Law Firm valuations in the post-Covid market

Law Firm Valuations

“What is my firm worth?” is the question that we are most frequently asked when dealing with firms where partners are looking to retire – i.e: they want to be acquired. Almost all firms will survive the Covid period but once we are through it, we expect a lot of partners will want to exit especially as the PII market hardens further.

Whilst it is certainly true that firms are not worth the 3 x profit or 1 x turnover which owners of other businesses might expect, it is not all doom and gloom and a well-structured deal can allow a canny owner to exit with real value. There are 5 elements which should add up to a proper return:

Net Asset Value. At the very least, the firm is worth Net Asset Value. Simply put this is calculated from the assets on the balance sheet minus the liabilities and can be paid out over an agreed period.

Run-off: Whatever you think about the mad system (and England & Wales seem to be the only jurisdiction in Europe with it) a pound saved is a pound earned and so at the most basic level if you can find another firm to take your firm over and become successor practice you have already made a return. For example, if you run a general practice turning over £1,000,000 with a fair amount of conveyancing and a good claims record, your PII is likely to be around 5% or £50,000 pa. To close, the run-off will be in the region of £3 x premium or £150,000 plus IPT at 12% meaning that being taken over has saved £170,000 and this is before saving on storage and other closure costs.

This is the same in real terms as being paid £170,000 for your firm and because with normal metrics, a £1,000,000 firm might produce a profit of £250,000 the seller is in reality getting 68% of profit which is an excellent return. This is a saving and so is tax free of course.

Consultancy: In the above example, upon takeover the seller would expect to work for 12 months as a consultant to hand the clients over and bed in the new firm. This might not need to be full time, but would probably start full time and then diminish towards the end. Some deals we advise on have a 24 month period, but in our experience 12 is enough and the second 12 months is a little like having Banquo’s ghost sitting at a desk.

It would be reasonable in this 12 month period to split the profit with the acquirer so that the deal largely pays for itself, and maybe the seller might earn £120,000 and the buyer £130,000 for this 12 months. Depending on how the contract is structured the seller could earn most of their £10,000 per month at a very low tax rate (c10%) taking maybe £1000/month as consultancy and £9000 as price paid to qualify for entrepreneur’s relief.

Therefore, already the seller has safely moved over the clients to the new firm, has protected the staff and avoided the costs and disruption of closure as well as earning around £110,000 in real net terms and saving at least £170,000 giving a real return of £280,000.

Further, what we often see is that the seller will remain as a consultant to the firm, attending events as needed and referring clients across being paid on an ad hoc basis. Most Partners are attached to their firms and are not ready to cut the ties and an arrangement like this should benefit both parties.

History: There is often a real benefit to a new entrant taking over an existing firm. We have recently been advising a firm that has been in it’s premises on a high street for 30 years. They are a known and trusted firm and many local people see them as “their solicitor” so the firm or individual taking them over will benefit from this history. There is also likely to be a large will bank which will provide ongoing work for years and whilst there is no formula for working a value out, an extra payment to acknowledge this history, maybe £20,000 in the above example, might be negotiable because for the buyer this is a lot cheaper than starting up from scratch.

Premises: Often the retiring partner will own the offices, or have them in a pension scheme. If the firm were to close they would need to be re-let and so an additional benefit might be to agree a 5 year lease with the new owners. If this was, say, £10,000 pa then this is an extra £50,000 that the seller has made from the deal.

Therefore, when it comes to valuing your firm for acquisition, the stock answer that no-one pays for goodwill is probably correct. But as shown above, by being flexible and sensible, the seller has actually made in real terms c£350,000 from the transaction at very attractive tax rates and can retire elegantly.

Ampersand Legal is a specialist business dealing with law firm M&A and we have developed a specialism helping partners in smaller firms retire. For an initial non-obligatory conversation please contact Andrew Roberts on andrew@ampersandlegal.co.uk.

M&A in the new Covid-World. Part 2…

M&A for law firms in the current climate – Part 2. For firms who wish to merge post-Covid.

