Survival kit: Planning a successful merger
A decision to merge with another firm must be based on realistic aspirations and carefully planned as part of a clear development strategy, say Howard Hackney and Barry Wilkinson
In the year to June 2018, 345 firms closed and 154 merged or amalgamated. In September 2018, there were 10,456 law firms in England and Wales. Of these, 2,392 are sole practitioners.
We also know that the distribution by turnover has a long tail – to get into the top 200 firms, you need a turnover of over £10m. The implication is that there is an awful lot of small to medium-sized (SME) law firms, and many are ripe for merger or acquisition.
There is also evidence that law firm partners in most SME firms are getting older. Experience suggests that before the 2008 crash, many law firms were making good profits and some partners, aged in their 40s, were not inclined to bring senior staff into the partnership.
The crash happened and life got difficult for many firms, and the overlooked aspiring partners left. This has now improved for most law firms, but ten years on, those partners are now in their 50s and often with no succession plans, making their firms good acquisition targets for growing firms.
So, how do you ensure that your firm is one of the minority that will be still in business in ten years’ time as a result of either merging or admitting new partners to replace those retiring – or both?
When considering these options any acquiring party should remembered that, according to a 2015 Harvard Business Review article, between 70 per cent and 90 per cent of mergers fail to add value.
An acquisition strategy is therefore a far riskier route to ensuring succession than the admission of new partners in a planned and organic progression. If growth is the objective, however, this will be achieved far more quickly than by organic growth, which is notoriously slow.
Before embarking on either strategy – and a merger in particular – it is important that you do so from a clear understanding of your strategic position. A proper understanding of your service offerings and their respective position in the market is usually the most important starting point, and an assessment of each using the Boston Matrix (see below) can be useful.
It will help classify service streams, and potentially other areas such as geographic locations, based on market attractiveness and market share. Services such as, for instance, wills, trust and probate, may be an attractive offering because there is limited competition and high profit margins. If they have a high market share they will be a ‘star’, but with a low market share they would be a ‘problem child’.
On the other hand, legally aided crime work may be an unattractive service because of the low profit margins; but depending on the market share, it could be a ‘cash cow’ (high market share) or a ‘dog’ (low market share). The accepted wisdom is that you ‘milk the cows’ and ‘shoot the dogs’, that you invest in your ‘problem child’ and ‘star’.
So, if you have a low market share in, say, will, trusts and probate you may consider acquiring a practice with similar work. In turn, if you have a ‘dog’ you may wish to find an acquirer with a strong market share of similar types of work.
Strategy clearly is wider than just service offering and will consist of other matters such as desired geographic coverage, bench strength, size, and perhaps most importantly the desired PEP (profit per equity partner).
PEP can easily be increased, can it not, by increasing fee income, cutting overheads and reducing the number of partners? If only it were that simple.
However, an acquisition strategy should only ever be embarked upon with the aim of increasing PEP or at least maintaining it. While strategy should drive succession plans, cultural issues are the most significant reasons for either failed mergers or discussions that never progress. In the well-known words of management consultant Peter Drucker, “culture eats strategy for breakfast”.
Before embarking on either course having a genuine understanding of the market value of your practice is an equally vital precursor. The old joke is that when an accountant is asked what 2+2 makes, a good one answers: “what do you want it to make”. And the answer to “what is my practice worth” is either the same or, more worryingly, “not as much as you think”.
This is particularly apt in the current climate where there continues to be an expectation among senior long-established partners that there is a value to goodwill.
There have been a number of deals where goodwill either has been paid or appears to have been paid, and these include the now historic various Slater & Gordon deals and more recently the IPO of Knights and the purchase of GCL Solicitors by Gateleys.
GCL were acquired on what appears to have been a multiplier of 6.9 on one basis or more probably of 9.1 on another. However these are relatively unusual. There are two practical approaches to valuing a law firm, which is effectively the same as valuing any business: net assets, and earnings basis
The net assets basis is simply a matter of identifying the value of each of the assets owned by the firm and deducting its liabilities. It is more straightforward than an earnings basis as it has fewer subjective elements, but it still has a number of complexities.
