Many law firms have to plan for the eventual departure of increasingly large numbers of aging partners. Half of all the lawyers in the United States are over age 46, and more than 13% are age 65 or older, according to recent data from the ABA. As a result, lawyers are among the oldest in average age in U.S. occupations.
Having a strong financial plan for these departures will help smooth the transition of leadership roles and operational responsibilities; help retain client relationships and staff members; and preserve the firm's reputation, institutional knowledge and overall goodwill for the next generation of lawyers. Such planning is also required to comply with the applicable ethical obligations.
Key Objectives
A succession plan providing financial compensation for departing partners can achieve four key objectives for a firm:
- Incentivize long-term thinking. Departing partners are encouraged to act in the long-term best interests of the firm and successor partners by ensuring the productive transition of ongoing cases, existing clients and referral sources.
- Retain valuable partners. Lawyers who have spent their careers building specialized practice expertise and clients increasingly want to "monetize" those "assets." If their current firm does not have a succession plan that permits a financial payout, lawyers are more inclined to shop their practice to another firm, either to obtain their desired result elsewhere or to create bargaining power with their current firm.
- Address financial expectations. Departing partners expect to receive compensation for the tangible and intangible assets they have built at the firm over time and "monetize" some of their ownership interest.
- Ensure stable transitions. A structured approach provides a stable and established way to transition leadership to successor partners while preserving the firm's value.
Forms of Succession Compensation
One common form of succession compensation is an "earn-out" agreement that compensates departing partners over time for the value of their current cases, their client list and their referral provider list. Departing partners receive a negotiated percentage share of any fee collections derived from these three sources over several years, which motivates them to transition their practice based on actual, rather than unrealistic projected, results.
Another form of succession compensation is a fixed payment upfront that reflects the firm's brand value and goodwill and the departing partners' contributions to building those assets. This requires a calculation of the firm's reputation, its practice knowledge, expertise and experience, and its financial performance and growth potential. It also increasingly requires an assessment of the firm's potential for future business and fees based on its digital presence and marketing and its use of accumulated data to increase referral sources and client origination prospects.
Valuation Methods
Both of these payments require a determination of the firm's overall value, including its annual gross income, assets and liabilities, and cash flow, to ensure that the payments are aligned with the firm's net worth.
Common methods of valuing a firm using this information are:
A "multiple of a law firm's annual gross income" approach multiplies the firm's gross revenue over the past several years by a factor that projects the firm's ability to maintain or increase those revenues in the future. The "multiplier" typically ranges from 0.5 to 3.0 based on variables like the practice areas of the firm, the number of clients, the amount of repeat business and the stickiness of client relationships, which in turn would yield a result normally equivalent to a range of 1.2 to 2.0 times net income.
An "asset-based valuation" focuses on tangible assets held by the firm-both fixed assets (e.g., property, technology and equipment) and intangible assets (e.g., goodwill, which includes the firm's brand identity, reputation, client base, market position, specializations, growth potential and referral sources)-and subtracts the firm's liabilities but does not consider cash flow and earnings.
A "discounted cash flow" analysis is forward looking and projects future revenues and discounts them back to present value using a specified rate.
A "market comparable" approach assesses the firm against a peer group of firms in terms of gross revenues.
Financing Solutions
Most firms will need some form of outside capital to fund upfront fixed payments and earn-out arrangements as needed. Legal financing companies that specialize in providing this capital can provide terms that permit repayment over time to conform to the firm's cash flows and enable the financing to be secured by the firm's assets instead of guarantees from successor partners. Legal finance companies can also help firms perform the necessary calculations and determinations as to what funding is needed.
For example, if departing partners wish to withdraw from a firm and monetize their partnership shares while transitioning their practices, the firm could use legal financing first to cover a percentage of an upfront fixed payment for the shares and second to cover a percentage of earn-out payments (payable over a 20-month period) in the event that cash flow from the firm's fee collections was insufficient to cover those earn-out payments plus normal operating expenses.
The Future: Alternative Business Structures
Of course, financial planning for firm successions would be easier if states would permit nonlawyer ownership of firms (such as firms organized under Arizona's new alternative business structure law). Under the current structure in most states, lawyers can have an ownership interest in the firm in which they receive a share of the firm's profits each year. But, normally, lawyers have no ongoing equity interest in the value of their firm after they retire.
Nonlawyer ownership would permit lawyers to create such ongoing equity in the long-term value of their firms and to carry that value with them or sell it upon retirement, making the succession process much easier for lawyers who are retiring and ensuring longer-term investments in firms by their partners. Until states permit this more advanced equity structure, departing partners will have to rely on the attorney financing described above.
Conclusion
The best succession plans for firms should include compensation arrangements for departing partners that promote a firm's continuity, stability and ongoing prosperity. The terms of those compensation arrangements can be accomplished with tailored financial structures that use some form of legal financing. Taking these steps is a good investment in a firm's long-term success.
This article is for marketing purposes only, does not constitute legal advice, and should not be relied upon as legal advice.
