Mergers, acquisitions and law firm closures are at unprecedented levels, given the strategic changes that have taken and continue to take place in the legal industry. So, what steps should you take if you’re considering winding up your law firm?
In this article, three authors cover this question from three very different angles: Howard Hackney looks at how to make your firm attractive as an acquisition; Steve Ray outlines the issues around run-off cover; and Patricia Wheatley Burt explains how to plan for your own future career outside the firm.
If there is a successor practice willing to take on the risks of a prior practice and an insurer is prepared to insure both entities, then you will not need to purchase run-off cover
1. Selling your law firm
‘Not as much as you think’ is the traditional answer you get from an accountant when asked ‘what is my law firm worth’. The starting point for selling your practice must be a realistic understanding of its value, its strengths and weaknesses, the minimum value you need to achieve, and the strategic reasons for wishing to sell. Assuming you have addressed all these areas and have ‘buy-in’ from all owners of the practice, you are ready to start the process.
Creating a competitive market
The objective in selling your law firm will be to obtain best value. This does not necessarily mean the highest price, as there may be other considerations, for example, that key staff are retained; there is a cultural fit; clients will be looked after; or there is an ongoing role for some or all of the partners. However, price is often the headline factor, and to achieve the best price, it is necessary to create a competitive market where interested parties (targets) know that they are not the only ‘player’. Of course, many ‘friendly’ deals are done by direct approaches between managing and senior partners, and these can work well. However, ‘you don’t know what you don’t know’, and creating a competitive market allows for a proper assessment of the opportunities that may exist. This is where an independent ‘lead adviser’ can help.
- guide you through and manage the whole process;
- give an indication of market value;
- assist in identifying potential buyers;
- advise on market conditions;
- lead the negotiations;
- interpret and advise on offers received;
- prepare an information memorandum;
- control confidentiality; and
- advise on and consider the tax issues.
In essence, the lead adviser creates the market and provides impartial advice, unfettered by the emotional considerations of the partners who are selling.
The information memorandum (IM)
Targets can and should only be approached when you are properly prepared to do so. This involves the preparation of an IM, setting out key information about the firm, such as its history, financial performance, service offering, claims history, property commitments, banking facilities and covenants, and partners and staff. This document is the ‘sales pack’ in which to display the firm’s best features. The process of preparing the IM is also crucial in both identifying negotiating strengths, weaknesses and ‘deal breakers’, and in pre-sale grooming.
Inevitably, the area which will have the greatest prominence will be the financial position and history of the firm. It is, however, vitally important that the document should not in any way be misleading – if it is, not only might there be legal consequences, but when discovered (as it surely would be), this would destroy any credibility, and damage (perhaps irrevocably) the negotiations.
The value of work in progress (WIP) is one area to address, as it is often not in as good a state as it should be. Dead files should be closed, old irrecoverable time written off, and a fair assessment of the true sales value of the WIP made with the input of all partners – both where time is unrecoverable and where there may be ‘nuggets’ of undervalue. It
may be helpful to involve specialist consultants to evaluate the WIP accordingly. Targets should only be approached once the IM has been signed off and formally approved.
Identifying and approaching targets
Target firms will be identified by working with your lead adviser. There will be local, regional and national players, and neither you nor your lead adviser will have a monopoly on whom to approach. Working together, you should attempt to identify perhaps a dozen possible targets. Such targets will be chosen based on full and proper market research on their likely interest, in terms of: types of work; personal knowledge; market reputation; geography; known strategic objectives; and (especially in the current market), financial strength and ability to pay.
A small number of targets is appropriate (although it can be widened at a later stage if necessary), with a view to maintaining confidentiality in the market. A blanket approach is dangerous – if news of the potential sale leaks to the market, this may well be taken advantage of by your competitors and could damage the value of the business.
The lead adviser should make the initial approaches to the targets on a ‘no names’ basis, with a limited amount of information just sufficient for them to decide whether they are prepared to sign a non-disclosure agreement, following which the IM with the name of the firm would be released.
