One means of growing your practice is to purchase the practice of another attorney. Such a move could increase your client base and enable you to expand your areas of practice. Most (but not all) sales of legal practices proceed along the following steps: initial negotiations between the prospective seller and purchaser, signature of an asset purchase agreement, notification to the clients of the seller, due diligence, and actual sale of the assets of the legal practice.
Any sale of a legal practice must be in compliance with the governing jurisdiction’s Rules of Professional Conduct. Although the ABA Model Rules of Professional Conduct do permit the sale of a legal practice, both the buyer and the seller of a legal practice must make sure that they follow all of the requirements of Rule 1.17. Variations of Model Rule 1.17 have been adopted by most states. In my home state of Maryland, Model Rule 1.17(a) provides that a legal practice may be sold if the following conditions are satisfied:
- Except in the case of death, disability, or appointment of the seller to judicial office, the entire practice that is subject of the sale must be in existence for five years prior to the date of the sale;
- The practice is sold as an entirety to another lawyer or law firm; and
- Written notice has been mailed to all of the seller’s current clients regarding:
A. The proposed sale;
B. The terms of any proposed change in the fee arrangement;
C. The client’s right to retain other counsel, to take possession of that specific client’s file (files), and to obtain any funds or other property to which the client is entitled; and
D. The fact that the client’s consent to the new representation will be presumed if the client does not take action or does not otherwise object within sixty (60) days of mailing the notice.
Consequently, in Maryland, only attorneys who have had their practices for five years or more may sell their practice. The practice cannot be sold in a piecemeal manner, with different purchasers taking different clients. In addition, the notice requirements of Rule 1.17(a)(3) must be followed. (Note that particular requirements might vary from jurisdiction to jurisdiction; for the complete text of the ABA’s current version of Model Rule 1.17, see http://tinyurl.com/cgo57gm.)
One major problem involved with the sale of a legal practice is that the buyer is generally unable to verify the nature, identity, and amounts paid by clients to the seller. The buyer would like to know this information so that he or she can determine whether or not the additional income will offset the additional expenses. But Rule 1.6(a) of the Rules of Professional Conduct provides that “A lawyer shall not reveal information related to the representation of a client unless the client gives informed consent, the disclosure is impliedly authorized by an order to carry out the representation or the disclosure is permitted by” 1.6(b). The exceptions contained in 1.6(b)—which involve preventing death or bodily harm, preventing a crime or fraud, preventing or mitigating substantial injury to the financial interests or property of another, or establishing an attorney’s defense to a criminal charge, civil complaint, or disciplinary complaint—do not usually arise in the sale of a legal practice. Therefore, an attorney cannot disclose the contents of his or her advice, conversations, correspondence, notes, or payments between the client and the attorney selling the practice. And because the attorney selling the practice must obtain the consent of each client to transfer the files (or hope that the client does not take action or object to the notification prior to the end of the prescribed time limit), even the number of clients cannot be directly verified by the buyer.
Another issue involves the timing of the settlement for the sale of the practice. ABA Model Rule 1.16(c) provides that a lawyer “must comply with applicable law requiring notice to or permission of a tribunal when terminating a representation.” When required to do so by a tribunal, a lawyer “shall continue representation notwithstanding good cause for terminating the representation.” If the attorney selling his or her practice is a litigator, the attorney may not be able to withdraw from representing a client once the jury is impaneled. Therefore, the date of sale of the practice must be set after the trial is over.
Given these constraints (particularly those preventing the buying attorney from knowing the precise number of clients or payments received), attorneys acquiring a legal practice are often reluctant to make the purchase for a fixed sum at the time of sale. Yet, sellers of legal practice, like sellers of most other businesses, naturally want a fixed sum due at the time of sale, whether to fund the seller’s retirement or to meet other obligations.
One way to bridge this gap is through an “earn-out” mechanism. In addition to paying a certain percentage at the settlement for the sale of the business, the earn-out involves a payment to the seller in the future that is determined by the number of clients who consent to the transfer balance over the course of the next 60 days.
Payment to the seller could be structured in a following manner:
- 5 percent of the total amount payable upon signature of the agreement, before due diligence commences.
- 35 percent due on the date of settlement for the sale of the legal practice.
- 60 percent payable 60 days from the date of sale, based on a formula derived from the number of clients of the selling attorney who consented to representation by the purchasing attorney.
The earn-out mechanism is a way to allay the fears of the attorney purchasing the practice that he or she paid too much money for the practice. However, sellers are very reluctant to commit to an earn-out because the seller has no way of knowing the ultimate dollar amount to be received from the sale of the business. Sellers are also reluctant to agree to earn-outs because they are not unconditional obligations to pay (as many promissory notes are), and the earn-out payment obligation may not be secured against the assets of the purchaser’s legal practice after the date of sale of the practice.
One way to alleviate these concerns is for the seller and the buyer to agree that if the number of clients who were represented by the selling attorney on the date of the sale of the practice and are later represented by the buying attorney on the 60th day after the date of sale is a certain predetermined amount, then the seller and the buyer will sign a promissory note and security agreement securing the debt for the balance due; if, however, a certain number of clients of the selling attorney do not consent to representation by the buying attorney, then the buying attorney and the selling attorney will sign a promissory note and security agreement on the 60th day for a lesser predetermined amount of money.
Given that a buyer will be unable to verify the income stream from the purchased practice until at least 60 days after the date of sale, what measures can a buyer take in due diligence to obtain some verification of an income stream without running afoul of the Rules of Professional Conduct? The buyer could ask for the seller’s income and payroll tax returns and financial statements for the past three years. Unfortunately, most solo and smaller law firms do not follow Generally Accepted Accounting Principles (GAAP) standards, so the financial statements and tax returns do not always paint a complete picture of what is going on in the seller’s practice. Consequently, any prospective purchase should ask for the seller’s monthly merchant account printout reports for the last 18 months (if the seller takes credit/debit cards), a summary of the seller’s bank statements (making sure not to disclose the names of clients or client deposits), and the seller’s total accounts receivable (without disclosing the identity of clients) and accounts payable. If the purchaser is acquiring the seller’s office space, the purchase should also carefully review the seller’s lease agreement.
In addition, the buyer should make sure there are no liens or security interests against the seller’s business. It is possible that the seller may have outstanding lines of credit with a lender. In such a case the line of credit will need to be paid off on the date the seller is selling the law practice.
The purchaser’s due diligence should not be limited to a review of financial information and the lease. The purchaser should inquire with the state disciplinary authority concerning whether or not there are any disciplinary complaints against the seller. The purchaser should also do a search of judicial records to reveal whether or not there is any pending or past malpractice litigation against the seller. Although the purchaser will not be assuming any of the seller’s malpractice liabilities, this is one way to verify how satisfied the seller’s clients are. Furthermore, the purchaser should obtain a letter from the seller’s current malpractice carrier that no claims are pending or have been filed against the seller in the past. Lastly, the purchaser should insist that the seller maintains malpractice insurance coverage from the date of sale until the expiration of the statute of limitations for malpractice suits in that state.
The purchase of a legal practice is not an easy undertaking. Yet it can be structured in a manner that enables a purchaser to overcome the uncertainty concerning the value and strength of the practice to be acquired.