Small law firm owners without an exit strategy want to know: “What is my law firm worth?” and “How can I convert that value into cash for my retirement?” This value may comprise a substantial portion of the owner’s total wealth, which may be needed for retirement. This article describes how owners of a small law firm can sell their ownership interest.
A fundamental element of any plan to sell a law firm partner’s ownership interest is knowing what it is worth. Law firms that bill clients on a contingent fee basis present a special valuation challenge. Knowing approximately what a law firm is worth before entering into negotiations to “sell” a business sets realistic expectations of a fair sales price and can be a solid foundation for a deal structure that’s fair to all parties.
A small law firm’s identity is often intricately linked to its owner. The owner of a small law firm often is its strategic planner, marketing director, sales manager, chief financial officer and accounts receivable collection manager, in addition to personally generating a large portion of the firm’s revenue. Contrast that with the owner of a typical small business in another industry, where the owner may perform just a few of those functions. The dominant role of a law firm’s owner may create additional risk for a potential buyer of a small law firm.
Selling a small law firm is not easy even if its market value has been determined. The owner of a small law firm can only sell his or her ownership interest in the firm to other lawyers in the same firm (an internal sale) or to lawyers in another firm (an external sale). Differences between the two methods are so significant they need to be considered different strategies, each with a unique set of advantages and disadvantages.
Five facts influence the parties’ relative bargaining position for an internal sale: profitability, age of the buyer and seller, number of buyers and sellers, size of the seller’s retirement nest egg and the seller’s timing.
Profitability is often defined as a business’s ability to generate net cash earnings. A primary reason an individual invests in any business is to receive future cash flow the business is expected to generate. Potential buyers evaluating an investment opportunity must consider the benefits of future ownership, adjusted for its inherent risks. Law firm values vary greatly from firm to firm, even when comparing two law firms of the same size, in the same geographic market with the same core practice areas, due to differences in profitability. But profitability is not the only factor buyers consider.
Age of the Buyer and Seller
The age of a retiring lawyer compared to that of the potential buyer can vary widely. If the lawyer targeted to buy out a retiring partner is only a few years younger, there may be little interest in a deal. It is easier to sell to younger lawyers who are not nearing their own retirement age because they will benefit from the investment for a longer period of time.
Number of Sellers Compared to the Number of Buyers
A transaction with one owner as the seller and one associate as the prospective buyer gives significant bargaining power to the associate. Variation in the number of buyers and sellers will change the dynamics of the negotiations. In situations with multiple prospective buyers, some associates may object to others in their peer group becoming their co-owners. In general, the larger the number of prospective buyers, the more likely a deal will be consummated and the more bargaining leverage the seller will have. However, multiple buyers complicate the process in other ways and may introduce new hurdles to a successful transaction.
Retirement Nest Egg
The financial security of a retiring partner influences how flexible the partner can be in structuring an internal buyout. Some law firm owners have no need for money from their ownership interest in the firm. Others have much of their financial net worth invested in the law firm and need a high sales price to finance their retirement. A retiring partner normally receives income after retirement from four sources: (1) Social Security; (2) retirement plans; (3) personal savings in excess of retirement plans; and (4) post-retirement employment. If these sources are insufficient to allow a retiring partner to enjoy a comfortable retirement, there may be more tension between buyer and seller over the sales price and how much of it needs to be guaranteed.
Some retiring partners intend to retire immediately after closing a deal, while others are not mentally prepared to stop practicing law for a few years and will continue at a reduced pace. The ultimate success of the transaction, and perhaps the total price paid, is often a function of how many clients are successfully transitioned to the new owners along with the revenue they generate. It may take a year or more to effectively transition clients from an owner, depending upon the firm’s practice areas and size of its clients. Large corporate clients take more time to transition. A retiring owner may transition clients to the buyer over a one- or two-year period in exchange for compensation, or that effort may be factored into the sales price. If a client does not like the designated successor for the retiring lawyer, the client has the final say on whether they will be transitioned to the new lawyer. Sellers who actively transition clients increase the likelihood of a successful transaction.
