Separation of powers and profits

Talking to many law firm partners, one would think the subject of profit sharing, ownership and capital structures is akin to rocket science.

Take it on trust, however, that it is not – so long as one key principle is always kept in mind: that is, the need to separate the sharing of profits from the underlying ownership of the firm.

There will always be a link, but if one treats the business like a limited company paying the partners a fair commercial reward for the work they actually do – be it fee-earning or management – but then on top of that, a dividend as a reward for ownership of the firm, then that unlocks the confusion.

That’s not to say that there will be no need for some difficult discussions, but it will assist in resolving the issues.

Meet the team

This article is best illustrated through a case study of the mythical five-partner firm LSF & Co LLP, as shown in figure 1. 

Figure 1

LSF & Co LLP

The firm was founded in 1976 and is now an LLP. Brian is looking towards retirement and wishes to be able to withdraw his capital. There are two salaried partners who are keen to join the equity and from whom the others are anxious to secure a long-term commitment to the firm. 

The remaining equity partners are keen to ensure fairness between themselves. 

Profit sharing

There are only three methods of profit sharing:

•    Equality, often over a number of years via lockstep.
•    Performance related, often via assessment against SMART (specific, measurable, achievable, relevant, time-oriented) objectives.
•    A mixture of the two.

The third option often finds favour and represents commercial reality, but with the profits split into a number of segments:

•    Interest on capital invested to cover interest that may need to be paid to the bank on borrowing to provide capital.
•    A fixed share to represent a reward for the job, commensurate with what would be an arms’ length salary should they not be a partner. This can either be equal for all partners or based on an assessment of market worth.
•    A performance pool – either for meeting SMART objectives or to be allocated in some other way. Potentially this could also include a geographic or departmental pool for the larger firms.
•    A dividend of the remaining profits based on the underlying ownership.

Of course, anything that involves an assessment of performance, as in the performance pool or market worth for the fixed share, can be divisive; but arguably the larger the firm, the lack of a performance related element is just as divisive.

A rule of thumb is that if there are more than, say, a dozen equity partners, there needs to be a performance related element. 

However, for those with fewer partners it may not be worth the angst and potential ill-feeling that may be caused between what is otherwise likely to be a tightly-knit partner team. 

There are a variety of decision-making options for the performance element, though for the performance pool (but not necessarily the fixed share), the managing partner should have significant influence, if not the final decision with a view to ensuring the firm’s strategic direction is congruent with profit allocation.

Figures 2 and 3 demonstrate these principles; with the performance pool allocated equally for the sake of argument and the dividend following the points in issue (of which more below).

Figure 2

Profits for division

Figures 3

Performance pool allocation

Allied to profit sharing is the establishment of a drawings policy.

The suggested approach allows for drawings to follow commercial reality, whereby monthly drawings are set based on interest on capital (gross of tax) to meet interest payable to the bank, plus the fixed share (net of tax) – but with the tax retained being paid into a separate tax savings account.

The performance pool and the dividend are paid once the final annual accounts have been prepared, and often paid (net of tax again) in two equal instalments – perhaps six months and twelve months after the year end.

Ownership

A partner’s interest in their firm should be split between:

•    Current account representing undrawn profits net of tax. 
•    Tax provisioning on a full cessation basis on all profits up to the LLP’s year end less overlap relief (space precludes any detailed explanation).
•    Fixed capital contributed based on the underlying equity ownership and set at such a level sufficient to meet the firm’s working capital needs.

A ‘points system’ is often the best way of considering underlying ownership, as it tends to avoid the divisiveness of specific percentages and allows for an easier understanding of the admission and retirement of partners. 

The points determine the capital that individual partners need to contribute (often from bank borrowing) and the allocation of the last (dividend) segment of profit sharing. An often-adopted approach is that a full equity share is represented by 100 points; and a new partner comes in on, say, 50 points rising via lockstep over five years to the full 100 points. 

A partner approaching retirement may, on the other hand, reduce their points to, say, 50 over the five years immediately prior to retirement.

