10,000 in working capital.  The firm is successful and over time they buy equipment and build up unbilled time and receivables totaling $300,000.  They have taken some loans to help with cash flow and equipment purchases that total $100,000.  So their net equity is now $200,000, i.e, if they liquidated the company tomorrow their $20,000 investment would have grown to $200,000.

Moe and Curley decide to bring in Larry as an equity partner.  Assuming Larry will get an equal share of the profits, how much should he pay for his partnership?  He contributed nothing to the past sweat equity that built the firm’s value tenfold but, in most law firms, he would be asked to invest $10,000 and the net equity would grow to $210,000.  Larry’s investment would have grown to $70,000 and Moe and Curley’s would have shrunk from $100,000 each to $70,000.  The assumption is that the clients and expertise that Larry brings to the firm is worth the $60,000 net acquisition price that Moe and Curley have paid.

In truth, Larry should have been asked to invest $100,000, the equal to what Moe and Curley had invested, but with law firms that rarely happens.  As a result, the value of most firms, by any proportional basis, decreases as it adds lateral partners because it often takes months for a lateral partner to reach the point where the value of his or her billings covers the cost of their compensation and practice.  Recouping the capital investment may take years.

The complexity of this issue magnifies as merger partners become larger and span the country or are international.  Partners hate contributing after tax dollars to the capitalization of their firm and frequently argue that law firms can borrow less expensively than can individual lawyers.  As a result, we see huge disparities of net equity in what would otherwise appear to be similar firms as they sit down to discuss a merger.
Pricing an Acquisition

This is not an insolvable problem, however.   It requires that the parties must go through the full mechanics of calculating the net equity that each firm is contributing on some proportionate basis.  This is accomplished by using the analysis outlined in figure 1.  Some warnings:
1. It is very easy for an advocate or opponent of a merger to subconsciously make adjustments that distort the analysis.  Consider using an independent accountant or consultant.

2. Devote appropriate attention to accounts receivable and work in progress.  During merger discussions firms will often agree to some arbitrary reserve standard for work in progress and accounts receivable, e.g., amounts over 120 days old or a percentage that approximates annual write-offs or write-downs.  In the current economy, the unbilled time invested in transactions that will never close or contingent litigation matters that are years from settlement can distort the value of assets by millions of dollars.

The same is true with accounts receivable.  Because accounts receivable don’t appear on cash basis financial statements, there is little motivation to write off doubtful accounts.

In the final analysis, the per partner or per compensation unit difference in the net equity of the two firms must be reconciled in some manner.  Either the partners in the firm with the lower equity must write a check (or carry a negative capital account) or the firm with the higher equity must realize that the amount of the difference is the price of the acquisition.

The issue is not that law firm mergers should only occur among firms with identical net equity or that a merger in which one firm pays an acquisition price is not a highly valuable transaction.  The point is that the dollars involved can be very large and in the current economic environment, taking rapid advantage of opportunities can be a driving influence for taking action.  An acquiring firm has to take a deep breath and consider whether the value of the subjective assets justifies the acquisition price.

Learning to Dance Backwards: What Successful Acquirers Know

Most law firms want to grow.  Whether to gain depth of capability or achieve the credibility among clients that comes with critical mass, growth in the number of attorneys is a strategic priority for the majority of law firms in the U.S.  Of course, firms have several growth options.  They can grow organically by hiring new lawyers as first year associates and move them through a developmental program.  But this takes a huge amount of patience and requires that the firm have the capability to generate enough leveragable work to keep these young lawyers busy.  They also have the option to engage in large lateral hiring programs.  But this requires a big expenditure in headhunter fees and could cause a cash flow hit that will have negative effects on profits.  Plus, for many firms, large scale lateral hiring has created a revolving door with as many lawyers leaving the firm as joining it.  And for firms in declining legal markets, their best growth opportunities may be through expansion to new geographic markets where they face the costs of opening and equipping a new office.

