Tag Archives: due diligence

A Tale of Two Sales

The merger and acquisition market of law firms in Australia appears to have gathered pace this calendar year. Already I have undertaken 11 valuations – with five of these being used as a starting point for negotiations for mergers, or to guide a deal where a firm is being acquired. In conjunction with the increased valuation activity, I have been engaged to find purchasers for three rather significant firms as well as finding merger partners for another two firms.

This role of law-firm matchmaker gives me a front row seat to understand what acquirers are looking for and what makes a sale or merger happen seamlessly. None of this will be a surprise to those reading this article – if you sat down with a pen and a piece of paper, you would probably soon come up with a fairly comprehensive list of desirable attributes a firm should have to be considered an attractive proposition.

When I sit down with partners who want to sell their firm, one of the first questions they ask me is how long the process is going to take. The answer to this question is: if you have all the information required for a due diligence to hand, and a sensible asking price, then we should have someone on the hook within three months, and a deal concluded within six months.

Once I have a confirmed sell mandate, I do two things before even thinking of approaching the market. First, I provide the firm with a checklist of likely due-diligence information that will be sought, and make sure that information is in a data room, ready to go. Nothing turns off a prospective purchaser more than very slow responses to reasonable requests for basic information. Second, I use this information to determine what I think the value of the practice is, and work with the partners to agree on the asking price and terms of the sale. From there, it is a matter of approaching the market and finalising the deal.

Contrasting Examples

In late 2018, I was engaged by two different firms to find buyers for their practices. On paper these firms appeared very similar, but in fact the ease of sale was vastly different. Revenue of both firms was about the same, all partners wanted to sell (there was no internal conflict about the desired outcome), both had specialisations that the market was seeking, and both were equally profitable. What could possibly go wrong?

In fact, in the case of the first firm, nothing did go wrong. The sale process was as smooth as could be, and they were the model client. At the first meeting, the partners spelled out their asking price and their (very reasonable) justification for it. On receiving my due-diligence checklist, they provided all the information within a week. By the time I had given them a target list of likely purchasers, we were all as confident as one could be. Of the five likely acquirers we approached, two were interested in exploring further, with one agreeing to the vendor’s sale price and proceeding to due diligence within three weeks of hearing of the opportunity. A Heads of Agreement was signed within two months and the whole deal concluded within five months. Quick, tidy and all parties were happy.

The process with the second firm could not have been more different. When I asked the partners for their sale price and terms, they said they wanted to see what the market would offer, based on a somewhat convoluted and subjective revenue-share model. When I pressed for a ball park they obfuscated and kept turning the conversation back to the revenue-share model. In a moment of weakness, or exhaustion, I went along with this.

When it came to due-diligence information, at the first meeting I was told this was already at hand as they had been contemplating a sale for some time. I accepted this, and went to the market with the opportunity. At this point the wheels fell off.

Meetings with interested acquirers became convoluted when they raised the question of price. Examination of the revenue-share model by some acquirers quickly fell apart when its lack of transparency was exposed. Any confidence in the vendor was further eroded when, pushed for a purchase price, they put forward a wildly optimistic number which could only be described as commercially insane.

A handful of potential acquirers that were prepared to talk further (once some sense around price had been accepted by the vendors) then sought the most basic due-diligence information. After waiting more than six weeks for information that should have been produceable within five minutes, these firms lost all confidence in anything that was put forward.

Now after almost eight months, we are really at the beginning of the process. The vendors have a reasonable price in mind and are open to terms. All due-diligence information is in a data room. My thinned out target list of potential acquirers provides some hope for success. However, I know that in future I will stick to my guns with a process that I know works, or I will walk away from the engagement.

Thought you might enjoy this story.

Edge Principal Sam Coupland is considered the foremost authority on law firm valuations in Australia, offering firms a robust valuation methodology to help them calculate accurate capitalization rates and assess the risk profile, cash flow and profitability of their firms. He is a frequent presenter on practice-management-related topics, delivering dynamic presentations to hundreds of lawyers every year in the areas of financial management, business development, succession planning, strategy, and people management.

Merger Fever in the Air

2018 is shaping up as the year of the merger. Somewhat understandably, the legal media only report the larger mergers and there have been three of them – one concluded and two announced – and as I write we are not even at the end of March.

Far greater numbers of smaller firms are entering into or examining some sort of merger. Over the past 12 months, I have been involved with a number of these mergers or sales, and this year I already have another two on my books. Some logical questions are:

  • What are the motivations for firms to seek mergers?
  • What is the reception of target merger partners?
  • What are the likely outcomes?

Motivations

Motivations for mergers will vary from firm to firm. On the positive side, firms with an expansion mindset see acquiring a firm or practice group as the fastest and cheapest way to grow their business. They will usually have a support structure that can accommodate – both physically and managerially – an additional practice or two, which provides economies of scale.

At the other end, an acquisition or merger can provide a firm with a circuit breaker for some of their managerial challengers or deadlocks. This could be anything – ranging from succession, to disparity in contribution, or a hollowing out of market share.

Those firms who see succession as a looming issue cite their lack of success in developing or retaining likely internal successors. The hope is that by joining with another practice, there will be a larger pool of talent that can service the clients as retirement of the partners looms, and that the newly merged firm (or one of the youngsters) will have the financial resources to purchase the equity of the retiring partners. There are a lot of moving parts in this scenario, and the likelihood of success is based on the idea that a larger merged firm will have the staffing and financial resources to effect an outcome.