These include: valuation of contingent WIP, redundancy and other potential liabilities, run-off PII cover, recoverability of disbursements, understanding the true level of bank debt (whether it is on or off balance sheet), and the firm’s claims record.
Many firms do not include contingent WIP in their accounts, in spite of recent changes to accounting standards, in the expectation that such WIP will not be subject to tax until realised.
This particularly applies to personal injury firms and to those undertaking corporate transactions and other work under conditional fee agreements. While this may (and only may) save tax, it does mean that outgoing partners will be less than happy not to receive value for such WIP.
This will be a key part of any negotiation, both on merger and on putting in place an appropriate structure for the admission and retirement of partners. There can be little doubt that such contingent WIP has a value in the market place, but at a discount to its ultimate realisable value.
A variety of discounts have been applied in actual transactions which are structured usually on either a realisations basis (paid when realised) or on an upfront basis (possibly with deferred terms).
Upfront payments have a far higher discount, often as much as 70 per cent, while discounts on a realisations basis are a lot lower and can for exceptional cases have no discount at all.
Valuation on an earnings basis looks at the maintainable ‘super profits’ of a firm and applies a multiplier to those profits to come up with the overall value of the firm. This figure is then compared with the net asset value and the difference is goodwill.
The difficulty here is that there are a whole host of subjective elements:
- What level of remuneration is appropriate for the equity partners for their fee-earning and management roles which should be deducted to arrive at the ‘super profits’;
- What multiplier to use? Recent deals suggest that the more usual 4 to 6 may be on the low side;
- What are the maintainable profits; l What exceptional items should be adjusted;
- Over what period should the profits be averaged to determine maintainable profits, should they be weighted and should forecasts be taken into account.
Embarking on a merger
There can be true mergers but these are very rare. It is more usual for one firm to be the dominant partner – the acquirer. To outsiders this is usually self-evident from matters such as the merged firm’s name, membership of the management team, which offices are closed or profit sharing arrangements. This is often not the case as far as the parties involved in the merger are concerned.
One notable example – which did not proceed – involved a firm which, to outsiders, were clearly the weaker party, as evidenced by the fact that the bank was insisting on a merger after an independent business review, and where the partners were in denial and believed they had superior management skills. So, if merger is an option be realistic about who is acquiring who and negotiate accordingly without unrealistic expectation.
Whether one is a buyer or seller, the merger process is broadly similar often involving:
- The appointment of an independent lead adviser and the identification of a merger subcommittee of partners with clear decision-making clout;
- The identification of strategic intent;
- A clear understanding of the value of your own practice – just as appropriate for the acquirer as for the seller, as on merger acquired partners are likely to have a share in the merged practice.
- If you are the seller,thepreparationof an information memorandum (IM) for circulation to potential acquirers. If you are the buyer, the preparation of a similar document which succinctly sets out the key facts that target firms would be interested in. This document should be prepared and approved before making any approaches.
- The preparation of a long list of perhaps no more than a dozen firms to be approached. This list should be drawing from local knowledge and wider research both by the firm and by the lead adviser based on strategic objectives.
- Initial confidential approaches will be made by the lead adviser by email, then phone, followed by a ‘teaser’ document.
- If there is interest, a non-disclosure agreement (NDA) should be signed before supplying the IM.
- A short list can then be drawn up of the firms with whom a substantive meeting is to be held and indicative terms requested.
- These indicative terms will then be considered and there will be a short period of preliminary negotiation.
- Agreement of preferred firm followed by non-binding (save for confidentiality and exclusivity) heads of terms (HoTs).
- This is followed by detailed negotiation and due diligence, ultimately leading to a signed agreement.
Role of lead adviser
There are of course alternatives to this approach and there are advisers who widely distribute information to the market without taking on the lead adviser role.
However, if a lead advisor is appointed they will help create a competitive market, act as independent critical friend, provide additional market knowledge, and advise on a realistic expected value as well as on deal structure and tax implications.
Their specific tasks will usually include the preparation of pre-sale information, such as the preparation of the IM, and control of the over- all process. T
hey should also be tough, where necessary, with people who may be your future partners and ask difficult questions of targets. It would be usual for a lead adviser to provide a number of fee options for a defined scope of work including time cost, capped and fixed and to each of these a semi contingent fee may be applied.
