A Fresh Look At Law Firm ValuationLeon Sacks and Nick Jarrett-Kerr
The legal industry has consolidated slowly over the years, but this process will be accelerated by the impacts of the current crisis, its economic effects, and the operational changes it drives. Some practice areas will flourish, and others will be negatively impacted. Some firms will need to bolster infrastructure (technology, remote working), requiring investment, while others will have excess infrastructure (office space, back office) that can accommodate growth.
Adopting the right strategy and taking decisive actions at this time are key to optimizing the future of the firm and protecting the interests of its clients and its people. Not only does the current crisis warrant such attention, but it provides a case for change that would not be politically viable during normal economic conditions. Additionally, there are now very few firms in the fortunate position to be able to rely on organic growth to ensure a successful future.
Most firms will evaluate how to restructure their business, particularly in the light of future financial perspectives. Partners of firms will also be evaluating their own individual status and professional goals. Considerations by firms will include:
- Acquisition Strategies – enhancing competitive advantage by luring laterals or acquiring competitors (referenced in “Planning for Recovery: 7 Strategies for Opportunistic Law Firms” authored by N. Jarrett-Kerr) or merging with another firm
- Succession Strategies – maintaining the financial health and strength of the firm through the transfer of ownership to younger partners and/or retirement of founding partners
- Consolidation Strategies – selling the firm to take advantage of the brand and investment resources of the bigger firm as well as a means of realizing goodwill and to allow older partners to depart (assuming the firm is in reasonable shape)
Such changes will involve valuation issues, be it the valuation of firms or shares in them. While traditional methodologies of valuation may be used as comparative benchmarks, they do not necessarily focus on the real value involved in any transaction.
- Capitalization rate/multiple of earnings: it is difficult to justify these methodologies due to the absence of a real market/market information on deals between law firms and the differing circumstances of each transaction. Why, as is often touted, should the value be between 1-3 years of profits and, even if it is, how do you arrive at the value within that range?
- Discounted economic income or discounted cash flow: it is similarly difficult to determine a discount rate to apply to future earnings/cash flow. Any increase of the cost of capital based on risk (the “risk premium”) is prone to be subjective.
To illustrate this conundrum, consider a few situations.
In an acquisition the acquirer will pay for net assets as well as any goodwill since the seller will relinquish control and management of its business, even though its partners may continue to participate in the acquiring firm. The value of goodwill, if any, will depend on the added value an acquirer foresees.
An acquirer is unlikely to want to pay much just for an increase in size of business represented by the summation of its revenues with those of the seller (i.e. 2+1=3) unless that results in a significant increase in profit per equity partner. The latter may arise for several reasons:
- leverage is increased and the increase in the number of equity partners is disproportionately less than the increase in projected income
- reduction in infrastructure and support costs (i.e. economies of scale)
- profit margins of the seller are significantly higher than those of the acquirer and its profit per equity partner exceeds the perceived market compensation for their peers
Note that any value judgements here are based on projections of the acquiring firm’s position post-acquisition and not on the economic income projections of the seller or a multiple of its earnings.
Acquirers are more likely to pay for value in the form of incremental revenue flows and/or the cost avoided by having to develop business (i.e. acquiring a new practice area, a new geographic region or a new client base). This arises where there is a strong synergy between the business of the acquirer and the seller, manifested by
- enhanced service offerings for the captive client base
- accelerated ability to compete in new markets
- complementary capabilities and intellectual capital
The value of goodwill could be significant and again does not necessarily bear a direct relation to the previous or projected earnings of the seller. A seller may argue that their business was developed over years and significant investments were made but, if that is not perceived to generate any value to the acquirer, there is no use in applying traditional valuation methods to determine sales value.
Clearly the degree of certainty that incremental revenues/avoided costs will be realized impacts the value attributed to them. Factors that will influence the outcomes include
- retention of seller’s client base and the predictability of future revenue from it
- maintenance of key partners/attorneys and referral sources of seller
- characteristics of seller:
- brand reputation and profile
- nature of relationships (institutional or transactional)
- susceptibility of business to economic/market changes
- diversification of clients and practice portfolio
- level and durability of institutional knowledge and intellectual property
In summary, there are multiple factors at play in determining the value of a firm. Tangible assets are quantifiable but the value of intangible assets, or goodwill, will depend more on the projected post-acquisition dynamic than merely on the ability of a seller to generate earnings in its own right.
In the case of a genuine merger, where two or more firms are contributing their resources and net assets to a new merged firm for mutual benefit, the concept is different. Generally speaking, each firm, and its equity partners, will assume responsibility for the realization of pre-merger assets and payment of liabilities and any resolution of pending items will be the subject of the merger agreement. The same applies to settlements with partners who will not join the merged entity.