At this point, the formal sales process has now started, and it should be controlled by the lead advisor to a specified timescale. Of the initial list, there will be perhaps eight who receive the IM, and perhaps six of those will want to meet with you so they can determine if they wish to make an offer. After further enquiries, it is then not unusual to expect written, non-binding offers within two to three months of issuing the IM. It will then take perhaps a month to interpret and clarify the initial offers, with a view to identifying a preferred bidder. Non-binding heads of terms will then be signed with that bidder, giving a binding period of exclusivity to allow for due diligence to be undertaken (on each side), and for the final binding terms to be agreed. This should take a further couple of months, so that the whole process, from the issue of the IM to a binding contract, is likely to take four to six months. The shortest timescale is unlikely to be anything under three months, and if it takes longer than nine months, experience dictates that a deal is unlikely to happen.
Tax is a vital ingredient of any deal, and can either make a deal happen or be a deal-breaker. Tax treatment depends on what’s being sold. LLPs and unlimited partnerships will be selling assets – WIP, debtors, goodwill, and so on. A limited company may be selling shares in the company or assets out of the company. Sellers usually wish to sell shares to avoid a potential double tax charge. Buyers, however, tend to prefer to buy assets, as it avoids having to accept the financial history of the company. Which route you go down depends on the relative strength of your respective negotiating positions.
However, two key tax issues apply in both scenarios. The first is the availability of 10% capital gains tax via entrepreneurs’ relief (ER), where the ‘partner’ needs to have had a 5% interest for at least one year. The second is how much of the consideration is allocated to goodwill and how much to other assets – especially WIP. The goodwill in an assets sale should be subject to ER, while WIP and other assets will be taxed at a higher rate of either income tax or corporation tax, as appropriate. Understanding the buyer’s position is important here, as they will only get (phased) tax relief on goodwill if it is purchased via a limited company, and then it will be in everyone’s interest to allocate as much as can be commercially justified to goodwill, rather than WIP and other assets.
Selling your firm is a huge step – but one that many firms have done or are about to do. It is incumbent on the custodians of the firm to have a clear understanding of their strategic reasons for doing so, to get early buy-in from all partners, and then to maximise value for all stakeholders.
2. Dealing with run-off cover
There is currently an emphasis on run-off insurance and, indeed, on the successor practice rules, brought about by straitened times for some law firms and the spotlight currently being shone on the financial standing of firms – regardless of their size – by the regulator. There is also the unfortunate issue, given the failure in recent years of a number of qualifying insurers (Quinn, Lemma and Balva), that a firm electing to go into run-off also has to be confident its insurer will be on hand to insure its future liabilities.
Selling your firm is a hige step, so it is incumbent on the custodians of the firm to have a clear unerstanding of their strategic reasons for doing so
It is therefore worth looking at the rules, how they apply, and what the options are for firms looking to close down, those purchasing other practices or books of business from particular firms, or, indeed, those in the throes of merger discussions.
When law firms first came into the commercial insurance market following the demise of the Solicitors Indemnity Fund (SIF) in September 2000, the drafters of the minimum policy terms provided, as we all know, a broad wording, with the goal of providing the widest possible consumer protection. Similarly, the regulator wanted to ensure that policy protection continued, in the event that a firm closed down or merged. Successor practice rules were therefore strict, and firms acquiring books of business from failing firms had to ensure that they did not become a successor practice by default.
Many firms went on to build relationships over a long period of time with their insurers, and some found that these years of good work were undone by becoming the successor practice to a firm with a history of claims with insurers. So, in 2010, the rules were changed, allowing acquiring firms, for the first time, to elect to put an acquired firm’s insurance into run-off. This meant that any past acts (for work undertaken before the acquisition) would fall to be dealt with under the run-off policy, thereby affording some level of protection to the acquiring party.
What is run-off cover?
Run-off insurance is a device which allows for the orderly run-off of the firm’s liabilities to their clients, for a fixed premium.
This run-off insurance lasts for six years, which is generally deemed to be sufficient time to allow for potential claims to be brought against the firm’s professional indemnity insurance (PII), and is provided on a ‘claims made’ basis. This means that it is the responsibility of the insurer at the time the claim is brought, rather than when the work was originally undertaken. ‘Claims made’ insurance is the standard in PII and there is no indication that the market or the Solicitors Regulation Authority (SRA) is prepared to move to a ‘losses occurring’ approach for solicitors’ PII cover.
Run-off cover is necessary because, after cessation of the firm, there remains the possibility that claims will be notified. Some claims are made very soon after the alleged error or omission by the firm, because the mistake is immediate and obvious to the client. In other cases, it can take many years before the problem comes to light. Run-off cover is necessary because of the way professional indemnity operates (as above).