Other factors may influence how an internal sale should be structured. For instance, the deal must be affordable to the buyer. If younger lawyers in the law firm do not have the financial resources to finance a deal, bank debt can be used to bridge the gap. If necessary, sophisticated financing techniques are available to transfer value to the seller indirectly, thereby reducing the sales price required from the buyers.
Each buyout plan ends up being unique in some regard because every deal structure must be custom designed to address the facts and circumstances of the buyer and the seller. The key factors that drive the development of a fair deal are identified above. If an internal sale is not viable for any reason, an owner of a law firm can try to sell the firm to another law firm—an external sale.
The challenges faced by the owner of a small law firm selling an ownership interest to another law firm are discussed below, along with practical tips on how to successfully consummate such a sale. The following criteria are usually used to identify ideal merger partners:
Practice Area Compatibility
Many law firms may be eliminated from a seller’s list of eligible acquirers based on their practice areas. Law firms serving corporate clients usually will not consider being acquired by a “retail law firm” that primarily serves individuals (i.e., family law, estate planning, elder law, etc.). Many sellers prefer a strength-to-strength strategy. For example, a plaintiff medical malpractice firm focused on birth injuries may only want to join another plaintiff firm with a strong reputation for handling neonatal injuries. In contrast, some sellers prefer an acquirer that does not offer the same practice areas as the seller to maximize cross-selling opportunities. A seller’s preference for specific practice area expertise in a potential buyer often screens out a large number of potential buyers.
Geographic coverage and expansion are important components of many law firm strategic plans. A Cleveland, Ohio, small law firm may only consider being acquired by another Cleveland law firm. Another Cleveland law firm may want to be acquired by a firm from a contiguous region, but with no current presence in Cleveland. The latter approach should enhance the value of the seller to the buyer, because the seller’s name, physical office location, client list, telephone number, trained employees, furniture and fixtures, goodwill and reputation will be more important to the non-Cleveland acquirer’s future success.
A highly profitable law firm often prefers to negotiate a deal with an acquirer that has comparable profitability. A firm concentrated in commoditized practice areas with low billing rates will usually not be attractive to a higher-end practice with much higher billing rates and its perceived relative profitability.
A seller familiar with its primary competitors may reject some potential acquirers due to personality conflicts or incompatible firm brands. A law firm’s partner compensation system often provides good insight into the firm’s culture. Firms with a formulaic compensation system tend to be less paternalistic in their management philosophy. A good indicator of a deal’s prospects for success is how collegial the two parties are during merger negotiations, but this manifests itself only after merger negotiations begin.
The above process applies to all external sales of law firms. When two law firms combine, the deal structure largely depends upon the form of legal entities involved (i.e., C-corp, S-corp, LLC, LLP, general partnership, etc.), the financial condition of the entities, partner demographics, personal retirement goals of the partners, tax issues and other factors. Transactions designed to provide an exit strategy for a retiring partner are very different from transactions where the lawyers in the small law firm are seeking a larger platform upon which to market their services. Deal structures for lateral partners who will continue practicing differ significantly from those designed to accommodate a retiring partner’s situation.
External Sales: Lateral Partners
Owners of small law firms are often at a disadvantage compared to large law firms when selling their services to large corporations because the corporation’s chief legal officer (CLO) or chief financial officer (CFO) may be accused of making a poor decision if anything goes wrong. Even though the small law firm’s lawyers may be equally skilled and effective at handling legal issues for the large corporation, there may be a perception that the larger law firm with a known brand would have been a safer choice. Selecting a large, prestigious law firm may entail no such reputational risk for the CLO or CFO, often called the “boardroom defense.” It is not uncommon for partners in small firms to strive to join a larger law firm with better name recognition and the broader depth of resources a larger law firm offers. Small law firm owners who will continue practicing may strive to join a larger law firm for a variety of reasons.
