Managing and Growing a Law Firm: Part 2 of 3

In this series of three articles, I highlight the legal scene in Asia, the changes to the legal industry, and the different resources available to law firms for expansion. In my first article, I shared my thoughts about managing and growing a law firm. In Part 2 of this series, I share thoughts on the global legal industry and its challenges.

At a micro level, the estimated USD600 billion global legal industry is very much in transition, with many different disruptors entering the legal markets.

Major Challenges Faced by Law Firms

#1 Disruptors

In my view, the biggest challenge to the profession comes from disruptors offering quality alternative legal services, such as contract lawyers, at a reduced cost. To counter this, firms like Allen & Overy have set up alternative businesses such as Peerpoint, offering similar services to compete with these disruptors. There is also much evidence of this type of defensive strategy being adopted by other global firms to counter the threat of disruptors. To drive down costs and still provide quality services, some of the larger global firms are also moving some of their process-driven commoditised products to centres of excellence. Examples of firms taking this approach include Allen & Overy, Baker McKenzie and Herbert Smith Freehills, with significant paralegal bases in Belfast.

#2 Big Four accounting firms

The Big Four accounting firms also pose a major threat. Their core strategy is to complement their compliance and transactional businesses with a quality legal function. This multi-disciplinary offering creates a “one-stop shop” which is very attractive to clients. History tells us that when accountants attempted this strategy in the late 1990s, it failed. In my view, the reasons for that failure were that they were not fully committed to the strategy, and the world was less connected 20 years ago. I do believe that there is much more resolve now, and the accounting firms have much deeper pockets than they did in the 1990s. Furthermore, today – unlike the 1990s – we live in a global marketplace. With that said, I do not believe that the accountants’ core strategy in entering the legal space is to directly compete against quality global law firms. At least not yet! This initiative is being taken more to complement the existing core businesses of accountants, such as compliance (audit, tax, etc.) and transactional work (mergers and acquisitions, consulting tax structuring, etc.).

Banks and corporations are also repositioning themselves by creating sizeable in-house legal departments which focus on providing commoditised services internally at a lower cost. These services are the staple of many small- and medium-sized law firms, which are being slowly eroded. To put this threat in context, an internal legal department of 50 or 100 lawyers is, in effect, a medium-sized law firm.

Opportunities

While there are challenges, there are also opportunities. In a similar fashion to what the accounting industry went through in the 1980s, if and when regulations are relaxed over the next five to ten years I see more consolidation of law firms, more alliances, and continued global expansion – particularly into emerging markets, such as ASEAN, Africa, Latin America, and India. The traditional markets of USA, Europe, China, Japan will remain strong; however, I am of the view that these markets are over-lawyered and oversaturated and the competition for quality work and talent is fierce. Firms need to look at new markets to grow revenues. The one note of caution: Firms looking at a foray into emerging markets will require patience and deep pockets initially, as an acceptable return on investment from these markets will take time.

From a micro perspective, small and medium firms will have a part to play. Some firms may be experiencing a dip in revenues and profits, as much of the “commoditised” work that previously flowed to them from global firms or which clients found too expensive for large firms to discharge is now being captured by the disruptors in the industry – i.e., the alternative legal-services providers and, to an extent, in-house legal departments. The one sweet spot for firms in Asia and particularly south-east Asia would be to consider expansion into ASEAN markets and alliances with firms looking to enter these markets from the U.S., Europe and Australia. As a general rule, global firms are not as nimble and not always geared towards emerging markets; hence local firms are attractive to global firms looking to enter the ASEAN market.

Closing Thoughts on Countering The Challenges

It is my belief that many firms are still living in the past. They need to focus on the present and plan for the future. To survive and grow, these firms need to take a step back and take stock. In this fast-developing alternative-market environment, doing nothing is not an option, as profitability and even possibly survival is on the line for many firms. The first step is to perform a deep-dive review into their core businesses and determine if service lines are still profitable and if there still exists a decent pipeline of work. They should then strategically review what can be done internally and externally to capture more of the market, and consider an off-shore emerging markets strategy and / or a merger or alignment strategy with firms locally or internationally that is complementary to their core business.

The key to operating in today’s legal environment is to ensure a quality, value-based offering at all times, being nimble and innovative, and making an appropriate investment in experienced professionals to advise on, facilitate and drive this strategy.