The reception of targets

In my experience, all potential targets I approach are happy to talk. Nothing is lost from a discussion about what is possible, and humans are naturally curious – particularly if they think someone is interested in them. It is not that different from the school yard.

A meeting of the minds is the first step before any information is shared. The crucial question is ‘Do I want to be in business with this person’? More often than not the answer is ‘Yes’, or ‘I am not against being in business, as long as the deal stacks up’.

Likely outcomes

Assuming the threshold issue of cultural fit has been cleared, it then boils down to the financials. Many perfectly good mergers have floundered on the rocks once the due diligence is complete.

The right financial fit is important. I have been involved with a smaller firm that sought to be acquired by one of Australia’s national firms. There was a good fit in terms of complementary practice areas and experience of the partners. The deal fell apart because the smaller firm was profitable in its existing lean structure, but the modelling showed that when the gross fees were put into the structure of the larger firm, the profitability of the partners would be halved.

As attractive as the brand of the larger firm was to the smaller firm partners, the financial haircut was too much for them to swallow. Ultimately they ended up merging with a similarly-sized firm with an equally lean structure.

In most cases, discrepancies in profitability between merger parties will exist, but the merged entity should be able to deliver economies of scale (or cost savings by removing duplication), with the result that the financial might of the merged entity is greater than the sum of its parts.

There are of course many factors that need to be taken into consideration for a merger to be successful; a quick Internet search will provide you with any number of comprehensive due-diligence checklists if you don’t already have one. What I wanted to convey in this article is that the appetite for mergers – or at the very least exploring the opportunities – is high. Firms that are considering their options should explore the market without fear of rejection.

 

Due Diligence: What to look for under the hood

3 under hoodIn recent months I have been working with a number of firms going through the process of either merging firms or involved in a sale and purchase. That this activity has increased in recent years should not be a surprise as the ability for firms to grow organically to achieve economies of scale or fill excess capacity – be it office space or management structure – is far from certain. Many firms have weathered a turbulent couple of years and are at the point where they need to do something substantial, as chipping away at the edges has not yielded the desired results.

Purchase price or merger terms in a Heads of Agreement are usually relatively straightforward. Fortunately most firms have a realistic assessment of what they bring to the table and what they would be prepared to pay if they were purchasing their business. The biggest risk is that the parcel of fees in the acquired or merging firm are retained. This risk can be mitigated by the terms of the deal having sufficiently motivating financial handcuffs to retain partners for a period and encourage them to tend their client base appropriately.

What is often a little haphazard is the due-diligence process. Given that in all mergers or acquisitions the partners from the acquired firm will be coming across (I am yet to see a deal where the incumbent partners are not integral to getting the deal across the line), it is essential that both parties conduct their own due diligence as opposed to one party sitting meekly on the sidelines providing the information requested by the other party.

The following is a due-diligence checklist that I recommend all parties use as a starting point. You may well have more to add, but this would be my base level of what should be covered. Some of it can be done via meetings and some by reviewing documentation.

Areas to be reviewed
Information required
Strategic Considerations
• Capital expenditure – past 5 years and planned future expenditure
• Planned future acquisitions
• Business plan
• Meeting to discuss capital expenditure and planned future acquisitions
• Business Plan
Partnership
• Demographics of partnership
• Entry and exit of partners
• Performance management of partners
• Voting rights of partners
• Current partnership agreement
• Age, practice area, date joined firm of all equity and salaried partners
• Equity share of all equity partners
• Pathway to full equity partnership – admission criteria and process
• Partner performance criteria
• Partner drawings – past 2 financial years
• Management roles of partners
Financial considerations
• History of consistent earnings
• Inter-company transactions
• Extraordinary (or non-recurring) expenditure and income
• External funding
• External funding
• External funding
• Financial modeling - Profitability of merged entity
• Financial accounts for the past 2 years
• Cashflow – past 2 financial years and current year budgeted
• Terms and security for all loans, borrowings, and debt
• Taxation Depreciation Schedules for the past three financial years
• Monthly WIP and debtor balances by practice group for past 2 years
• Aged WIP, debtors and creditors list – current month
Management / Other
• Management structure – current and post merger
• Role of the board in running the business
• Committees of the board– eg: compensation
• Premises
• Professional indemnity claims
• Management organization chart
• Role of individuals in management – job description and experience
• Plan for integration (if required) of new firm management personnel
• Meeting and documentation to address questions on the operation of the board
• Lease details for all premises
• Details of any outstanding PI claims
Performance management
• Assessment of practice areas
• Structure of practice groups
• Integration of practice groups
• Income by practice area and office for past 2 years
• Originator reports – fees by responsible partner
• Organization chart for each practice group
• Hours, rates, write-offs by practice area – past 2 years
Expense allocation to practice areas
Personnel
• Work plans / budgets / performance criteria for fee earners
• Total FTE personnel by office – fee earners and non fee earners
• Restraints for all key personnel
• Internal and external training curriculum
• Details of bonus or incentive plans and who is covered
• Staff satisfaction surveys or exit interviews
Client base
• Spread of clients – fees generated by top 25 and 26 – 50
• Panels
• Client by rank for past 3 years
• Details of all panels – duration, other firms, fees from panel clients, rates, relationship partner(s)
• Departmental marketing plans
IT capability
• Ease of integration of practice management systems, databases, other IT
• New systems installed – past year
• Proposed new systems
• List of all IT systems used
• Lease commitments for all IT – amount, duration
• Meeting to address IT issues

Good luck!