Raising your game

Law firm stock market listings have dominated legal press headlines in recent months, as DWF became the first law firm to list on the main market of the London Stock Exchange in March 2019. A total of six law firms are now publicly listed: Gateley, Gordon Dadds, Keystone Law, Rosenblatt and Knights are all listed on the junior AIM market. While the admission documents of each of these firms proffer a variety of reasons for opting to list, one common theme is the desire to raise capital for growth and investment. Initial public offerings (IPOs) are an attractive proposition for firms looking to raise significant amounts of capital, as the funds generated through an IPO can often dwarf the amounts that can be raised in the same amount of time through traditional funding methods.

Increasing partner capital loans is an inherently risky strategy for partners, as the loans are treated as their personal liability

Most law firms (whether small, medium or large) will face comparable challenges when it comes to raising cash for investment and growth – to fund, for example, new offices, lateral hiring, investment in infrastructure and technology or acquisitions – particularly if they operate through partnerships or limited liability partnerships (LLPs). While the partnership model has many attributes, their tax treatment encourages a degree of financial short-termism. Partnerships and LLPs are not liable to corporation tax; instead, partners are taxed (at their personal income / capital gains tax rates) on their share of any profits or gains of the partnership / LLP as and when these arise, whether or not such profits / gains are distributed. As a result, most law firm partnerships / LLPs distribute all profits to partners in the year they arise (or soon after) (the “full distribution model”). This approach can hinder a firm’s ability to invest and grow for the medium to long term.

While law firm IPOs currently appear to be in vogue as a way of raising capital for law firms, listing won’t necessarily be possible or suitable (or even desirable) for many firms, nor is it without considerable challenges. In this article, I consider the various options available for law firms looking to raise capital, and the challenges and benefits of each approach.

Partner capital call

The traditional way to raise capital in a partnership / LLP is for the firm to request additional capital contributions from its partners or members. (For law firms that operate through limited companies, this will mean raising equity capital from shareholders; in this article, I focus on partnerships and LLPs, but many of the principles discussed will also apply to companies.)

The capital is usually contributed by the partners from their own funds, through retained profits, or borrowed from a bank. The first two options require partners to have available funds or take a reduced income over a certain period (neither of which may be attractive or feasible), and such contributions will be made from taxed income (as explained above). A key advantage of partner capital loans is that any loan interest is tax deductible for partners. For these reasons, partner capital is often borrowed.

Most law firms will have a pre-arranged partner capital loan scheme with a bank, which is usually unsecured and often at competitive interest rates (when compared with personal loan rates). If a firm is looking to raise additional funds through its partner capital loan scheme, it will, of course, need the support of its bank; a strong balance sheet, good financial management and a viable business plan will be key to securing such support.

However, increasing partner capital loans is an inherently risky strategy for partners, as the loans are treated as their personal liability. If the firm were to become insolvent, the individual partners would still be liable to repay the capital loans to the bank. With law firm insolvencies appearing to be on the rise, partners will be very wary of increasing their personal financial exposure.

Debt funding

The firm could request an increase in its existing bank facility, or seek a new facility for the purposes of funding investment. Success in securing debt funding will largely be dependent on the firm’s ability to demonstrate a good financial track record and cashflow management, as well as a strong business plan with realistic growth projections.

An IPO can offer substantial benefits for law firms, including access to capital markets for secondary offerings

If the firm enjoys separate corporate personality as an LLP or a company, the loan will be treated as a liability of the firm (unless partners are required to underwrite the loan with personal guarantees). As this does not increase the personal financial exposure of partners, they may be more willing to approve debt funding (as opposed to additional capital contributions).

Again, any loan interest is tax deductible, but increasing the debt burden of the firm may have negative balance sheet and cashflow implications and can lead to reduced profitability, particularly in the first few years of the investment phase, before revenue growth is actually achieved.