 

Once the lockdown ends, I expect the M&A market to be very different. There will be a largish minority of firms who had the practice areas, systems and deep pockets to have come through relatively un-scathed, another largish minority of firms who have survived and who will set about re-building themselves and the final segment of firms who have made it through thanks to the largesse of the government but who are either in no fit state to continue, or more likely where the partners do not have the appetite to do so. So which one of these categories will your firm fall into?

 

This will become pretty self-evident from your partner group discussions on the future and really boils down to one question. After this is all over do you see yourselves as the predator, the prey or an observer. Each of these 3 mind-sets is equally valid and it is sensible to take the time now to prepare properly for the post-Covid market.

 

Predator: These are the strong firms with good management and systems who have weathered the storm better than most. There are likely to be two avenues to explore, either bolstering current offices or opening in new locations. The post-Covid world will be an ideal environment for these firms because in either scenario there are likely to be a number of willing targets.

 

The managing partners of these firms should take the time to assess their current office strengths and decide where to grow first, then second and then third because no M&A strategy works when there are two or more firms joining at the same time. Once they have this information, they can conduct simple desk- based research (or use a broker of course) to research those markets, find the right target and make an approach before anyone else does.

 

Prey: Looking at the demographics of the profession, these will often be run by older partners who have survived a number of downturns and just do not want to face the prospect of doing so again. They have good firms which have supported them, clients and the staff over a number of years, but now it is time to pass them on.

 

The most important actions are to do the house-keeping and prepare a strong bundle of documents. In terms of house-keeping this might be looking at excess storage over 6 years, any long supplier contracts that are coming to an end and also cutting any superfluous staff. Essentially, this is all about trimming the cost base to make the firm more attractive.

 

The bundle should contain copies of the lease(s) including storage, employment contracts and supplier contracts. Financially it will need the top 20 clients over the past 3 years, 6 months MI and 3 years accounts. On the PII side, it will need the most recent PII Proposal form and 6 years claims history. These are the basics any predator firm will ask for so having them ready will create a positive impression.

 

The Partner group should also start to consider what kind of firm would find them attractive and why, and then play to these strengths. Once everything is prepared, using desk research (or a broker) they can find and approach suitable firms and start the acquisition process. One final point regarding being the prey, it is vital for all owners to sign off on what a good deal will look like so that this can be negotiated. We often see situations where mission-creep enters or partners start to diverge in what they want in which case the project is doomed.

 

The last group is the Observer type firm and these will concentrate on re-building what they have already got, letting M&A activity pass them by for now at least.

 

To conclude, once this period is over I am convinced that M&A activity will boom and the long-heralded consolidation will take effect, so now is the ideal time to work out which of the three types of firm you are, get prepared and then seize the moment.

 

 

 

 

M&A in the new Covid-World. Part 1…

M&A for law firms in the current climate – Part 1: For firms who are currently in discussions.

 

Before the lockdown happened in late March we were happily working on 13 different M&A deals of various sizes and aspects but within a few days every single one of these deals was on ice because a major part of M&A work is the cultural fit and blending the teams together.

 

It is very difficult to get a feel for a firm’s culture from a zoom call with the managing partner in their home office and of course with social distancing it is not possible to blend the teams and help people get to know each other. The deals are all still there and viable, if they were good before there is no reason why they shouldn’t be good afterwards, but the question is what can the firms do now to make sure that once we get through this period they can get discussions back on track?

 

The obvious first stage is to keep talking to each other. Depending on where the discussions had reached, the 2 managing partners should hold regular calls or video conferences to keep the pilot light lit or, if discussions were more advanced, the various heads of department heads could be talking to devise joint business plans and the various heads of the support departments such as IT or HR could use this period to put policies in place.

 

This is also an ideal time to do any desktop DD such as supplier contracts, leases, PII quotes and even file reviews in secure data rooms. For smaller firms with physical files, there is no reason why a storage company cannot deliver files to the other COLP to review.

 

Finally, it is also a good time to negotiate the finer aspects of the merger agreement and following on from this the ongoing partnership agreement, consultancy agreements or employment contracts.

 

Once we are out of lockdown, and depending on what that looks like, we suggest that both firms agree a roadmap of tasks to complete with a tight timescale to re-inject momentum. For instance, if things start to ease in June/July, aiming to beat the PII renewal on Oct 1st would make a lot of sense.