The initial allocation of shares/equity participation and the partner compensation system of the new merged firm will regulate profit sharing. Together they should represent fairly the relative value contributed by the parties at the time of the merger and in the future, as well as protecting against dilution. Financial projections of the new merged firm and simulation of participations will be a key part of this process. In essence, the “goodwill” pre-merger is being translated into future profits to be distributed equitably amongst partners.
Restructuring of Partnership
Usually there are rules or methodologies in place to govern incoming and outgoing partners, the transfer of their shares and profit sharing. In any case, in contrast to acquisition by an outside party, the partners are familiar with the business and any added value to continuing partners will be based less on synergies and more on the retention of clients and referral sources, as well as the profits “liberated” by retiring partners.
As shown, valuation is not a simple mathematical exercise and values will vary in accordance with the type of transaction, the characteristics/profile of all interested parties and the value perceived by those acquiring an interest in a firm. Traditional valuation methods, such as multiple of earnings or discounted cash flows, can be used as benchmarks or as a reference point for sellers to establish an asking price for a firm or their shares, but they have limitations. A customized approach analyzing the different elements involved is necessary.
Those in acquisition mode will be searching for value at the most economic price possible. However, they will be avidly calculating the value that any acquisition target can bring to the firm.
A seller, with the luxury of time, can always optimize its own business and organization to enhance its value but, finding a buyer that would find most value in its attributes should be a priority. Offering the buyer greater certainty of increased economic income by, for example, agreeing to a period during which certain key partners remain and clients are transitioned, adds even further value.
A planned transition of ownership also adds value in an internal restructuring. Unless there are extenuating circumstances or disputes, a phase-out of retiring partners, over a period of time, should diminish any disruption of the client base and management of the firm as well as lessen the immediate financial burden on continuing or incoming partners.
In summary, entrepreneurial firms should forget how things were traditionally done in the legal sector or in their firm and should consider how a radical restructuring strategy might benefit the firm, its clients and its people and what smart plans can be deployed to evaluate how value can be optimized.
There is one thing I have learned over many years helping run large law firms and since then consulting to professional service firms: keeping things simple and as brief as possible is the essence of achieving success. That means ‘easy to understand and to apply’.
The reasons are simple too. Professionals, in particular those in ownership or senior roles, simply don’t have the time, motivation or gas-power to take on yet more complex, lengthy systems or processes to get things done, especially when it is outside their comfort, practice or client-zones.
I have spent most of my time figuring out how to deal with relatively complex issues and challenges, but in a way that is easy for busy professionals to understand and apply. Put another way, I learned early on not to put anything on the table that was too complex or time-consuming. People simply switch off or don’t give it the attention it deserves. Also, philosophies, concepts or approaches have to be simple enough to able to ‘walk around in peoples’ heads’. Then they don’t need to consult a lengthy document or manual to remember the essence, or need a new dose of discipline to get these things done.
One rider to this; simple approaches and ways of doing things take a lot of thought, dedication and effort to identify, work out, test and prove in the field. This is sometimes not so simple! So, this is one of those things that is easy to talk about, but tricky to achieve in practice.
Let’s take a brief look at a few areas where these principles can be applied in practice to good effect. Coincidentally, they happen to be the areas where I do and enjoy most of my work.
Strategy is one. This principle applies equally to strategy for the whole of the firm or for a department or individual: only include the essentials, use a practical, proven framework that gets results, and which can be summarised in six to ten pages or less. Break the exercise down into pre-strategy essentials that need to be settled, actual strategy formulation and then post-strategy implementation and stress-testing. Be able to summarise the key aspects on one ‘strategy snapshot’ page – ideal to hand out to new recruits or even existing and potential clients so that they know what you are about.
We can never move too far away from the finances when discussing anything to do with firm practice in professional services. In this area, after dealing with many firms internationally, it has struck me how often partners and staff are drowned in reams of lengthy financial reports and analyses. It soon becomes clear that very little of this material gets absorbed and truly serves any purpose.
All of the excess material might keep a certain type of management happy – those who like to think, ‘At least they can’t say they didn’t have the information’. But that of course is not the point. The point should be to help everyone get results.
In this area, I have found a key is to produce a monthly (or on-demand) one- or two-page financial snapshot or dashboard report that is colour-coded, and summarises partner, partner-team, department and firm standards for performance and actual performance on key financial variables. If one needs to dig deeper in relation to a key variable – e.g., total lock-up days – one can always request that detail from the finance or accounts team.