External investment

The Legal Services Act 2007 made it possible for law firms to seek external investment, or share ownership of the firm with non-lawyers, by converting to an alternative business structure (ABS). Since 2012 (when ABSs were introduced), a number of law firms have benefited from taking external investment. The Business Growth Fund has been particularly active in the legal market and now has a number of law firms in its portfolio. Before Knights and Keystone Law floated on the stock exchange, they had both taken external investment from private equity firms (Hamilton Bradshaw and Root Capital, respectively). Following the introduction of the ban on referral fees for personal injury claims under the Legal Aid, Sentencing and Punishment of Offenders Act 2012, many claims management and insurance companies also took direct ownership stakes in personal injury law firms to avoid restrictions on fee-sharing.

External equity investment can be a compelling means of raising capital for law firms which do not wish to increase their debt (or are looking to deleverage). It can also be a stepping stone to achieving the growth trajectory and management rigour needed for an eventual IPO. However, it is not without challenges or risks, including the following.

• External investors (particularly venture capital and private equity investors) will be looking to make a return on their investment; the firm will therefore need to demonstrate tangible growth prospects with a strong management team to deliver on the business plan.
• In the case of venture capital and private equity investors, there almost certainly has to be an exit at some stage (typically within three to six years) – whether through a sale to another investor or trade buyer, or through an IPO. Partners will need to be fully cognisant of this prospect and ensure that an exit is envisaged in the firm’s medium- to long-term business plan.
• Partners will need to relinquish a degree of control and management of the firm to the external investor. How much control will be a matter of negotiation between the parties and will usually reflect the percentage of equity the investor is acquiring.
• Partners who sell their equity will benefit from a capital gain, but partners’ income profit rights and future capital gains will be diluted by the external investor.
• The firm would need to convert to an ABS, which can be a time-consuming and protracted process.
• There is additional complexity if the firm also operates in jurisdictions which do not recognise ABS structures and/or non-lawyer ownership of law firms (such as Scotland).

IPO

Many of the challenges cited in relation to external investment will apply equally to an IPO. In addition, the following considerations will be relevant.

• The ‘first mover advantage’ for law firm IPOs has already been claimed; investors will now be looking for any new entrants to the market to differentiate themselves (such as niche firms or disruptors) as part of a compelling investment case.
• Certain types of law firms are likely to be more suitable for an IPO than others; a traditional ‘tenancy’-model partnership with mainly transactional and relationship-driven practices is less likely to be a suitable candidate than, for example, a firm with an annuity business where equity is concentrated in the hands of a small number of individuals. Only two of the six listed law firms (Gateley and DWF) were tenancy-model partnerships; the rest were either a platform model (Keystone) or had concentrated ownership (Gordon Dadds, Knights, and Rosenblatt).
• Gaining partner support for an IPO is key – disaffected partners are likely to leave the firm, which will have a knock-on effect on valuation. Achieving partner approval can be tricky in firms where equity is dispersed among a large partner population.
• Preparing for and achieving an IPO is not a straightforward process. The firm will need to manage it very carefully, including appointing corporate finance, PR and legal advisers (at considerable expense).
• Partners’ equity in the business will be diluted (possibly to below 50%) and the manner in which they are remunerated will change fundamentally; they will usually receive a mixture of a low, fixed-base salary and dividend income, as well as any capital gains when they sell their shares after any lock-in periods have expired. While senior equity partners who are in place when equity is crystallised in an IPO may benefit greatly, the post-IPO remuneration model may not appeal to the new generation of partners, leading to retention and succession issues in the medium to long term.
• Listed firms are required to publish half-yearly financial results and update the market on any price-sensitive information or developments. It is also likely that non-executive directors will be appointed to the firm’s management board. The greater transparency and independent governance oversight will require a cultural shift for law firm partnerships, which are typically used to operating a ‘closed shop’.

Despite the issues highlighted above, an IPO can offer substantial benefits for law firms, including access to capital markets for secondary offerings (which can be helpful to fund future acquisitions and investments), the ability to incentivise staff through share schemes (which can assist in attracting and retaining key people) and the opportunity to raise the firm’s profile through press coverage generated during the IPO process.

Concluding remarks

Law firms have a lot to weigh up when considering how to raise capital for their business. Each firm will have different objectives and needs, and the choice will depend on many factors, not least partners’ appetite for personal risk, as well as their tolerance for fundamental transformations of their business models.