 

So to conclude, whilst this is a difficult time, it is also a great opportunity to complete proper DD and business planning so that when the eventual merger happens the merged firm has the best chance of success. My next article will suggest what firms should do if they wish to start the merger process after lockdown.

Is there a future for legal aid firms?

Is there new Life breathing into Legal Aid firms?

As we all know recent governments have cut the legal aid budget down to the very minimum and still they look to make savings. Legal aid goes to the very core of what the legal profession should be about, helping the small person stand up to larger interests but this seems to have been largely forgotten in a rush to save costs and punish “fat cat solicitors”.

However, there are still brave souls out there who see the law as a vocation rather than a means of getting rich who are valiantly trying to provide these services. However to be able to do this they also need to be able to make a living and the truth is that, just as in the commercial world, size is key.

In the past 12 months we have arranged three mergers within the broad legal aid world. These have tended to be either where one party wishes to retire or where the burdens of running the business are directly affecting the firms ability to survive let alone thrive. Afterall, compliance and PII are just as onerous for a small firm in Clerkenwell or Clapham as they are for a firm in a glass tower in the City. One pleasant change that we have noticed is that firms in this sector are not as competitive as in the commercial world and so the cultures tend to be less aggressive and more collaborative allowing the firms a much better chance of success at blending the teams together.

We have a number of clients who appreciate that scale and systems are the only way that they can make a profit whilst also providing the legal services that society needs. These firms are willing to invest in the sector and take on smaller firms, using the central hub and spoke model to make each office a route to the local market with a % of central costs rather than a standalone silo with 100% of the costs. Thus the community can access good quality local legal services, the teams can continue to make a living and the owners enjoy a profit.

So, in our view, legal aid and community legal services are not dead, they might be injured and pretty sore but there are still dedicated solicitors out there trying to help their communities and combining with a larger firm is one way of guaranteeing that they are able to keep on doing so.

Merging into new profit centres

Merging into new profit centres

 

There are 2 major motivations for firms considering merger for growth. Consolidating their current location, or merging into a new profit centre.

 

There is a lot to be said for consolidating, but property is always the key driver here. One or both firms will need to be able to exit their leases within the next 12-18 months or else you just get 2 silos with twice the headaches and none of the benefits. However, if one or both can move then it is a great opportunity to bring everyone under one roof, save costs and have the ability to cross-sell to a larger client base. Ideally your neighbour will have complementary business areas – private client to add to your commercial for instance which will allow the combined firm to maximise both.

 

But maybe your firm is already dominant in your location, or when you look around you feel that any merger with a neighbour would damage your brand, so how do you grow then?

 

Put simply, you need to merge into another location and replicate what you do well there. Of course you could set up a new office wherever you want, but the local firms will try to snuff your new office out and there is a long lead time to profitability so a merger, if you can find the right partner, is a far better option. So what are the practicalities?

 

Firstly your new office needs to make sense geographically and be close enough for the main firm to be mutually supportive. A few years ago we worked for Withy King who were in Bath, Swindon and Marlborough with a small office in London so the obvious place to go was Oxford. Bath and Oxford have similar client characteristics, and the new office was not too far away to manage and integrate properly. The merger has been a great success with over 40 lawyers now the WK Oxford office

 

Secondly, once you have decided on location what about the target’s owners? Consider their equity partner demographics and the ages of the junior partners. If these are looking good for the future, then the deal is a merger. If the partners are all older with no succession, then it is an acquisition which is probably better but you will need to put your own leaders in there.

 

Thirdly, practice areas. Do you want to add more of the same, or add business lines that you do not currently have. Mogers are another Bath firm who have a range of skills and are particularly known for their Private client business, but they are not too well known outside the town. Dyne Drewett were based south of Bath in a very wealthy agricultural area and were known for this type of work but were perhaps struggling to develop more work from their clients. A merger allowed both firms and their client bases access to new skills and work sources and their merger has been a total success.

 

Fourthly, recruitment. This might seem like an unusual benefit, but in the above example, candidates find Bath a more attractive location to live and work in perhaps than Sherborne or a Wells which are both fantastic places but are often not on candidate’s radars. Again, the merger allowed the new firm to attract high level talent to work in Bath but then service the client base stretching down into the Mendip agricultural belt.