Not surprisingly, many firms consider mergers to be their most attractive growth option.  But there is one limiting factor.  Regardless of their size, profitability or strategic direction, most firms want to pursue mergers in which they will be the surviving entity.  Often the driving issue is their desire to maintain the firm’s culture or name.  In other cases it is a fear of losing control of their practices.  But, for whatever reason, there are a lot more law firms who see themselves as the “acquirer” rather than the “acquired” when considering consolidation with another firm.  In fact, some law firms’ entire strategies are built around serial acquisition.

First, it should be noted that, regardless of the relative sizes of firms involved, most law firm consolidations are technically mergers as opposed to acquisitions, i.e., there is no compensation paid for the assets of the smaller firm.  But regardless of the technicalities, when a consolidation occurs between two firms of substantially different size, often both parties and the business community tend to view it as an acquisition.
When you have a situation where everyone wants to be the surviving entity, you have a problem of supply and demand.  I remember when my son described his junior high school ballroom dancing class as a “big mess.”  Apparently, in this age of gender equality, everyone wanted to lead.  In his 13 year old wisdom, my son pointed out, “This isn’t going to work unless somebody is willing to dance backwards.”

Aside from the obvious need of law firms that are willing to be acquired, being the acquirer in a law firm merger is not as easy as some firms may think.  For firms that have had little success with integrating laterals or stemming the revolving door of former laterals leaving the firm, there is little reason to believe that upping the ante to take in an entire law firm will result in greater success.  However, as we observe larger law firms that have built their size primarily through a series of mergers with smaller firms, there are a number of actions that seem to enhance their potential for success.

Ten Things Successful Acquirers Do
1.  Know the vig.  From the start, an acquiring firm has to know what it wants to get out of the deal.  As acquirer, they may be seeking a variety of things ranging from a geographic location on which to build an office (which means location of office space and a functioning telephone system is worth more than the lawyers) to strength in a specific practice (e.g., firms coming into Las Vegas may be looking for a gaming practice; firms looking at Denver may want energy).  Sometimes the firm is simply looking for talent — the best lawyers available.  The point is that successful acquirers establish their objectives in advance, not as a backfilled justification after they start discussions with a firm.

2.  Understand motivations.  The collective ego of larger firms sometimes causes them to assume they understand the smaller firm’s motivation in a consolidation (“Who wouldn’t want to be a part of our firm?”).  But the real motivation may be a collection of individual partner’s needs and expectations.  For example, some partners may be expecting their acquirer to supply them with a pipeline of sophisticated work.  Others may be looking for a larger platform on which to expand their practice.  Some may assume they will get a big compensation increase.  Failing to appreciate the individual motivations of significant partners (especially if the acquiring firm is basing the justification for the merger on those partner’s practices) can be an expensive mistake if they are dissatisfied and leave soon after the merger.

3.  Define a win.  One of the reasons we rarely hear about unsuccessful mergers is that law firms set the bar of success too low, i.e., if the firm is still in existence and most of the lawyers haven’t left, it’s a success.  Law firms that are frequent acquirers establish financial objectives for the first 12, 24 and 36 months both so they can learn from mistakes and to demonstrate success to their partnerships.

4.  Forced stability.  In mergers of equals it is anticipated that neither of the predecessor firms’ procedures will take precedence and that the new firm will be created on best practices.  But for the acquiring firm, part of what it is selling is stable operating systems.  The instability of significant compensation system changes or new client acceptance procedures can destroy the benefit of an acquisition.  Plus, it opens the door for the acquired firm to open negotiations on everything the combined firm does.  Unless the internal problem is critical, acquirers avoid tinkering with systems during periods of significant acquisition.

5.  Managing cultural fringes.  Acquirers understand the impact that a deviant culture in an acquired firm can have on a larger firm.  At the median, most law firm cultures are very similar.  The differences come at the extremes, and in smaller firms cultures are often far less homogeneous than in larger firms.  Successful acquirers make a point of meeting every partner and the associates who are near partnership to understand what the cultural influence is likely to be.  The exodus of lawyers from a firm being acquired is not always as voluntary as those lawyers would have you believe.