Such an approach allows new partners to borrow their initial capital from their bank at levels that are more likely to be favoured by the bank, with annual increases coming from retained profits. In turn, the retiring partner obtains access to their capital allowing a smoothing to retirement.

Just as crucially, the firm is then in control of their capital outflows balanced by inflows from new partners. 

Using capital of £1,075,000, figure 4 demonstrates how LSF & Co may be able to deal with exiting and joining partners and their respective equivalent financial interest in the firm.

Of course, the greater number of points in issue results in capital per partner reducing – but also their share of the ‘dividend’. This represents an interesting risk reward conundrum for every firm.

Figure 4

Exiting and joining partners and their respective equivalent financial interest

Capital structure

‘What is my law firm worth?’ is a frequent question, to which the rather glib answer is – ‘not as much as you hope’.

This, however, is the fundamental issue when determining what capital partners need to provide when joining the firm; and what they can withdraw when leaving the firm. 

There are two assets that may well not be fairly reflected in the accounts of the firm:

•    Work in progress (WIP) – Especially as it relates to contingent work, as accounting standards are open to a variety of interpretations and the value is often understated so as to minimise tax liabilities.
•    Goodwill – This is notoriously difficult to value; and accounting standards do not allow for the inclusion of anything other than purchased goodwill – and even that has to be depreciated. Its value is a function of the level of profits (usually EBITDA) after deducting a fair reward for the partners times a multiplier in comparison with the net assets. It’s more likely to have a value in a process driven firm and less likely in a collegiate type firm.

Nevertheless, the value of each of these assets needs to be agreed between the partners when addressing the issue of the admission and retirement of partners, as it should directly affect what is paid and received. 

The value of goodwill is the issue that causes the biggest problems, as joining and leaving partners will have diametrically opposing views – outgoing partners will believe it is worth far more than incoming partners who, in any event, will believe that they will have created at least some of its value and hence be reluctant to pay for it. 

This is compounded by the difficulty in persuading the banks to lend against goodwill to fund the capital requirements for incoming partners.

Compounding these difficulties is the fact that the capital required by the firm is dynamic. It will reduce or increase as lock up reduces or increases and be affected by strategic decisions made relating to investment – particularly premises, IT or new services.

Then, of course, there is the philosophical attitude of the partnership to borrowing – some have no desire to rely on the banks while others will wish to have a high usage of bank funding. 

There is no right or wrong, but the decision taken directly affects the amount of fixed capital required by the firm and, hence, the amounts that partners have to contribute. Figure 5 shows how all of these factors can change the level of capital in the firm.

Figure 5

Factors changing capital levels

When LSF & Co first introduce this new approach, it decided to include an extra £300,000 for WIP but agreed not to include anything for goodwill, thereby increasing the level of fixed capital to £1,075,000.

This is shown in Figure 6, which also shows that Brian has left too much in the firm and is now able to extract the excess £56,250; while, for example, Cathy on the other hand needs to contribute £41,250. 

Figure 6

Fixed capital to include WIP

Any consideration of capital structure cannot ignore the question of whether to operate as an LLP or a limited company.

The principles set out presuppose an LLP but can be easily adapted to a limited company which has the added benefit of being able to retain profits taxed at lower corporate tax rates.

The decision is not an easy one and is often finely balanced. However, as a rule of thumb, if profits are to be fully withdrawn on an annual basis with no bank borrowing to be paid down, then an LLP is the more likely option.

These firms are more likely to be collegiate in nature and welcome the far greater flexibility afforded by LLP status as opposed to the greater complexity and less flexibility of a limited company. 

On the other hand, if the firm wishes to retain profits to either pay down debt or to invest in the future, then a limited company is the more likely option. These firms are often less collegiate in nature and often provide process driven services such as personal injury or volume conveyancing.

Covid-19 and Brexit

No article written at this time (just before 31 December 2020) can avoid the dreaded B and C words.

Whatever one’s views on Brexit; whatever the length of the inevitable further lockdown, experience over the decades suggests that the principles outlined will stand the test of time and are sufficiently flexible to cater for all eventualities.

Howard Hackney is a partner at chartered accountancy firm Howard Hackney howardhackney.co.uk