 

Merging into new profit centres can work very well, and often the target firm is more open to the idea than a local merger because they are able to maintain some element of independence and they will feel their service offering is enhanced rather than diluted as it might be by taking on a neighbour. If we can help with your plans, please get in touch.

Why merge with a “consolidator firm”?

What are the benefits of joining with a consolidator.

 

There is a new type of law firm slowly gathering traction in the legal market, and these are the consolidators. Primarily these have been in London but they are now spreading out into the regions.

 

So what is a consolidator and why are firms attracted to them?

 

Put simply a consolidator is a firm whose business is to acquire other smaller firms and by using economies of scale make the acquired firm more profitable for the benefit of all. To take an example, we act for Cubism Law in London which has grown from £0 to £8m in 10 years. As part of this growth, we have placed 6 firms with them, all of whose Partners report less stress and more profit. If one analyses the 9 CBD postcodes in London there are c350 1-3 partner firms. Most of these are good firms with long histories and run by good partners, but all are dealing with landlords, the bank, PII, SRA, recruitment, current staff, photocopier leases etc and myriad other non-law elements which are a distraction. Partners report that running the business of the firm takes about 1 day per week and therefore they are all losing 20% of their competitive edge to rivals. Joining a firm such as Cubism takes away all of these distractions and so immediately they are able to be 20% more productive.

 

“But we value our independence” is generally the stock answer to such an idea. That is not a problem, if your firm’s brand has real value, then keep it as a trading name. However, be honest and ask yourself what is your independence really worth? By joining a larger umbrella organisation which will run everything from the offices, to billing, to marketing, to compliance in return for a % of fees generated what have you lost apart from your problems?

 

Simply calculate what your draw currently is, and if it is less than the 60-70% Cubism would pay you then such a move will make money. Then consider the ability to cross-sell to other members of the group. One of our firms was primarily a conveyancing business, but the partner had a client with a major litigation matter. He could not deal with this but passed it to his litigation colleagues and earned 20% of the fee, in this case a six figure sum. Finally consider that your succession is now dealt with and suddenly independence might look like an expensive luxury.

 

There are a few other firms out there doing this, Gordon Dadds is a great business looking to go national and there is Star Legal and now Echelon Law as well, so if traditional merger with a similar firm is not the answer, and often is not because you just get a larger firm with the same issues, then the consolidator route could be for you. One thing to note, with this type of fee % model there is nowhere for unproductive partners to hide, but for those that are driven they offer a very sensible option.

 

We act for a number of consolidators, if you would like a conversation about whether this option might be for you, please get in touch.

 

What is my firm worth?

If there is one question we are often asked it is what is my law firm worth. The simple answer is nothing and that seems so unfair until you consider a few points.

Investment. Most partners draw all the profit out and do not invest in the firm. Indeed there is not at lot to invest in which would bring value. Premises maybe and IT certainly but any firm looking to acquire your firm will most likely have different premises and IT. You can invest in staff, but they can leave so it is understandable why partners draw out all the profit.

I often use the analogy of a bakery. If a new baker sets up a bakery and builds it up to £2m turnover, with a factory and new ovens, mixing machines and conveyor belts, with long term clients and future contracts then when he comes to sell this has a real value of something like 3 or 4 times EBITDA. However a lawyer in the same situation has nothing structural to invest in and will not have any long term contracts and so it has no value. The upside is that he or she has drawn all the profits out along the way unlike the baker, the downside is that at the end of the day there is nothing to sell.

The second point is insurance. In every market other than England & Wales, whichever insurer insured a firm in 2014 for instance is liable for any negligence in 2014. This seems fair, they took the premium they should have the liability. Not here though, the last insurer is left with liability and run-off. Lawyers complain about having to buy run off and it being 3 x premium, but look at it for the insurers point of view. The final insurer is obliged of give 6 years cover for 3 years premium. They don’t want it any more than you want to pay it and so as a partner gets to their end of their careers I see premiums going up as insurers “encourage” that firm to go elsewhere.