Following the earlier point, it took us about three years of formulation and testing until we got this right, and working to our complete satisfaction. Then it was a case of refining it each year.
I long ago came to the conclusion that the key to results in the management of people is ensuring a truly genuine interest is taken in anyone for whom one is responsible. We developed a new philosophy, system and approach to ensure this took place throughout a firm – the Responsible Partner and Development Discussion system. With this system, most people at every level reached something like their full potential, they were happy, partners attracted good staff who stayed longer, and our employment brand and engagement levels grew stronger.
Again, this was kept as simple as possible. That is a key reason why it works.
The system we developed for the management of people has a number of off-shoot benefits. One is addressing the hardy annual issue of succession planning. So many firms struggle with this. Some introduce quite complex monitoring and management systems to address it, but with limited results.
As in other areas, succession planning can be kept quite simple. If something like the Responsible Partner philosophy mentioned above is adopted and applied rigorously, over time it automatically builds succession throughout a firm, and it has the benefit of being organic. Let me expand on this a bit. If a partner uses the approach successfully and builds a high calibre team of professionals at different experience and competency levels over time, she or he will find successors start to pop up within that partner team. It takes a good few years, but it is guaranteed to happen: this has been proven time and again.
Achieving success in practice today undoubtedly takes high levels of competence and performance in a number of different areas. It used to be that working like a dog and looking after clients was it. The rest could more or less take care of itself. Those days are long past.
Practice and client needs have become much more sophisticated and challenging. Trouble is, in many firms, partners and staff still don’t really know what they should be expecting of themselves or one another. It is important to spell this out in summary in a positive, constructive way which propels the firm forward and acts as a motivating guide to individuals to contribute in various key areas. These will include hardy annuals like financials, business development, people and support for the firm, but also things like building the capital fabric of the firm, building succession and active support for the brand, and raising each of these to exemplary levels through innovative approaches.
Finally, brand is another key area which can get attention. Everyone in the firm should understand what the firm’s understanding of brand is. ‘Brand,’ as I teach it, is the aggregate of what other individuals think and feel about the firm as a practice, as an employer, its services and the key individuals within it. Everything brand-related flows from this simple framework and makes it easy for everyone in a firm to grasp the nuances, concepts and necessary support systems to strengthen a firm’s brand, its employment brand and the brands of individuals within it.
Dare I say it? I believe that adopting this ‘simple’ approach to everything relating to leadership and management also makes this part of practice fun. More practitioners and staff will want to participate in and contribute to these initiatives as they will feel they ‘get it’ and don’t need a course in management to get results and get things done. This in turn grows future leaders and managers internally.
Star WatchingDavid Cruickshank
As law firms wrap up the evaluation season, much of the conversation revolves around the under-performers and what should be done to get them “up or out.”
At the same time, every firm acknowledges that they have both rising stars and established stars. What attention did they get and how will they be watched and supported in the year ahead?
In our conversations with firms that have top talent management practices, here are some of the guidelines we hear for “star watching.”
- The firm should have a clearly defined “path to partnership,” with specific communication points. Associates want to know what competencies to work on next and whether they are “on track” for partnership.
- Provide the stars a complete evaluation message, including goals for improvement. Stars are often told, “keep up the good work,” but they don’t believe that they are flawless; they’re highly motivated and want specific direction for improvement.
- When the firm has to deal with disruptive change (layoffs, mergers, significant partner departures or lateral arrivals), sit down with the stars and assure them that their path in the firm is secure and on course.
- Make sure they get assignments that will cross practice groups and offices. This gives them a chance to demonstrate their qualities in a bigger arena and will help them cross-sell work in the future.
- Provide them (and insist) with training on client relations, business development and management skills.
- As they become more senior, share responsibility for budgeting and billing practices.
- In their year leading up to partnership consideration, provide a partner “sponsor” who will help the associate make the case for partnership and clear obstacles. (The sponsor usually is not on a decision-making committee.)
All of these practices will keep your stars close. Think of the “star that could have been” who left your firm for in-house work or another firm. Could the firm have done a better job of making it more attractive to stay?
Management by now is well aware of the impact of aggressive recruiting in their back yard. Rising star partners are getting regular invitations to depart with their book of business. What can you do to assure them that yours is the right galaxy for them?
- Give these partners feedback from senior management at least three to four times throughout the year, even after a positive performance evaluation.
- Give them opportunities to cross sell and join other partners in requests for proposals. The message is that our teams are strong, and that solo originations are not the only measure of success.
- Bullet-proof your compensation system to make sure you can give rewards for exceptional year-to-year performance and teamwork. Many lockstep systems need some “tweaks” to make this possible.