My firm is ceasing to practice. Do I need to purchase run-off cover?
Run-off cover is a regulatory requirement imposed by the SRA that ensures that consumers are compensated for claims that arise after a firm has closed down, and gives financial security to retired partners. The SRA Indemnity Insurance Rules and Code of Conduct provide that your clients must have the benefit of your compulsory PII, including run-off cover (outcome 1.8).
When do I need to purchase run-off cover?
Under clause 5.1 of the minimum terms and conditions (MTC), your insurance must provide run-off cover in the event of a cessation. For these purposes, an insured firm’s practice shall be regarded as ceasing if the insured firm becomes a non-SRA firm. The cessation takes effect on that date.
Where there is a successor practice, you may elect to trigger run-off cover under your current PII policy (clause 5.3 of the MTC). You must make an election and pay your run-off premium before the date of cessation for your run-off cover to be effective. The insurer must give notice of the election to the SRA within seven days. If there is a successor practice willing to take on the risks of a prior practice and an insurer is prepared to insure both entities, then you will not need to purchase run-off cover.
How much run-off cover do I get?
Under the SRA Indemnity Insurance Rules 2013, firms are required to obtain six years’ run-off cover when they cease to practice without a successor practice (or with a successor practice, but an election is made to run-off the prior practice’s PII policy).
In the solicitors’ PII market, the insurer that was on cover at the time of the firm’s cessation is obliged to provide six years of run-off cover from the expiry date of the policy (even if the firm ceases or merges part way through the policy year), in return for the payment of a premium. A firm is only required to maintain cover for the minimum level: £2m for any one claim for a traditional partnership, or £3m for a LLP or limited company.
What happens to run-off cover after six years?
Your insurer is only required to provide run-off cover for six years under its agreement with the SRA. Currently, the profession collectively, via SIF, provides supplementary run-off cover beyond this period, although this insurance cover is due to expire in September 2020. At the time of writing, it is not clear what will happen after this date.
What is the cost of run-off cover?
The cost of cover is determined by your contract with the insurer, but is typically equivalent to about two to three times the last annual premium. A short review of the conditions contained within 2013 insurance policies shows that the range was between 225% and 350% of the expiring premium.
What if there is a successor practice?
If there is a successor practice, you may nevertheless elect to have run-off cover with your own insurer, provided that you notify your insurer of your election and pay the run-off premium before your firm closes.
If you do not elect to have run-off cover, then any claims made after the closure of your practice will be dealt with by the qualifying insurer providing cover for the successor practice at the time the claim is notified (or when the insurer is notified of circumstances that may give rise to a claim).
Whether you will be liable for any excess depends on the contractual agreement between you and the successor firm. If you are liable, then you should ensure that your successor practice is required to provide you with details of their future insurance and any excess. Bear in mind that you will have no control over the level of the excess that they fix.
You must inform the SRA of your intention for the firm to cease practising, and consider the outcomes in chapter 10 on ‘You and your regulator’ of the SRA Code, particularly outcome 10.13.
Engaging with your broker in discussions, whether you are looking to cease trading, merge your practice or acquire another one, should provide you with options, and allow you to weigh the pros and cons and the cost implications of your future strategy.
3. Developing your future career
Over the past few years, we have seen firms make more efforts towards preparing partners for retirement (though less, if any, emphasis is placed on staff, it appears). But, if we delve into what retirement has traditionally meant, it appears that this is no longer a fit-for-purpose term to describe what you need to consider for the time when you are no longer part of the firm. Webster’s Dictionary’s definition of ‘retirement’ includes the following: “Many people in the workforce look forward to retirement. After years of being employed and working hard, retirement can be viewed as an appealing time when a person can finally direct his time toward leisure and personal fulfilment.”
- ‘Retirement’ is also defined variously as:
- withdrawal from one’s position or occupation or from active working life;
- withdrawal now for prayer, study or meditation;
- the state of being retired from one’s business or occupation, denoting stable states of affairs such as ‘retirement’ as a kind of position or status, especially as perceived in our society; and
- conclusion, ending, termination, hibernation (moving to inactivity), rustication (living in the country).
