Mergers and Managing for Profit

Whilst a fear factor may push law firms in the direction of a merger, proceed at your peril if you are not currently managing for profit. Tracey Williams, chartered accountant, gives a black and white guide to improving financial management and profits…

“Observe all men, thyself most.”

These words, poetic license permitting, are of equal application to a law firm’s position in the current legal market. Sensible and honest self awareness is the key to survival in any environment, not blue sky thinking and ill thought out strategies, but the sort of thinking that can embrace merger activity.

“These are extremely challenging times for businesses of all sizes and across every sector – and professional services firms are no exception,” said Janet Marton, chair of the Solicitors Group of the Institute of Chartered Accountants in England and Wales (ICAEW). “In the present climate, sound financial management is more important than ever”. See Table 1 for the ICAEW’s 10-point credit crunch survival guide for law firms.

Assuming that your firm has fully implemented the credit crunch guidance, you may be emerging from the recession in good shape. You may even have a new business model fit for the Legal Services Act 2007 future and be well placed to consider making lemonade from the lemons that the economy is dishing up. Perhaps you would like to take advantage of your relative strength and are considering a merger?

Smith & Williamson conducted a survey of 120 law firms and in December 2009 reported that while firms of all sizes anticipate a rise in mergers, those from medium sized firms (those with 50-99 partners) appear to anticipate the highest level of mergers. There appears to be even greater interest in acquiring bolt-on teams from other firms. Team bolt-ons avoid the cultural and integration issues and may achieve the upside that firms are looking for without carrying any additional baggage.

This suggests that behind-the-scenes discussions regarding mergers and acquisitions are a regular and current feature in the legal community.

Inevitably, not all acquisition discussions come to fruition. The all important cultural issues aside, talks commonly break down due to reasons of financial performance and partner/member remuneration and in the current climate. These are more important than ever.

Law firm partners are paying themselves too much. Law firms are rarely worth as much as partners believe.

This is according to Professor Stephen Mayson, director of the Legal Services Policy Institute. “Firms need to generate returns for owners, investors and staff. The essence of this is managing for profit”. The assertion is that most law firms manage for turnover and even if they can understand profit, there are too many profit-takers.

Whilst the above is somewhat controversial, unsurprisingly, valuation techniques are no different despite the present climate. Profitability is usually the only way in which the relative value of the two law firms can be determined, and so it continues to form the financial basis of a law firm merger. If the difference in profitability of the two firms is wide, a complex remuneration scheme will need to be put in place in the ‘new’ firm to reflect this. Otherwise, if all partners are remunerated on the same basis, the existing profits of the partners of the more profitable firm will be diluted.

From experience and as a general rule of thumb, partners seem willing to trade off up to a 10% in profit per equity partner (PEP), provided the business case and supporting analyses demonstrate that this is recoverable quickly, and that the merged firm will be able to generate a sustainable level of profitability above the pre-merger levels.

Differences in PEP, depending on the factors, can be accommodated in a number of ways. Current remedies range from not bringing all the equity partners across to the merged firm, to agreeing a minimum performance standard for the ‘new’ firm and for partners operating below the standard to receive special profit shares. This could be on a permanent basis or preferably for an agreed period.

It is not quite clear if the legal sector is through the worst of the recession. Whilst a fear factor may push firms in the direction of a merger, proceed at your peril if you are not currently managing for profit. You will be forced to differentiate between the elements that make up your net profit and you may be in for a shock. If your numbers stack up, start making lemonade!

Table 1 – The ICAEW Solicitors Group 10-point, credit crunch survival guide for law firms:

  1. Ensure fee pricing is reviewed regularly and that annual charge-out rate increases become a thing of the past.
  2. Exercise good control over unbilled work and disbursements to maintain working capital.
  3. Monitor cash flow on a daily and monthly basis – it is important to give the banks detailed, relevant information in a clear format.
  4. Concentrate on minimising large items of expenditure, but don’t waste undue time reducing immaterial amounts.
  5. Remember – it is seven times more expensive to attract new clients than it is to gain extra work from existing ones.
  6. Try to avoid cutting jobs by redeploying fee-earning staff to busier departments – or seconding them to clients.
  7. Take debt collection work away from busy fee-earners and put it in the hands of a nominated debt collector/department.
  8. Charge all time, bill fully and quickly, requesting payment up front whenever possible.
  9. Consider sale and lease-back of the car fleet to accelerate tax relief and reduce the tax cost by choosing low CO2 emission vehicles.
  10. Look at staff costs. A salary sacrifice scheme replaces employees’ taxable pay with tax-free benefits such as extra holiday, life assurance, childcare vouchers and critical illness cover.

Whilst a fear factor may push law firms in the direction of a merger, proceed at your peril if you are not currently managing for profit. Tracey Williams, chartered accountant, gives a black and white guide to improving financial management and profits…

Tracey Williams MBA is a chartered accountant and a member of SSG Legal’s advisory board, with experience of helping commercial organisations grow via merger or acquisition.

If you would like to find out more about how Ampersand Legal could help your firm to ensure competitive advantage as you come out of this recession, then please Contact Us.