Run-off is also only for 6 years and whilst the law society is looking at a number of insurance products to cover the rest of life, how do you price that? Currently 11% of claims are post run-off, so to be clear that is where a Solicitor has closed their firm, bought run off and retired, but at some point there was a coveyancing error, or a child was mid-advised and the resulting liability falls on that partner directly. He has not worked for a number of years and is in no place to fund the claims and more often than not the only option is an IVA. No one wants that, and the only cast-iron certain option is to find a firm to be successor practice. This saves run-off and a pound saved is a pound earned but most importantly protects the partner for life. Maybe Sleeping soundly and saving the 3 x premium is a fair value after all.

So is it really that bad? No, most of the deals we do are with good firms, well run but just where there is no succession in place. Local hero firms if you like, who have fulfilled a need for legal services in their community for a number of years and we act for a number of buyers of such firms. Generally the kind of deals are they will pay 1 x the average of past 3 years profits paid over 12 or 24 months and if done correctly can attract entrepreneurs relief at 10%. So if he or she is clever, a partner can draw profits throughout their career, hand the firm over without run-off cover and sleeping soundly in retirement plus get a series of cash payments at 10% tax over the first couple of years of their retirement. That’s not so bad after all.

Succession – how to attract younger partners to buy in

Succession planning by attracting junior partners to buy in.

 

I was speaking at the Local Law Societies conference last week and a theme that kept on cropping up was that junior partners are no longer keen to buy in to small firms. I was asked what firms could do about this and I think there are some clear steps that partners can take to secure their succession internally.

 

The biggest hurdle I have found is a culture of them and us. We are equity partners and they are not, so what we do with our business is none of their business. This is true, but the market is full of head-hunters ready to poach good staff and if your stars don’t know what at the future holds for them with your firm, and they get a call from a rival firm with a clear path and goals, it will be very attractive.

 

If you have some future stars you are lucky. So, tell them they are the future. Kind words over a glass of wine letting them know that you have their best interests at heart is worth far more than an annual review and a small pay rise. Bring them into your confidence, tell them they are the future and that your aim is to leave the firm in a better place than it was when you found it.

 

As part of this process, if they are the future let them be part of shaping it. Discuss the firm’s strategy and ask their opinions. Explain that you are the owners and so the final decision rests with you, but get their ideas. I suggest giving them basic accounts and help them understand how to run the business. We always hear that ” I love the law, but I didn’t go to law school to spend all my time running the firm”. But if they know how to do it properly, running the firm properly is just as important as the doing law and probably minute for minute is more profitable, drawing profit from efficencies rather than selling another hour.

 

Also, it is important to discuss your plans. If you are late 50’s or early 60’s telling your stars that you plan to retire at 65 is not a sign of weakness. Telling them you want to carry on forever or even worse not telling them anything is true weakness and will eventually leave a husk of a firm when they have left for better opportunities.

 

From a practical perspective, a sensible first step is to incorporate. There are tax benefits which make a limited company the best vehicle but that aside, asking a future star to buy shares in the business they work in is, philosophically, a different conversation than asking them to take your equity. The later hints at taking over liabilities and is often an all or nothing kind of deal. So why not sell your 50% equity to your star at 10% a year for 5 years. This makes it affordable for everyone. Or just sell 40% and keep 10% of non-voting shares so that you can enjoy their success and remain as an ambassador.

 

We advise that it is sensible to prepare a sales brochure just like a normal commercial business would do if it was looking for investment. This should contain 3 years accounts and PII records, leases (see below), staff numbers and salaries, current business plan and a brief SWOT (Strength, Weakness, Opportunity, Threat) analysis. They can then study this, discuss it at home or with a friend who is in business and it shows you in a positive light. It demonstrates that you are running a proper business which is investable.

 

We are currently working with a firm with 3 equity partners, all mid 60’s who have been talking to us for 5 years about their plans and how the 5 salaried partners are the future. Unfortunately, they did not say this to those 5 salarieds. Now the equities have decided to retire over the next 2 years but not one of the salaried partners is interested in taking over. They are not going to leave, but nor are they going to take ownership due to timescales and frankly, because the equities have milked the firm and it needs investment, let alone paying the equities out. The only alternative is merger which we will help with, but internal succession is much less stressful and difficult and this situation was so avoidable.

