Tag Archives: succession

Equity: From Goodwill to No Goodwill

In recent years I have been engaged by a number of firms to change their equity arrangements and transition from a ‘goodwill firm’ to a ‘no goodwill firm.’

The push to make these changes usually arises from one of two managerial requirements, both of which are due to the success of the firm. The first reason is a desire to move to a differential profit share and the second is to make an equity stake in the firm more affordable for new partners.

Differential Profit Shares

I have long maintained that one of the strengths of smaller firms in Australia and New Zealand is that in most firms, all equity principals (new and existing) have an equal number of points, or are on a pathway to equality over a defined period of time. The rationale should probably be the subject of a separate article, but one benefit of equality in a smaller firm is that ‘performance’ can be measured on effort as opposed to revenue or profit, because not everyone can do the work that is profitable given the general nature of most of these practices.

I have worked with a number firms recently that have wanted to move away from equality to a differential profit share. (I should note that not all partners are keen on this idea for obvious reasons.)  The snag has been that these firms sold goodwill to incoming partners on the basis that it was an equal profit-share arrangement, and in many cases the most recent entrant paid the most and is now being subject to questions over contribution.

Moving toward a differential profit share without changing the equity admission and exit mechanics of the firm will result in years of unhappy partnership before the whole thing implodes.

Admitting New Partners

There are an increasing number of first-generation firms that have become so profitable or carry so much work-in-progress that it is not affordable for an employee to buy equity at fair market value. The equity partners in these firms are faced with a decision to either significantly discount a sale / purchase price, not sell any equity and drive the firm as hard as possible until the end then walk away, or change the equity structure to make it more affordable.

A Workable Solution

From an accounting perspective, removing goodwill from a firm can be relatively simple. Resistance to making a simple accounting change understandably comes from those who have paid goodwill either directly when buying in or via ‘sweat equity’ to establish the firm.

When advising firms that need to make the change, almost all can see the rationale and benefits that arise from bringing new partners into equity via a lockstep, as opposed to the sale and purchase of goodwill, but most struggle with working out how to extract their embedded value in the process.

Doing away with goodwill and transitioning to a lockstep firm will provide firms with the flexibility required to overcome many of their equity challenges. Broadly this will require:

  • The firm agreeing on the value of goodwill;
  • Borrowing a portion of that value and distributing to each partner according to their equity holding;
  • The balance of the goodwill being paid via a ‘superannuation’ fund or similar at an appropriate time.

The benefit of doing this is:

  • Compensation is no longer linked to Return on Investment;
  • You have flexibility to provide additional points to the absolute standout star performers (plus the capacity to take points away from the under-performers);
  • No one will be bound to stay in a poisoned relationship due to the financial handcuffs of their buy-in price and/or an onerous partnership agreement;
  • Partners are not obliged to keep someone they would rather not work with;
  • It is easier to admit new partners

The mindset of the incumbent equity partners is key to the success of such implementation. The above will involve some pain, and in the short term there will be some winners and losers. If you start the journey early enough, any short-term loss will be washed away by the longer-term gain. This will not work if the primary focus of any of partner is to win in the short term (or to ensure that someone else does not win).

I get a sense that we will be seeing more of these transitions occurring in the near future as the pace of succession in the law increases.

Edge Principal Sam Coupland is considered the foremost authority on law firm valuations in Australia, helping firms calculate accurate capitalization rates and assess their risk profile, cash flow and profitability. 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.

Law Firm Mergers: Why and How?

In March this year, I wrote an article citing the large number of mergers in the Australian and New Zealand market. Some of these mergers were quite public but most flew under the radar – or out of the gaze of the legal media.

Reasons for mergers are many and varied and often go beyond the usual financial benefits of economies of scale. Common rationale for mergers are:

Financial Pressures or Opportunity

Law firm performance and profitability is trending upward for the first time in a long while, regardless of firm size. What makes this somewhat newsworthy is not the financial buoyancy of the profession but how these profits have been made. The market for legal services is enduring price sensitivity (which likely won’t abate for a long time), and growth in fees is limited. What is driving the improvement in profit is that firms are right-sizing and operating with leaner structures. It is this low-growth environment, where organic growth is difficult, which makes the proposition of a merger an attractive option for many firms.