6.  Start with relationships.  Law firms that are good at merging understand that, while the deal may be about numbers for the acquiring firm, the smaller firm is giving up its identify in a transaction that is irreversible.  This requires the development of a strong relationship early on.  In a merger of equals firms can start due diligence early in the discussions.  With acquisitions there must be some romance and a bit of courtship before the firms can get on with the details.

7.  The pre-mortem.  In mergers both sides deal with a vision of what they can create together.  Acquirers have to understand both the upside and the downside.  The most attractive pro formas can get slammed by mistakes in implementation and mistakes will happen.  Successful acquirers get their implementation team together and imagine what can go wrong in the process and preplan what they can do to fix it.

8.  Objective counsel.  Even an experienced acquirer can get too involved in a deal to look at it objectively.  Therefore, there should always be an objective party involved in finalizing the merger.  It can be a partner who was otherwise uninvolved in the discussion, a consultant or a retained outside legal counsel.  But last minute demands for “kickers” and other closing issues can’t be handled by the same people who did the “romancing.”

9.  Understand the brand.  We’ve all seen someone buy a successful restaurant and then change the menu and the décor.  Experienced acquirers precisely know their acquisition’s reputation.  If that reputation is of value to them, they don’t mess around with the features that constitute that brand, even if it results in a short term inconsistency within the overall firm.  On the other hand, if the acquisition doesn’t have a definitive brand, the acquirer will move quickly to brand it with their reputation.  This may sound like “marketing-speak” but early actions go a long way to determining whether an acquisition is known as “the Phoenix firm that was acquired by Smith & Jones,” or “Smith & Jones’s Phoenix office.”

10.  The golden rule.  Much of the above seems quite mercenary.  But, acquirers realize that, as of the effective date, the partners in the acquired firms are partners in the successor firm and will have to work together for many years into the future.  As the managing partner of a firm quite good at bringing in smaller firms said, “Remember the golden rule both ways: ‘do onto others as you would have them do onto you and ‘if I were them, what would I do to me’.”

The point of all this is that, while being the successor firm may seem more attractive than being acquired or participating in a merger of equals, the acquirer takes on a lot of responsibility and risk.  Sometimes dancing backwards isn’t all bad.

Staying Out of Sam’s Club: Making Small Acquisitions Work

The recession provides an excellent opportunity for law firms to achieve strategic objectives through a series of small mergers that are effectively acquisitions.  Increasingly, smaller firms with less than 50 lawyers see “being acquired” as the best means of surviving the economic downturn.  For larger firms, picking up lawyers in small groups enhances the likelihood of a successful integration and a lower financial risk exposure of individual laterals.  And, a series of smaller transactions typically has a greater potential of actually occurring than trying to put together a single large merger. The problem for both sides is finding an opportunity that fulfills the firms’ respective strategic objectives.

Understanding Objectives
For smaller firms being acquired is typically an issue of survival.  As the economy tightens, larger firms expand their business development efforts to including “emerging clients” which is generally code for businesses being served by small law firms.  At the same time, as larger firms become more competitive for lateral hires, smaller firms’ lateral candidates are generally limited to lawyers who have practices that are sufficient to support themselves but can’t spin off work that builds profit for the firm.  In short, the opportunities for smaller firms are contracting at a time when economic demands are more stressful.  Being acquired by a larger firm is often viewed not only as a viable solution but, sometimes, the only option.
Conversely, the objectives for larger firms are often less defined – in fact, I call it “shopping at Sam’s Club”  (in fairness, I should confess that my wife hasn’t allowed me to shop at Sam’s Club since I came home with a five pound can of black olives and a 240 roll pack of single-ply toilet paper).  Like me at Sam’s Club, large law firms often approach small mergers as “too good a deal to pass up.”  As a result, they end up with a lot of stuff they don’t need.