Law Firm Marriages

I’m spending time with many firms these days that seem to be really interested in “combining,” partnering up, or at least acquiring groups of great lateral partners. Apart from the conventional observation that these efforts to juice up growth “inorganically” often mask failed efforts to grow “organically” (i.e., acquiring new clients!), aspirations typically reflect some pretty undeveloped thinking about why another firm would want to combine with their firm.

Lawyers – that is to say, law firms – tend to be pretty narcissistic in their everyday thinking anyway. It’s not surprising that firms embarking on a “combination-quest” think only about what they are looking for in a target firm, and not the converse. Now that the commercial legal services market has changed more in the past ten years than it had in the previous 100 years, law firms in search of target firms or lateral groups need to re-think and freshen up their answer to the question, “Why should a law firm seriously consider combining with us?”

Firms capable of being a good fit have to see something in your firm they want and know they need. Don’t make it hard for them. Out of the gates, PLEASE express a genuine interest in their view of how they would like to – and, in fact, would – benefit from combining with the right firm. Conventional criteria still apply (geographic footprint, practice group mix, economics, etc.), but should be consulted within the “necessary but not sufficient” context. In today’s legal environment, other emerging screening criteria are starting to matter a lot more and inform the best decisions about courtship and ultimate marriage.

It’s the Music You’ll Make Tomorrow That Matters, Not the Music You’re Making Today

It is more important now than ever for serious firms to paint a detailed picture of where a combined enterprise is trying to go and how it is going to get there. The best “renderings” do a great job of isolating all of the gaps in the two firms today – both as independent firms and as combined firms. Bolting together two firms usually doesn’t instantaneously address these gaps. In short, it’s just as important to realize how far the combined firm will be from full potential as it is to realize what the ultimate potential looks like. You’ll be better positioned to sell a desirable firm on the opportunity you represent if you’re honest about the admitted difference between “desired state” and “present state.” Additionally, have a detailed plan – articulated with conviction – for addressing that gap over the next five to seven years.

They’re Buying Vision and Innovation as Much as Anything

You should put together a clear, detailed, and ambitious multi-year innovation agenda. The economy is active, and most law firms are chugging along at a solid economic clip; it’s very easy for firms to get complacent about their day-to-day operating performance and their future. However, if there’s one area in which many firms are exhibiting great self-awareness (and humility), it is relative to innovation. “Innovation-phobic” firms know when they’re not doing anything to help their clients experiment with new ways to consume, manage, and measure legal work. These firms feel exposed, and often can be very attracted to another combination firm that has come up with a thoughtful multi-year innovation agenda, and a roadmap to become that firm of tomorrow.

That Culture Thing

Everybody talks about culture and it connotes such a fuzzy measure of a firm’s composition – it’s easy to be cynical about whether culture matters at all. The truth is that for firms that are built for success today, culture is everything. Peter Drucker famously said that “culture eats strategy for breakfast!” The challenge of course is that culture means nothing if you can’t touch it, feel it, and define it. Law firms that are serious about finding the right combination partner firm should define all of the cultural attributes and features of their firm in objective, describable elements that can be measured.

Additionally, such firms must be able to identify what processes, structural incentives, managerial methods, and training regimes support and produce the objective elements that make up their firm’s culture. It’s one thing to say that we are collaborative, team-oriented, and care about the success of other partners; it’s quite another thing to point to a specific bonus structure and monitoring process that activates partners to, in fact, behave this way. At Edge, we use a tool called the Edge Cultural Assessment to develop an understanding of all objective elements of firm culture; with this tool, our understanding of culture is removed from the abstract and subjective and is translated into the measurable and concrete.

Write It Down

If you’re a true believer about why a target firm should be interested in combining with your firm, then you’ll need to articulate all of those reasons, linkages, and benefits with conviction. It’s hard to express conviction about your own combination criteria and process if you haven’t taken the time to write them down on paper for prospect firms to digest. Remember, both firms are potentially placing a very big bet on an unknowable future. The only insurance policy target firms have is your intentionality about the summit, and the mountain you’ll need to climb together. Bring them along – and, in so doing, seduce them – by expressing as much of your thinking on paper as possible.

“Law firm combinations” and “lateral partner recruitment” sound like easy ways to drive growth. However, seasoned law firm leaders know that it’s easy to make bad decisions, and very difficult to mature and execute good decisions in this realm. My advice is to know who you are well, do your homework, and sell the plans you’ve authored for future success so you can get credit for being intentional and ambitious. Don’t let your appreciation for the summit distract you from your respect for the mountain!

Mergers & Strategic Alliances – What Should Law Firms Expect out of Synergies in India? 