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 challenges or deadlocks. This could be anything – ranging from succession, to disparity in contribution, or a hollowing out of market share.

Succession

It is often the case that a smaller firm that has been successful over a number of decades has a relatively small number of partners of about the same age. They have worked together for years, and they realise it is this collegiality and camaraderie that has been the ‘secret sauce’ for their success. With retirement on the horizon (and their personal financial positions well looked after) the idea of starting again with a new set of partners is not that appealing.

I have seen this happen with a number of firms where the development of internal successors has not been effective, and in some cases is not desirable in order to keep the equity tightly held. These practices are usually very profitable with a solid and transferable client base. In these instances rolling the firm into a larger organisation is a win-win for both parties. The larger acquiring firm picks up a solid parcel of fees and, as it has the managerial structure and support functions in place, is able to achieve economies of scale.

The smaller firm that is being tucked in achieves longevity with clients and a home for the staff. Depending on how it is managed, this may also be a one-off opportunity for the partners in the smaller firm to realise the value of their balance sheet (predominantly work-in-progress and debtors).

Client Demand and Geographical Reach

Single-city firms with a national client base are often faced with pressure (real or imagined) to have a footprint that matches that of the client. Opening a Greenfield office in another city brings with it a lot of risk, such as convincing a partner or team to relocate. A merger may provide a ready-made solution as well as some benefits of economies of scale.

Making Your Firm More Attractive

With any merger, a range of cultural considerations and other issues need to be taken into account and would form part of any due diligence. Making your practice more attractive to potential purchasers relies heavily on the ease of transferability, or integration, of the practice.

A history of high performance is key. Firms where the merger is successful are ones that have been operating effectively for a long period of time and are not seeking the merger as the panacea for their operational shortcomings. To get your practice into shape consider the following checklist:

Actions to Improve Profitability

Leverage / Staffing

  • Delegate anything that more junior people can do
  • Implement a robust internal training program
  • All junior lawyers to be ‘allocated’ to a partner who meets with them daily or weekly to discuss their file load and performance
  • Support-staff-to-fee-earner ratio of less than 0.7

Price

  • Ensure rates in the upper 25% of what would be considered ‘market rates’
  • Discuss fees regularly with clients and train all fee earners about how to do this

Time utilisation

  • Minimum performance levels – recorded 5.5 per day (most firms would thrive if all solicitors billed 5.0 hours per day)
  • Hold people accountable to minimum acceptable performance
  • Daily review for juniors; weekly review for seniors
  • Look at hours leverage (number of chargeable hours per fee-earner for each hour generated by an equity principal) – it should be greater than headcount leverage. This step: 1) measures the effectiveness of delegation, and 2) requires management to be more focused on the fees generated by employees than the personal billings of equity principals

Actions to improve Cash Flow

Managing Work in Progress

  • Record all time
  • Set maximum file limits for each fee earner
  • Regularly monitor activity (and non-activity) on each file
  • Bill fortnightly
  • Hold quarterly client-free billing days

Managing Debtors

  • Discuss price in the initial interview. Be the first to raise the issue of fees. Draw matter trees
  • Bill clients the way they want to be billed – hourly rate, fixed fee, capped, etc.
  • Implement a ‘no surprises’ policy to ensure all clients are expecting an invoice and anticipate the amount of that invoice
  • Have the responsible fee earner phone delinquent clients after 30 days
  • Be open to payment plans

Client Management and Transition

  • Have a documented approach to seeking and receiving client feedback
  • Conduct end-of-matter reviews
  • Detailed client data base – ideally with a ranking
  • As many touch points between clients and firm as possible
  • With trusted repeat clients and referral sources, discuss your succession with them. They may be more willing to help than you imagined.

Discrepancies in gross fees and profitability between merger parties can be worked through to ensure the merger doesn’t fall apart. If you tick the boxes in the above checklist then you are putting your firm in a strong negotiating position for how things will operate post merger.