The answer, of course, is to predetermine the firm’s needs rather than reacting to opportunities that become available.  There are basically four – and only four – valid reasons for acquiring smaller law firms:

• Increasing the depth of capability.  A merger with a smaller firm, especially a firm that is fairly specialized in its practice, can provide critical mass in a practice area.  This is especially true in a smaller office of a large firm where focus is required to gain recognition in the marketplace.
• Expanding the breadth of capability.  Merging with a boutique may be an excellent means of adding a practice area without the baggage involved in merging with a larger firm.
• Establishing positioning.  Small firm acquisitions are often an excellent means of moving into a city or publicizing the firm’s capabilities.
• Gaining access.  Often, acquiring a small firm’s access to trade associations, a specific client or a regulator may be more cost-effective than building from scratch.

Small Acquisition versus Large Merger
There are some significant advantages to growth through the acquisition of smaller firms in comparison to large scale mergers and singular lateral hires.  For starters, they are typically easier to put together.  Smaller size diminishes issues of surplus real estate and, because they are often more frugal in their management, smaller firms usually have fewer liabilities and redundant employees than in mergers among larger firms. At the same time, political issues are typically less complex than in mergers of equals because the assumption is always that the “acquirer’s” name, compensation system and processes will prevail.  And, while the addition of any personnel has an impact on culture, it is unlikely that a smaller firm acquisition, or even a series of them, will have the jolting impact that a large merger does.  The financial and reputational risk involved in the merger’s potential failure to achieve its objectives is lower and, therefore, the transaction is easier to sell to the larger firm’s partnership.  And, because the acquiree’s financial records are available for due diligence and their work in progress and accounts receivable come with them, there is less risk and lower cash flow impact than with laterals.

There are, of course, some downsides.  Partners from smaller firms are usually accustomed to fewer restrictions and procedures than are in place with larger firms and practice group leaders may have some difficulty coaching their acquisitions in functioning in a collaborative environment.
The greatest difficulty, however, may be for the larger firm’s partners to accept that an acquisition will usually mean the expenditure of some capital.  Small law firms are almost uniformly more efficient in sending out bills and collecting receivables and they usually carry much lower capitalization than larger firms.  At the same time, typically their statistics – revenue per lawyer and profit per partner – are lower than those found among larger firms.  The result is that it is hard to make a small acquisition the cash neutral transaction that firms usually seek in mergers.  This means that there is a price attached to most acquisitions of smaller law firms.

Making Acquisitions Work
Acquisitions, particularly in the current economically stressed environment, offer some wonderful opportunities. The bottom line is whether the strategic objectives of an acquisition truly justify its price or whether the deal just seems too good to pass up for something you don’t really need (like shopping at Sam’s Club).

Here are four questions law firm managing partners and boards should be asking themselves before they go shopping for an acquisition.
1. What are the three to five top strategic practice areas where the firm needs to grow?  What are the parameters surrounding that growth, i.e., in what sub-areas should the growth occur and what is the minimum amount of growth required (by number of lawyers or dollars of revenue) to reach critical mass?
2. What, if any, practice areas does the firm need to add in order to meet its strategic objectives (simply not having a practice does not necessarily make its addition of strategic importance)?
3. What geographic locations are of strategic importance and what is the necessary practice and minimum size to meet the strategic objectives?
4. What is the price tag the firm would be willing to accept to achieve each specific strategic objective?

Once a firm has come to grips with these issues, even in a comparatively informal way, they are at a tremendous advantage in considering acquisitions.  First, they have a measuring stick with which to evaluate opportunities.  And, perhaps most importantly, they have the information and confidence to actively seek acquisitions that meet their criteria rather than just waiting for opportunities to come to their attention while roaming the aisles at Sam’s Club.

As the economy tightens we see an increasing number of law firms seeking to take advantage of the recession as an opportunity to “acquire” smaller firms.  In some situations, firms want to add to their critical mass in their existing locations.  In others, they want to use a small merger as a means of entering new markets.  At the same time, many smaller firms have an interest in considering a merger with a larger firm to provide them with the stability and expanded capability to compete for more sophisticated legal work but they have no means of identifying firms that might have an interest in their lawyers and practice.