Sharing ownership: Why UK law firms should embrace employee share ownership

 

Are law firms' traditional ownership and reward structures fit for purpose in these radically changing times? A different approach might better equip many firms to address the challenges they face.

In 2012, the UK government announced plans to create a 'John Lewis economy'. The John Lewis Partnership is owned by 84,700 partners and shares profits between them. The government scheme aims to follow the department store group's business model and provide more employees with an ownership stake in the businesses they work for.

Law firms could also benefit from extending their ownership to more of their people. There is persuasive evidence of positive connections between employee ownership and business performance, both quantitatively (such as through sales growth) and qualitatively (such as through employee commitment and job satisfaction).

Rethinking ownership

Let's start by looking at what law firm ownership traditionally means. In the main, for an equity partner, ownership means an annual profit share, a say in who makes management decisions and a recognised level of status and responsibility. Although a partner will often have bought a capital share, this tends to be of fixed value: when you leave, you simply get back what you paid in.

In any business whose value is entirely linked to its people's skills, it is hard to see how any separate capital value can be created. However, a firm that builds a strong brand, develops intellectual property or uses proprietary technology in its service delivery may create value beyond the sum of its lawyers' skills and experience. An individual's shares or other membership interest may then have a value linked to the firm's performance, regardless of whether he continues to work there.

The current partnership structure excludes from ownership many people who are key to the firm's success. Partners play a central role, but are they the only value creators? A professional manager can arguably make an individual contribution at least as valuable as that of any single partner. Many firms will also have talented lawyers who, for a range of reasons, aren't in the partnership. A firm that enables these highly valuable people to become part owners will be more attractive to recruits and, with skilful management, will significantly increase their motivation and fulfilment, creating a competitive advantage.

It makes sense to extend firm ownership more widely to include all associate lawyers, paralegals, technologists and support staff. The performance and motivational effects of ownership are not limited to senior people. Firms with reasonably flat hierarchies (such as those providing volume advice through relatively high numbers of junior lawyers and paralegals) may find compelling the arguments for involving most of their staff in ownership.

Partly linking employee reward to performance through ownership brings flexibility, making it easier to weather tougher times, with the prospect of greater reward when conditions improve.

Profit per equity partner (PEP) continues to be the most familiar measure of law firm performance. Although fairly easily measurable, it creates a risk of under-investment through partner pressure to maximise annual distributions, unless combined with a robust management policy of profit retention.

The mobility of modern partners may make them unwilling to sacrifice cash today for the prospect of a greater profit share in later years. They might have moved on by the time they are able to reap those longer-term benefits. An adjusted ownership structure, in which a firm's owners hold shares whose value can reflect the impact of longer-term investment, may improve longer-term results.

Of course, not every law firm can or should create employee share ownership. Some law firms continue to thrive and have performed exceptionally well through the economic crisis. They may not feel there is a problem to solve. They could be right. There are new firms, niche or relatively small, for whom wider ownership is simply not a priority. The main focus of management time in their early years will be on business development.

International law firms may find it relatively complex to extend ownership. However, they may still find that there is a strong business case for doing so for their key people. Slater & Gordon, the Australian law firm that acquired UK law firm Russell Jones & Walker in 2012, operates an employee share ownership plan.

If you decide to take the path towards employee share ownership, what model should you adopt?

Structuring ownership

There is ample opportunity to design an ownership arrangement suited to the firm's particular situation and demands. The following questions provide a good starting point.

1. Does the firm aim to grow its capital value or is ownership really just about acquiring a right to an annual profit share?

If the former, it is very likely that the firm will need to be incorporated so that shares become the medium of ownership. If the latter, either a company or a limited liability partnership might be suitable. A traditional partnership is unlikely to be attractive, given its implications for personal liability.

2. If a company is the chosen vehicle, should there be individual share ownership?

If ownership is to involve sharing in capital value growth, then participating employees will most likely need to acquire personal ownership of shares.

However, if sharing in capital value is not to be a feature, a more radical approach might involve ownership of the company (or a significant proportion of it) by an employees' trust. This would be very similar to the true John Lewis form of ownership.