If a small law firm’s lawyers continue working in the surviving law firm post-merger for at least a period of several years, the deal is similar in many respects to the hiring of lateral partners rather than the sale of a law firm. The typical deal structure for such deals is for the small law firm to dissolve post-merger and the lawyer to be hired as a lateral partner, associate or senior counsel in the acquiring firm and be compensated by the new law firm from the date of hire. This may be an attractive deal structure for owners of small law firms with substantial accounts receivable and unbilled time and few liabilities. The small law firm owner is paid a salary or draw by the acquiring firm in addition to simultaneously collecting accounts receivable and unbilled time of the small firm being liquidated. There is ample justification of the fairness of this deal structure to both parties if it is evaluated on an accrual basis rather than a cash basis.
These transactions are relatively straightforward with a standard lateral hiring process. The process usually involves identifying a preliminary list of law firms that might be a good match for the lateral partner candidate using the four criteria described above. Firms are prioritized and then approached sequentially by an intermediary on behalf of the anonymous client to see if they have any interest in the lateral partner candidate based upon a generic description of the candidate. If so, a confidentiality agreement/nondisclosure agreement (NDA) is signed by the parties.
The larger law firm usually analyzes the financial statements and numerous operating performance reports of the smaller law firm, including lawyer performance statistics for several years, to determine if it wishes to pursue detailed merger negotiations. Its objective is to determine the historical profitability of the lateral partner and the book of business after consideration of all expenses.
It is not commonly understood that the lateral partner’s book of business (e.g., future revenue) is usually analyzed by prospective acquirers in conjunction with the projected future expenses of the lateral partner’s practice. That is, the future revenues and projected expenses are analyzed to determine how profitable the practice will be in the future using the practice’s direct expenses plus the acquiring law firm’s overhead expenses.
Salaries and benefits to be paid by the acquirer to associates, paralegals and legal assistants replace what the lateral partner’s firm paid those individuals in the past. Overhead expenses of the acquirer, not the historic actual overhead of the lateral partner’s law firm, are inserted into the financial analysis. This is important because the overhead of larger law firms often exceeds $250,000 per lawyer compared to a much lower statistic for small law firms, which may be less than $125,000 per lawyer. This may kill the economics of a deal.
It is common practice for the acquiring law firm to review all the available information and then decide if it will make an offer or not. It is inappropriate for the lateral partner to propose a deal offer. Negotiating power is heavily concentrated in the acquiring law firm. If a deal is consummated, the lateral partner will comply with the acquiring firm’s existing policies and procedures. The extent to which financial, partner compensation and other operating statistics are shared with the lateral partner candidate varies widely from firm to firm. Small law firm owners in this category are planning to continue practicing law and are often assisted by headhunters in this process. This category of transactions is distinguished from external sales of small law firms whose owners are seeking to retire and monetize the value of their law firm.
External Sales: Owner Retiring
This category is for law firm owners who are approaching retirement and are seeking an external buyer before they can retire. For whatever reason, an internal sale is not viable for their situation. Unlike a transaction where the owner is planning to continue practicing law post-merger (i.e., lateral partners), these transactions have no need for post-merger compensation to the owner (other than paying off the purchase price). That is, in essence, how such deals work: The profit that previously went to the owner of the small law firm now will be shared in some manner between the retiring owner and the buyer until the purchase price is fully paid, as negotiated between the two parties. After the purchase price is fully paid, the buyer will benefit from the old firm’s net cash flow every year. To make this a reality, the owner seeking to retire must conduct a search for an acquirer.
Similar to the process followed by lateral partners who plan to continue practicing law, the search process begins with identifying a list of law firms that might be a good match for the retiring partner. The list is then prioritized. The search criteria listed above apply to all external sales, including retiring owners. Qualified firms are approached in a serial fashion by an intermediary on behalf of an anonymous client to see if the prospective buyers have any interest in acquiring a small law firm with a brief generic description of the firm’s practice. If so, a confidentiality agreement/NDA is signed by the parties.
