Andy Poole, legal sector partner at Armstrong Watson, explores the succession options for small law firms, presents some practical tips for effective staff supervision in small firms. 

During recent years, profits dipped for many firms, and cash dipped further still. Profits have recovered in the main, but cash is still often lagging behind. That has meant that partners’ capital accounts have been increasing because firms cannot pay out all of their profits as drawings. At the same time, new partner admissions have been restricted due to lower profit pools; lack of talent; and lack of risk appetite by potential new partners.

When you combine all of that, the profession is faced with a huge succession issue on the horizon. We have an ageing population of partners; fewer potential new partners; and the need to find cash to pay out the larger capital account balances for retiring partners.

Smaller practices in particular worry about the succession factors outlined above. That worry is intensified with sole practitioners due to the fact that expensive professional indemnity insurance (PII) run-off cover would need to be acquired in order to cease practising.

So, what are the options?

Merger

The legal sector market as a whole is undergoing a period of consolidation. We are currently engaged to advise in ten separate live law firm mergers, more than we have had concurrently for some time. That consolidation is being driven by the vast number of changes being faced by the profession at the current time.

Merger/sale of the practice is the obvious option a sole practitioner would seek to take when looking to retire.

Given the issues noted above, it would appear to be a buyers’ market right now rather than a sellers’ market, and little goodwill is being paid. It can be difficult for sole practitioners to claim that their practice has goodwill, since they are the business and in most cases the clients instruct their practice because of them personally. The goodwill therefore rests with them as individuals rather than their practice.

Goodwill would only exist if the clients would continue to instruct the merged practice and if the profits generated from those clients exceeds the net asset value of the practice.

When looking to value a business, an acquirer will look at the income stream that the acquisition will generate for them - and by income stream, I mean the residual bottom line profits. Any valuation calculations are therefore based on what the residual profits are expected to be, with adjustments made for the risk of clients not moving to the new firm and the cost of employing fee earners to undertake the work performed by the selling party. A multiple is then applied to the underlying profitability to provide the full value of the practice. Goodwill is the element of that full value less the value of the net assets of the practice. Multiples applied in practice can vary from 2 to 5.

I am often asked whether the value of will banks of established practices will add to the value of the practice. If taking the goodwill valuation approach outlined above, then there is an argument that the value of a will bank is already included since you would expect the will bank of an established practice already to be contributing to the profits of the practice. If that is not the case, then an analysis of the wills can be performed to ascertain what future income might be expected from them, and I am aware of law firms that are looking to acquire firms with will banks.

The notes above are generic in nature and the exact value will be determined by the specific circumstances of the selling and acquiring parties. I am currently acting for one sole practitioner in his disposal and exit where there is a substantial goodwill payment due to the niche nature of the practice and the particular client base.

When selling to another firm, the PII impact will need to be determined. The acquiring firm may become the successor practice and remove the need for the selling firm to pay for the run-off cover. In some cases that I have advised in, that has happened and that saving has been used as the deemed value of the practice with the trade and net assets then being acquired for £1. More often, the acquirers are now insisting that run-off cover is still paid for by the selling party as they do not want to take on the risks of successor practice status.

Where the valuation of the practice is lower than the net assets value, deals are often agreed to base the value on the work in progress (WIP). That is a common route particularly with the large number of enforced closures that we are currently seeing, but also with those firms looking to exit the personal injury market.

Exit

It is possible to have an orderly closure of a practice and avoid an SRA intervention. With orderly closures, a number of separate deals tend to be agreed to sell the WIP to a number of separate firms and use that income to pay any creditors and to pay for the PII run-off cover.

Internal succession is also a possibility, although given the points noted above, that may not be an option.

Although there are difficulties for smaller practices and sole practitioners that are faced with succession/retirement issues, there are options and we are arranging solutions for the benefit of many firms right now. The key is not to leave it too late and to make the practice appear in the most positive light possible to any acquirer. There are ways of doing that and we are often engaged to prepare firms for sale a long time before they need to be sold.

Andy Poole
Legal Sector Partner
Armstrong Watson

Andy Poole is the Legal Sector Partner at Armstrong Watson, specialising exclusively in advising law firms. Co-author of the Law Society toolkit on Financial Stability in Law Firms, Andy heads the legal sector team at Armstrong Watson, which has 15 offices and over 400 people. The legal sector team advises law firms throughout the UK on strategic, structural and other business improvement issues as well as providing efficient accounting, tax and SRA accounts rules services. For further information

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