 

Property is always a major issue if the partnership owns it. Very often the current equity partners inherited an old building on a High Street which in the 1970s was not worth much. Now it could be worth well over £1m if it was developed and it is unlikely the equity partners will want to walk away from this. The logical thing to do as part of the succession would be to look five years out, find new leasehold premises for the firm to move to and develop the old office. The more understanding equity partners might even give a slice of this to the future stars which would really lock them in.

 

So, if you have future stars in the firm they need to be looked after, trusted and told they are the future or else your succession plan might very quickly become someone elses!

Retirement strategies for law firms

Retirement strategies for law firm owners.
There are 8000 firms in England & Wales of between 1-4 Partners and a large majority of these will have Partners who are in the last few years of their careers. For these Partners to retire there are only 6 possible solutions. These are that you already have tomorrow’s partners in place, you need to find them and attract them, you are acquired, you bring in professional management, you close the firm or you just keep on going hoping things will work out. It might be helpful for us to take each of these in turn and look a little deeper.

1. You already have succession in place.
Well done, you are obviously running an attractive firm and your younger colleagues can see that it is strong and sustainable and so they are happy to invest. We advise all clients in their 50’s to start seriously concentrating on this process because it takes time to develop your people. We find that the next generation find taking on ownership easier if the firm incorporates so that they can acquire shares in a business rather than equity in a partnership. This might seem a minor distinction but it does make the route to new ownership and therefore your exit, smoother.

2. You need to find your successors.
You no doubt have good lawyers in the firm but no one who has the desire or commercial nous to take over. This is quite common and maybe not surprising considering the regulatory and financial environment that firms operate in now. However, other owners are out there and so you need to find them and then make the firm as attractive as possible to them.
To find them we would suggest networking first – ask your accountant and bank if they have heard good things about young locals. Talk to your other contacts and clients but if these do not yield results, you need to retain a professional head-hunter who has the research capability to uncover the right person. Once you have a target, you then need to make the firm as attractive as possible. Obviously if there are any issues you need to remedy these first, or have a plan in place to do so. Then put together a sales prospectus containing all relevant information – fees and margin over 3 years, client types, staff demographics, liabilities, property details. Make it easy for them to see that this is a good long term business opportunity for them and always, always, be positive.

3. You are acquired.
People always talk about law firm mergers, but in reality they are always acquisitions. Again, you need to tidy the firm up and prepare a prospectus to get your thoughts organised. Then make discreet enquiries as to which firms might be interested in acquisition. These might be via your bank or accountant, or via a broker who will ensure that your plans are kept secret and who will help you cover all the potential options. Acquisition is an excellent way of solving the problem, there is no disgrace in losing the name or independence if by doing so you can exit whilst guaranteeing the continued wellbeing of clients and staff. Also, you don’t need to wait until retirement for this to work, again, doing it in your 50’s gives you 5 to 10 years to enjoy the benefits of the merged firm.

4. Professional management.
Bring in a non-lawyer to run the firm. For this to work it is far better to incorporate because you can then hold shares in the business and maybe sit on the board whilst having a CEO run the firm day to day. That CEO should also probably have shares. This solves the ownership issue and also allows you a kind of exit (whilst maintaining an income), but you are very reliant on finding and keeping a good CEO and it is probably not a sound long term solution.

5. You close.
Only firms with large liabilities or major issues should need to consider this as an option because there is always an inherent value in a firm. PII contagion is the largest issue and firms are rightly wary of becoming successor practice to firms with a poor history. However, if you decide to close, your current PII provider must offer run-off terms and you should then follow Chapter 10 of the SRA code and effect an orderly closure. This is a rather inelegant end to a career but at least it allows an exit and would usually happen upon expiry of the office lease.

6. Do nothing
The final option, do nothing and hope something turns up. This last option is very common but is not sustainable in the long term however attractive it might seem immediately. As I have said earlier, every firm has a latent value so long as it is not burdened by PII or other toxic liabilities and the sooner you start the process the better.

In our experience the best way to exit is to address the issue early and grow your own succession. If this is not possible (or doesn’t work out) then being acquired is likely to be the easiest option for you and the best option for your clients and staff. If we can help with any of the above please get in touch, andrew@ampersandlegal.co.uk or 020 7100 7188.