Setting aside whether you should operate through an LLP or limited company there are any number of deal structures that may be available but most involve a combination of the following:
- Cash payment on completion – which is often treated as part or all of the required capital contribution for incoming partners;
- Deferred consideration;
- Earn out linked to anticipated performance post deal;
- For the larger deals, perhaps some form of equity participation;
- Perhaps some form of staff and partner lock in by way, for instance, of equity option arrangement such as an EMI scheme.
Structuring for organic growth
Many law firms fail to distinguish between capital ownership and profit sharing and believe they are one and the same. Such an approach will almost invariably mean that the firm’s ‘partnership’ agreement is not fit for purpose and will prove to be a block on the future succession within the firm.
Capital structuring reflects the way in which the value (see above and including any goodwill) of the firm is owned between the partners. Having a points based approach is often the most appropriate, involving a full partner having 100 points with new partners joining on say 50 points increasing by 10 points per annum.
Partners at the end of their career can expect to realise capital on a similar basis in say their last five years of partnership. The capital that each partner contributes is directly related to the number of points they own and the required capital of the firm.
This can best be demonstrated by the following proforma example of a typical ten-equity- partner firm: It is evident that the more points in issue then the lower the amount of capital each partner has to find.
The corollary however is that the profits are divided between a greater number of partners and their profit share will be less.
There are only three generic approaches to profits sharing:
- Equality – usually via some form of lock step;
- Performance related;
- A mixture of the two.
Each have their strengths and weaknesses and there are no right and wrongs. However, generally, the larger the firm, the less likely that pure lockstep will apply, and the smaller the firm (say, less than ten partners) lockstep is more appropriate given the divisiveness of performance appraisal linked to profit sharing.
An approach often adopted involves three or four elements:
- Interest on capital to assist partners in raising funds from their bank
- Fixed prior share to reflect the work and market salary of each partner
- A ‘performance pool’ – often optional
- A dividend being the balance of the prof- its allocated based on the points owned by each partner.
Whether it is to fund a merger or to finance outgoing partners, any firm must have funding in place to operate and this is usually provided by the commercial banks.
The decisions that the partners have to take relate to how much of their profits should be retained by the firm as opposed to being withdrawn and funded by their banker, and to how the funding should be split between on-balance-sheet funding to the firm and off-balance-sheet direct to the partners to provide capital.
Funding from the banks has continued to be difficult as a result of the many well publicised failure of law firms with only very few prepared to provide funds for goodwill – especially internally generated goodwill. This is proving a significant difficulty in putting in place appropriate succession plans and forcing many firms down the merger route.
No survival right
No firm can be immune to economic reality nor do they have an automatic right to survival down the generations. Neither can firms necessarily cater for the vagaries of the effectiveness of management.
However, careful strategic planning and taking judicious decisions can give firms the best opportunities of not becoming one of the casualties.
- While a structured approach is the one most likely to succeed always be live to the opportunistic deal. Having clear strategic objectives and funding in place will allow you to move quickly
- Always expect the unexpected – one deal nearly fell over on the day of comple- tion because a photocopier would not fit through the door.
- In any deal expect to aim to achieve an “equality of unhappiness”. The buyer will think they have paid too much, while the seller will think they have not realised full value.
- Be live to unrealistic expectations – especially between different generations of partners.
- Do not believe any acquirer who says things will not change and do not underestimate the cultural change when joining a larger firm and the frustration of decision-making processes.
- In spite of what many partners of existing firms believe, will banks have little value although may be worth a carve out on a realisation basis.
- Always make sure you are dealing with the real decision makers. One deal involved three rounds of substantive negotiation, each with different parties. It was only the third round that was with the true decision maker who had no knowledge of, nor indeed interest in, the detail of the two previous rounds.
Howard Hackney is a chartered accountant and a former partner in Grant Thornton. He is a former winner of the CBI Best business adviser of the year award. Howard Hackney LLP
Barry Wilkinson is a chartered management accountant Wilkinson Read & Partners Ltd