There is no doubt that law firm mergers are trending like never before. One may examine the reasons why. Is it a strategy to grow numbers in terms of turnover? Is it sending a message of larger technical expertise and bandwidth? Is it a part of strategy to outsmart competition? In this article, we talk about the driving force behind exploring options of mergers and strategic alliance by firms in India, and what law firms should expect out of synergizing.

Alliances have, historically, been one of the ways in which countries used to bond and come together to form a stouter force against other, rival countries. Following a somewhat similar approach, law firm mergers are being considered as a move that would make them stronger vis-à-vis other firms. The expectations are very simple – enhanced bandwidth, more partners contributing to the top line, addition to the array of practice areas offered to clients and advantages of established brands. We will examine these factors one by one.

One of the primary factors that encourage law firms to merge is the addition to practice areas that the firm would be able to offer to its clients as a result of merging with another firm of diverse practice areas. Also, between firms of similar practice areas, mergers are a prudent strategy to let the merged firm become known as a ‘stalwart’ in a boutique practice area. This is an especially growing trend in recent times owing to increased interest by clients in specialized or boutique law firms.

Another major factor drawing law firms to look for mergers is the advantages associated with an established brand. This is largely applicable for law firms with a smaller practice, looking to merge with a law firm with a larger practice. Subject to working out modalities with respect to name change (most likely, smaller firms drop their name or get their name in the subsequent order in a joint name), smaller firms tend to gain advantages from the robust client base and well-known brand of the larger law firm.

In larger countries like India, especially the ones that are diverse in terms of geographical expanse and language, customs, religions and local practices, law firm mergers are a popular way to make inroads to far-off locations. In order to be the ‘Go-To’ firm for their clients across all locations, law firms try to open offices in different cities, covering the entire landscape of the country. Now it may not always be possible for a firm to establish an office from scratch and invest capital in building an infrastructure and office. In such cases, law firms explore the options of entering into synergy with a firm/lawyer based out of particular location by various means – say by way of merger, brand merger or referral relationships. The aim is to enhance the service offerings from a particular geographical location with least investment in terms of time and capital to set up a practice.

Another trend that has been noticed in the recent past is the ‘Panic Button Merger’. There are times when the key stakeholders, say managing or founding partners, either lose interest in running the firm, or understand the limitation in their capability to take the firm to the next level of growth. In such a state, the merger comes to them as an option to overcome the panic-struck state and reform the firm under the expert hand of a firm that has been running more efficiently or under a more efficient leadership.

What to Expect from A Merger

Now that we have examined some of the factors that drive law firms to synergize and form alliances, we should also understand what the firms should truly expect from a synergy. The factors driving the need for synergies are like swimming on the surface. One needs to dive deeper and understand what lies beneath the synergy. Are the firms merging only to create a statement within the fraternity? Or is there a better offering to the clients? Is there a true acceptance of best practices from the synergy? Are the firms being one-up in terms of technical competency? These are some of the questions both of the synergizing entities should consider.

By merely opening an office in another city, the clients are not obliged to direct their mandates to the firm. They will obviously need to be convinced that there is a technically sound lawyer to advise them on the most correct legal course of action. Hence, the firm must look to merge with another firm or lawyers after being convinced of their technical expertise, talent, experience, legal acumen and quality of work done in the past. Due weightage must be given to the benefit in terms of talent that will be on-boarded with a synergy.

Considering that synergies are once-in-a-lifetime kind of events in the life of a law firm, the approach to exploring a synergy cannot be treated like a formality or ticking off a bucket list of desired advantages. It is definitely a serious exercise that calls for all the parties to contribute to the planning and examine all the strengths that can be synergized to raise the service offerings to the client. It calls for imbibing best practices followed by the other party without any ego and hitch of dilution of power. One cannot be driven by short-term advantages like gaining from a better brand or larger share of profits, etc. There are deeper concerns that should not be overlooked by the merging firms. Activities like culture test, practice planning, financial budgeting, marketing strategy etc. are too often ignored. After the merger, their effects are far-reaching, and sometimes irreversible.

To sum up, a truly synergized entity is one that is integrated in its aim, and its approach to achieve that aim to serve nothing but the best to the clients. Law firms should look for synergies with a view to creating better service avenues for clients and to get on board a team of quality professionals. The merging parties should be like-minded in their vision to build an entity that is managed efficiently, that swears by best professional and managerial practices, that offers its services at competitive prices, and that aspires to be a ‘one-stop shop’ for all legal requirements of their clients, serviced by a team of best legal professionals.

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.