Growth structure: Choose the right business structure under the UK LLP tax reforms

As my partner Jonathan Cheney wrote in the first article in this series on business structures for law firms in light of HM Revenue & Customs’ review of taxation of UK partnerships and LLPs, before considering the form of business vehicle that is appropriate for your business, it is important to be clear about your strategy.

Seneca the Younger said almost two thousand years ago: “Our plans miscarry because they have no aim. When a man does not know what harbour he is making for, no wind is the right wind.”

In other words, clarity of strategy enables clarity of execution. Seneca’s words are as relevant now as they were then. Business is all about strategy and execution, and both are key. The legal structure of the business should facilitate its strategic ambitions, but neither drive nor constrain that strategy.

Many firms are currently undertaking reviews of their legal structures given HMRC’s changes in the Finance Bill 2014. That ultimate choice of legal entity, be it an LLP, limited company or any other form of business vehicle, should not be dictated by tax treatment alone. Instead, strategy and, critically, how growth will be both achieved and funded, should be central to that structural decision making.

Have a plan

There is clearly a fundamental need to have a strategic plan. Once you have
a strategic plan in place, it becomes
so much more straightforward to
evaluate opportunities and prioritise investment by reference to relevance
to the strategic plan.

It is by no means uncommon for a professional services firm not to have a strategic plan in written form. You need to debate it, agree it and then write it down. This will not only ensure that a firm doesn’t fall into what might be called ‘Seneca’s trap’, but also that there is less risk, say a year down the line, of squabbles between partners over what the plan is, or is not.

That strategy needs to be realistic. As Brian Pitman, chief executive of Lloyds Bank once said: “To attempt the impossible is not a good strategy. It is just a waste of resources”. It is important to distinguish between the firm’s vision and its strategy, because the latter is the routemap to achieving the former.

In professional services firms’ vision statements (all too often articulated as a variation of ‘to be the best’), rarely are true visionaries of the calibre of the late Steve Jobs available to design and deliver the strategies that might produce true world leaders. On the other hand, even if they were, it is a mistake not to aspire realistically, and thus risk underachieving on realistic potential.

The ‘aspirationally realistic’ place between those two extremes is neither easy to identify nor easy to maintain. Aspiration is commendable but, beyond
a certain point, it becomes unrealistic and therefore counterproductive.

In the environment of most ‘real world’ firms, no one – whether partners, clients or staff – will believe it is possible to execute an unrealistic strategy focused on an unattainable vision. Resources deployed in execution will therefore be wasted. Buy-in and commitment will be lacking. Being realistic is therefore very important.

Choosing a structure

Once clear about the shape of a realistic strategy, then comes the time to consider the optimum structure through which to operate the business and drive execution. On the assumption that the strategy involves growth by some measure – be it geographic coverage, profits, headcounts or another metric – the firm must consider whether that growth is to be achieved organically or via a merger or acquisition. Will that growth be self-funded or will it require external debt or equity finance? Does it target international or just domestic expansion?

An increasing number of law firms traditionally structured as partnerships or LLPs are opting for a limited company structure to facilitate growth. Perhaps the most high profile of these in the UK market is Slater & Gordon, the listed Australian law firm that has, in the past few years, bought all or part of the law firms Russell Jones & Walker, Fentons, Taylor Vinters, Goodmans, Pickerings and Pannone. As a result, the firm lays claim to the number one or two market-share position in the UK in most consumer law practice areas, such as personal injury, clinical negligence, conveyancing, family, private client and trust and probate.

Another example is Leeds-based Simpson Millar, a consumer firm that in early April announced that it is to be acquired by AIM-listed financial services business Fairpoint Group. Peter Watson, the firm’s managing partner, said when the deal was announced that he expected it would allow the firm to execute a long-term growth strategy to significantly expand the number of products and services on offer. It plans to approach new potential partners with the added incentive that they will become shareholders in a diversified financial and legal services business.

Both of these firms operate at the more commoditised end of the spectrum of legal work, where the number of junior lawyers and paralegals per partner is highly leveraged and where heavy investment is required in IT systems and other facilities, as well as in staff and in marketing campaigns. Being structured as a limited company in many ways facilitates access to working capital and may be more attractive to external investors and potential purchasers.

For small firms looking to grow, it is also more tax efficient to retain profits in a company, because shareholders only get taxed on income received, whereas in a partnership all profits get taxed in the year in which they are generated, irrespective of whether or not they are paid out. Some firms have put limited companies into the membership of their LLPs, allowing them to allocate the profits of the LLP to the limited company, but the Finance Bill has now restricted the use of those mixed partnerships.

The limited company structure works for firms that have a small number of owners and can rely on highly leveraged, less hierarchical workforces. But, traditional law firms rely on progression of solicitors through the ranks, and succession is easier to manage in a partnership structure.

Historically, law firms have not been based on goodwill models that require solicitors to buy a stake when they become a partner and then sell that on retirement. Companies create a hurdle to new ownership in that way and, in the absence of a complex share scheme involving different classes of shares, the shareholders will have proportionate rights to voting, dividends and sale proceeds. Partnerships and LLPs are largely governed by contract law and allow for easier allocation of votes, income and capital rights on a more flexible basis.

There are two final considerations to note. First, if a merger is part of the long-term strategy, particularly a genuine merger with a firm of similar size rather than a takeover (either as an acquirer or
a target), that will undoubtedly be easier
to execute if the two parties to the deal share the same type of entity.

Second, while it may make sense to incorporate part of the practice more suited to a limited company structure,
such as personal injury or conveyancing arms, doing so can create divisions within the business that may be difficult to address in the long term.

Strategy and structure

For every business, each type of legal entity will have its own advantages and disadvantages, and the possibility of blending different entities within a group should not be ignored. But, the primary concern must be settling on the right strategy and letting that drive decisions on structure, rather than vice versa.

Mark Jones is head of the professional practices consultancy at international
law firm Addleshaw Goddard
(www.addleshawgoddard.com)

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