- Acknowledge the reality of the partner recruiting industry that surrounds your stars. Make it easy for them to talk with someone in senior management about outside offers.
Finally, rising stars are the future of your firm. Will they have significant responsibilities, status and compensation in the near future? The firm’s succession plan also sends a message. For the associate, will there be a partner opening in my practice group? For the star partner, will the senior people start stepping down in a predictable manner? Succession planning, transparent to the partnership, will help keep your stars at home.
Succession Doesn’t Just HappenMike White
“We need a succession plan. My partners and I formed this firm thirty years ago. We started with clients aplenty, and spent the early and middle years – in fact, up until a few years ago – tasking younger partners to service the business we already had through the impressive rainmaking skills of the founding partners; we did not task them with developing their own client base because we wanted to make sure our (founding leadership) clients were serviced by the most seasoned and technically proficient lawyers. The truth is that we’ve always brought in most of the business, but now we’re concerned about ‘legacy’ and the health of the firm after we begin winding down and retire. At the very least, we’ve got a significant leadership gap and client development skills gap among the non-founding partners, and thinking more pessimistically our firm may not survive our retirement. Can you help us?”
I’ve been presented with this fact pattern pretty chronically over the past few years. On further inspection it usually becomes clear that the founders’ definition of the firm’s “problem” is a bit too limited. Lawyers in the associate ranks lack confidence about where their firm is going and the longer-term opportunity afforded them. They know precious little about how the firm is managed and what kind of compensation the firm generates for equity partners in the longer term; as a result, younger lawyers become very short-term focused and find lots of reasons to become disaffected. Layered on top of all this is the perceptible tentativeness of the “next generation of leadership” – they would like to inspire ambition within the junior ranks, but they don’t feel very confident themselves. What’s a firm to do?
It goes without saying that each law firm situation along these lines is fact-specific. However, I’ve found that there are a number of reliable recommendations from which most firms could benefit that fit this profile, namely:
Transparency – leadership needs to trust that non-founding partners and associates will benefit from having more information rather than less information. Let the rest of the firm know how you lead the firm and how you do your job. Help others understand and let them appreciate how effectively the firm is being managed in this regard.
Earn the Right to Teach Patience – if your firm generates above-market compensation for equity partners but achieves it in part because of a very tightly managed associate compensation grid, then let associates know what could be in store for them as they climb the ranks. Associates and non-equity partners have a hard time deferring near-term compensation gratification if they don’t know how that model could redound to their benefit down the road.
Define and Communicate Partnership Criteria – associates and non-equity partners crave a GPS system. Let them know in meaningful parameters what kind of “points they’ll need to put on the board” over time to become a shareholder.
Define and Communicate Partner Compensation Criteria – founding partners tend to not be very formulaic about how they split up the profits among themselves because it’s an intimate group that has worked side by side for so many years. As more non-founding “arm’s length” partners are made, first generation firms would benefit from defining their compensation criteria more explicitly. New partners and leaders want to understand how their activities are being valued, and they want to be put to their highest and best use; a law firm’s set of objective equity partner compensation criteria can supply direction and reinforce managerial credibility.
The “Vision Thing” – founding leadership ought to have in mind a longer term destination for the firm, and it ought to be documented. Whether the firm has landed on the right longer-term view of what place it will occupy in the marketplace is less important for these purposes then just having a destination in mind – a destination that can be articulated and supported intellectually.
Partner Readiness: Client Development Skills Training – lawyers do not passively bump into the skills they’ll need to begin sourcing clients on their own; rather, first-generation firms should take an active role in outfitting partners and leaders-in-waiting with the necessary consultative selling skills so they can build up their practices, and be ready to lead the firm’s revenue efforts over time.
Founding Partner Wind-Down Compensation – first generation firms often allow founding partners to retire gradually so that there is a wind down period during which partners are not active at the same historical levels. At wind down, founding partners typically become non-equity partners of the firm. As non-equity partners they’ll get a salary and bonus, but their bonus plan can and should be very tailored to the particular non-equity founding partner, and should answer loud and clear the question “What is my highest and best use to the firm?”
Client Transition – founding partners are well advised to put in place a 12- to 36-month plan for involving one or two other partners in the management of key clients, so that at wind down and full retirement there is at least one equity partner ready to slide into the full relationship management role. The non-equity bonus plan of a wind down partner should motivate and reward that partner to accomplish the client transition seamlessly over time, and interim client-transition milestones should be defined along the way before full retirement.
Generational transitions are not easy, particularly when it is the founding generation that is cycling out. Let the next generation of leadership appreciate how and why the firm has been so successful, and put some scaffolding in place so new leadership can leverage what you have built.