A more helpful analogy may be Arup, the international firm of consulting engineers, which is wholly owned by an employees' trust. No individual employees hold shares. Profits are shared between employees as bonuses. Everyone working in the company is an employee and, when staff leave, they do not have shares to sell.

3. If there is to be individual share ownership, how should leavers be treated and should shares be tradable?

If shares do not have a capital value, then participating employees might pay an affordable and fixed amount to acquire shares, which they sell for the same amount when they leave.

If shares are to have a capital value, a more sophisticated approach may be needed in which the company makes financial provision for funding the cost of buying back shares from departing employees.

4. If employees are to acquire shares individually, what form should this take?

In the main, direct employee share ownership is likely to involve one of the following.

a. Purchase of shares

This is arguably the purest way for employees to acquire shares, with no adverse tax consequences as long as they pay at least market value. However, employees will often not be able to afford to buy shares.

b. Free (or discounted) shares

To a degree, this solves the financing problem for the employee, but it will result in a tax liability based on the shares' value when they are acquired, unless an exemption is found.

c. Option to acquire shares in future

One reason options are so popular is that they create a right for employees to acquire shares at fixed cost, but defer the time they have to pay for the shares until a later date.

Tax incentives

It would be wrong to design any business ownership structure solely around available tax incentives. However, if tax breaks are compatible with a firm's preferred ownership structure, it makes sense to use them, as they may mitigate or even eliminate the cost to employees of becoming shareholders. Below are two examples of employee tax incentives.

1. Firm share option plan

For a firm wishing to extend ownership to selected key people, it may be able to grant them approved company share option plan (CSOP) options, the tax due on any employee gains being capital gains tax (CGT) at a likely rate of 28 per cent.

If they were to leave before their options had become exercisable, they would lose them, potentially creating an incentive to stay if share value rises after the option grant, and a reward once they are able to sell their shares.

2. Share incentive plan

For a firm wishing to make all employees shareholders, the share incentive plan (SIP) enables employees to buy or receive free shares, in each case with tax relief, thus significantly easing or even entirely removing the financial burden on employees.

Employees are given full relief against income tax and national insurance on any part of their salary used to buy shares in the company, up to an annual maximum of 1,500. Additionally, they can be given free shares, tax free, up to an annual maximum value of 3,000. Further, every share they buy can be matched with up to two more free shares, also tax free.

A number of conditions apply, including that the firm must be independent and that participation must be offered to all employees (or all who have worked for a minimum period). The shares must normally be retained for five years, but can be forfeit if an employee leaves within the first three years.

Any subsequent growth in share value is exempt from CGT.

 

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Key considerations in moving to an employee share ownership model

• Address market changes. Will the marketplace in which your firm operates change in the next few years? If yes, will your plans for addressing this include a review of how you reward and engage your key people?

• Identify key people. Which roles in your firm are critical to its success? Do these include non-lawyer roles?

• Align ownership with strategy. Does your firm’s current ownership include all of the people who are key to its long-term success?

• Optimise incentives and rewards. Could your firm potentially improve its performance if ownership was extended to other value creators?

• Improve employer attractiveness. Does your reward and ownership structure help you to get the best people?

• Consider alternative models. Look at other business ownership models, both in professional services and elsewhere.

• Prepare for possible obstacles. In some cases, broadening ownership might be harder, for example in international firms.

• Define ownership. What does ownership mean for your firm? Does it mean a share of profits, or is your strategy to also grow the firm’s capital value?

• Consider direct and indirect ownership. Should employees acquire shares directly or indirectly (e.g. through an employee trust)?

• Decide how shares are obtained. How are employees to acquire shares? If employees are to acquire shares individually, should they buy them, be given them or be granted options?

• Consider tax incentives. Do the tax incentives make wider ownership more attractive? 

• Manage ownership of shares. Should shares be tradable or should ownership be more tightly managed? Should employees be allowed to retain shares after leaving or be required to sell them back and, if so, on what terms?

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Long-term rewards

For a firm persuaded of its benefits, it is feasible to widen share ownership practically and in a form both compatible with its goals.

Employee share ownership is not a cure for all ills, but any firm serious about improving long-term performance, maximising engagement and creating a stronger link between profits and costs may find it interesting to explore.

Robert Postlethwaite is managing partner of UK law firm Postlethwaite (www.postlethwaiteco.com)

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