As I mentioned in March, the appetite for exploring opportunities is high. Almost everyone I call to discuss a merger or acquisition wants to find out more, so the fear of rejection (in the first instance) should be put to one side.

The More Things Change…

Improved Better Increase Enhanced Quality Superior ResultsObservations on 30 years in the legal profession

As I enjoyed a break in the New England mountains of Australia last week, kayaking and fishing for the magnificent native Murray cod, I realised I had been closely associated with leadership and management of law firms for close on thirty years – about twenty in managing partner roles in three jurisdictions, and ten in consulting to the legal and corporate world, with the benefit of working with firms from various parts of the world.

In thinking about this time, I realised that while a lot has changed (technology, areas of practice, social media, etc.), much seems to remain the same, and it’s not all good! A few thoughts on the latter, which I hope will be helpful to readers:

  1. Law firms still fail to appreciate the value of brand and the importance of developing an understanding of it in its three forms – organisational, individual and employment;
  2. When things appear to be going really well (and they do sometimes!), the biggest mistake one can make is to relax or take collective eyes off the ball. Things change quickly;
  3. While some firms have strategies of sorts, very few attend to the “pre-strategy essentials,” take the partners along for the ride, or achieve implementation or results from it;
  4. Quite a few firms have agreed values and cultural attributes. Unfortunately, these are seldom observed or enforced. Sometimes it is because people are confused about what they mean, or they may sound similar to every other law firm, or – in many cases – a number of high-profile partners ignore them and so set a bad example. It is for this reason that I advocate going down the path of Guiding Principles and making them enforceable;
  5. Very few partners, still, build or leave in their firm on departure what I call “capital fabric” – those many things which contribute to the long-term, fundamental, foundational strength and well-being of the organisation long after they have gone;
  6. In similar vein to the last point, it is seldom part of the DNA of the firm for partners to build succession. When they leave, the cupboard is bare;
  7. What is missing in many firms is a structural and philosophical “engine” whereby the things that are discussed and agreed at partner meetings or by leadership are naturally, as part of the firm’s DNA, applied throughout every section of the firm, both legal and support services;
  8. Firms still fail to appreciate the power of ensuring that a genuine interest is taken by senior individuals, both legal and management, in the personal well-being and professional development and success of people for whom they are responsible. This has implications for staff turnover, recruitment costs, engagement levels and the strength of a firm’s employment brand;
  9. For any young people coming into law firms three things remain extremely powerful – reliability, a true sense of responsibility and accessibility;
  10. Speaking of young people, they have opportunities to venture into new fields in legal practice like never before, in particular in relation to industry sector specialties. We always encouraged our young lawyers to develop these interests at an early age and know their industry of interest better than the clients in it;
  11. When thinking of appointing a new person or partner, firms often fail to apply a simple but effective test such as ensuring the candidate is “high calibre, committed and a team player”: they need to tick the box on each of those to get across the line;
  12. Whether the legal profession or some consultants (in particular) like it or not, there will always be a place for time–based billing as one of various bases for billing; the reason? Many clients like the clarity of the option;
  13. The power of team work and teams, whether in a hierarchical sense (e.g., between a partner and his/her lawyers) or between groups (a property practice group teaming with a town planning practice group) is underestimated and undervalued;
  14. The effective use of the salaried or fixed-share partner/director is a massive missed opportunity for many firms. Properly structured and managed and supported by the right philosophy, it can become the economic powerhouse of a firm;
  15. Most firms have pockets of high-level expertise within them. Few convert this into true thought leadership and the individual and organisational brand value and power that go with it. The missing link is effective communication;
  16. When one considers styles of thinking, behaviour and interaction within law firms, one of the standout styles on the part of both partners/directors and firms would be avoidance, in the sense of not taking tough decisions, putting off dealing with underperforming or misbehaving partners, etc.
  17. As the support service “manager” regime has taken hold in small to large firms, so more and more power is often devolved to them. Unfortunately, few seem to exhibit creativity and too often act subtly as blockers to change, particularly when it may impact their turf or role. Properly led, with the right calibre of manager, these individuals can easily contribute as much if not more than partners; and
  18. Somewhat in summary of the above, every firm I have ever worked with, no matter how ‘good’ or not so good or big or small, has had loads of potential and unrealised opportunity, very often right under their noses. To take advantage often takes consistency, persistency, strong leadership and team-work, not rocket science.