The larger law firm usually analyzes the financial statements and numerous operating performance reports of the small law firm, including lawyer performance statistics for several years, to determine if it wishes to pursue an acquisition. A key concern is how much client attrition will occur after the owner retires, as was previously discussed in the context of internal sales. It is common practice for the acquiring law firm to decide to make an offer, or not, after reviewing the information provided. It is inappropriate for the retiring owner to propose a deal offer.
The following best practices should be implemented in advance to increase the small law firm’s future profitability and thereby enhance its fair market value and selling price.
External Sales: Retiring Owner Best Practices (One to Two Years in Advance)
- Update/create a brief strategic business plan to communicate the firm’s focus and goals, and to concentrate the owner’s efforts on maximizing the law firm’s value. The lack of a focused plan is perceived negatively by a buyer, while industry expertise is often important to a buyer.
- Conduct an objective internal assessment of the firm’s strengths to emphasize in marketing the opportunity.
- Increase standard billing rates to market rates; if some clients will not accept rate increases, give them discounts and implement higher rates for clients where possible.
- Adopt good timekeeping and billing policies; strive to bill clients promptly and reduce write-downs/write-offs by enhancing client communications and setting reasonable client expectations.
- Implement a comprehensive expense reduction program. Obtain competitive bids from three vendors for large operating expenses, reduce excess office space, and terminate redundant support staff and unproductive associates or paralegals.
- Do not charge personal expenses to the firm.
- Retain a marketing consultant to update the firm’s website and enhance its digital marketing plan.
- Contact key clients and referral sources to seek new business.
External Sales: Retiring Owner Best Practices (Six Months in Advance)
- Retain a law firm M&A consultant or business broker familiar with serving law firms to assist and keep the firm’s search confidential.
- Use a focused approach to potential acquirers.
- Execute a confidentiality agreement/ NDA with prospective acquirers.
- Prepare a financial package to provide to interested acquirers.
- Plan to transition clients to the new firm.
- Keep in close contact with key clients to minimize client attrition.
Just Do It
Realizing the inherent value of a law firm ownership interest requires developing and implementing an appropriate exit strategy. It does not happen automatically and is not easy to do, but waiting until you are ready to retire risks losing that value. Many small law firms have significant value that can be realized by the owners of those firms via an internal sale to younger lawyers within the law firm or via an external sale to another law firm. Either strategic solution may provide owners of small law firms ready to retire a significant benefit, allowing them to “cash in their chips” and enjoy a more comfortable retirement.
Pitfalls to Avoid
- Do not allow a headhunter to send out email blasts to all their contacts marketing your firm’s availability for sale.
- Don’t expect the purchase price to be paid mostly upfront. Every buyer prefers to pay the purchase price over time to reduce their risk of overpaying. Negotiate reasonably.
- Overpricing a firm will reduce the likelihood of its sale. Get a certified business valuation expert experienced with law firms to provide a realistic estimate of the firm’s fair market value.
- Do not ignore the need to perform due diligence on a prospective buyer’s background.
- Acting impatiently and trying to close a deal too quickly will backfire; it takes time to sell a law firm.
- Acting aggressively creates the impression of being desperate and may kill a deal.
- Don’t begin searching for a buyer at the end of the year. Many law firm leaders are unavailable from Thanksgiving until the end of January focusing on year-end financial issues. Instead, begin the process in February to June.
Although the specifics of any deal need to be custom tailored to the facts and circumstances of the situation, here are some universal tips for a successful process in closing an internal sale:
- The owner needs to objectively assess their own situation to develop realistic goals for the transaction.
- The law firm’s value should be determined using business valuation methods to establish a fair sales price.
- The value of the firm should not be overestimated. Doing so will jeopardize the ability to close a deal, and an overstated price may cause the deal to fail over the long term.
- Increase the probability of a long-lasting, successful transaction for all parties by transitioning clients to the buyer over an extended period.