This seems a rather depressing selection of definitions, adding up to ‘now you are going to be a “has been”’. The definitions suggest that many select a career that they may not be passionate about, and so see retirement as a blessed escape towards being able to do something more interesting. The other conclusion is that by retiring, a person becomes less acceptable / useful / influential in commerce or society, and so moves into a state of decline – on the ‘fun road to death’. It’s all very cheery stuff – but from the many examples I’ve met of individuals post-‘retirement’ with enviable careers, it’s clearly not necessarily the reality.
Bearing in mind that retirement ages in firms run from 55 plus (despite age discrimination legislation) and that most pension funds won’t be worth tapping into until people are at least 70, retirement in its traditional sense simply isn’t the answer in the way that it used to be 20 or so years ago.
Physically, we are all living longer, with anyone less than 50 today likely to live, on average, to the age of 95. And this trend will only become more pronounced in years to come, given major advances in medical science. It would therefore appear more sensible to dismiss the whole idea of retirement, and instead view our careers as a continuum from our early 20s till our 80s, and accept we will undertake different activities and generate our income in different ways during that time.
Three years ago, my business, Trafalgar People, developed the Strategic Portfolio Career Management for Partners © Model. This sets out a six-step, mutually rewarding process for firms and partners, as follows.
1. External experts undertake a thorough assessment (to ensure confidentiality and openness) of each partner’s knowledge, experience, skills and attributes, benchmarked against, say, a commercial director / executive (that is, someone different to a partner), reviewing that partner’s profile in the market, networks, practice areas, clients, finances and health.
2. Using the data from the review, the individual comes up with personal business development and strategic plans to address each area of their profile, with appropriate links to the firm’s wider strategic plan. These plans should specify stages on a career timeline (say, every five or 10 years), up to the age of 70.
3. Working with the relevant senior partners in the firm involved in strategy, and also with external experts such as mentors, the individual agrees what actions they need to take to make the plan work. This might include taking on leadership roles, developing a stronger professional profile in a key sector, development of skills, commensurate remuneration including profit-sharing, key performance indicators, and so on. Each must have clear, defined timelines, and the actions must be reviewed quarterly.
4. The individual will then begin to build their own networks, linked to the firm’s strategy and business development plan, and the individual’s personal profile, in their sector / region. For instance, the actions selected will inevitably influence the marketing and business development plans for the firm that will contribute to that partner’s profile, and so make opportunities for additional roles on committees, in academic institutions, or as a non-executive director (NED) (while in the firm), easier to achieve.
5. In addition to the quarterly review of actions, there should be an annual review aligned with the strategy, and a five-yearly ‘MOT’, to ensure the currency of the plan. Reviewing should also be drawn into the firm’s performance management process.
6. Finally, as and when the individual partner ‘retires’ from the firm, there should be an active alumni role, as everyone should remain an ambassador for the firm.
In order to adopt this approach, firms must:
- have a robust partnership culture that accepts, recognises and values the individuality of each partner;
- have a remuneration / profit share policy that takes account of different contributions, again accepting that some partners should be rewarded more / less for their contribution and are content; and
- be capable of seeing beyond their own individual needs to ensure the firm has a sound future, allowing younger lawyers to progress to partnership (if that is what they are aiming towards).
I talked to a number of septuagenarians over Christmas and the New Year, and it was clear many are busier than ever as chairmen or NEDs, involved in schools, coaching sports, playing in tournaments, and / or running enterprises with younger people in areas of commerce they had not thought of before. This is not forgetting the other activities often associated with the ‘retired’, such as grandchildren, painting, fishing, golf, and so on. Some had been looking forward to and planning for this period for a long time, but almost all regretted not having accessed these opportunities for richer and more varied commercial and social involvement sooner, accepting they have been too self-effacing and ‘buried’ in today – with no proper eye on tomorrow.
There is no such thing as luck. You need to be active: be open-minded as to what is out there and consider how, with some lateral thinking, you could apply more widely the skills you have developed. Far too many people only start achieving that key point of Maslow’s Hierarchy of Needs, ‘self-actualisation’, when they are no longer in that one, single occupation they started 30 or 40 years ago.
So, don’t write yourself off too soon. We are all now likely to have a good 20 to 30 years’ post-‘retirement’ of useful contributions to commerce and society, based on our current experience in our professional lives. It is just a matter of taking stock, and working out how to make today as much fun as tomorrow will be.