Green Shoots Showing in Australia and New Zealand Legal Markets

After a number of years of patchy performance, the legal market in Australia and New Zealand appears to have found its feet and is performing strongly ­– that said, those plucky Kiwis probably climbed out of the slump a little earlier than 2016.

There is always a danger in making sweeping generalisations about an industry comprising more than 15,000 entities, so I will focus my comments on the more established firms in private practice – say those with revenue north of $2m. Even in this group, I will split it into smaller firms (revenue $2m -$20m) and the larger practices (revenue $20m+). Below are my views, or a non-exhaustive list, on what has contributed to the turnaround.

The economy

A rising tide floats all boats and both the New Zealand and Australian economies have seen business shake off the shackles and get on with it. In Australia, there appeared to be inertia in the lead up to the election but once it was over there was no longer an excuse. As a result, after a quiet couple of years, commercial and property practices have kicked into gear as have some of the more specialised practice groups.

A mindset change with staffing

I have noticed partners in smaller firms are not giving as much thought to the nebulous idea of succession. In the past it seemed many firms were carrying surplus fee earners with the vague expectation that many of this crop would be the successors of the current partners. This was despite the current partners having no interest in retiring, let alone transitioning clients.

Now we are seeing leaner staffing levels and busier partners. When the disillusioned ‘successors’ have found greener pastures, they have only been replaced after a cooling-down period if workflow demanded it.

When faced with the departure of a fee earner, a number of firms are replacing them with a contractor and in effect ‘buying an hour to sell an hour.’ This is being made significantly easier with specialist businesses offering this contracting service to the private profession. Some firms also have their own contracting arrangements in place, often with former employees.

Support levels continue to trend downward

The percentage of revenue spent on employee salaries has trended upward for the past 20 years. This is largely as a result of the inflationary increase in the dollar amount of salaries. One thing that has tempered the increased salaries margin is leaner support levels. Among larger firms the average is now 0.69 total support personnel per fee earner. Smaller practices have a much greater range – there, I am seeing some firms with no support outside of the accounts function, through to others that have one secretary for two lawyers plus a hefty complement of back-office staff.

There is no doubt that technology and the familiarity and enthusiastic adoption by the younger generations is enabling the leaner support levels.

Chargeable hours are decreasing

Hours charged to matters has been trending downward for all categories of fee earner for a long time and all indications are this will continue. There are likely a number of factors contributing here, most of which revolve around a view that clients have the upper hand and fee earners are juggling a well-understood client expectation in terms of price and quality with the realities of delivering on the job in a competitive market. Estimates have become quotes, and there is little enthusiasm from clients for an estimate to be revised when the matter is underway.

Price rides to the rescue

The key metrics of hours and profit margin have continued their steady decline. The profit margin is being squeezed largely because salaries are increasing at a faster rate than revenue growth,. Hours have been addressed in the previous section. The only thing that has picked up the slack is rate.

This may seem to conflict with what is being reported or even the general mood in the market, but where firms are able to charge hourly rates, they are doing so at all-time highs. How long this will continue is an unknown, and there is no doubt there is a trade-off between hours and rate; however, we must be about to level out in terms of price in the near term.

What next?

Change in the legal profession has historically been incremental and is likely to continue that way. There are a number of firms which are doing things differently, and new players with a different pitch or approach will emerge.

There appears to be a real appetite to try something new particularly if it leads to reduced overheads or could lead to the firm having a somewhat variable cost base. This means that when there is evidence of a firm doing something particularly well that leads to operational efficiency, it will be a relatively short time before it is adopted by other practices.

I expect the pace of operational change will increase and this – along with an improving market – will lead to better financial times for good firms in the next couple of years.