Law firms have a problem. There are too many owners that want to retire and too few people that are interested in taking over their business or share of their business and paying them out, so that they can do so.
If you are a partner or owner looking to retire soon, then you need a plan to ensure that you have a successor or two ready, willing and able to take over the reins.
That all sounds very simple but if you drill deeper into the problem, there are many issues to address in passing on your business. Most owners focus upon the clients and the files. They are important – critically important. But there are many other areas around the business that can create difficulties for the retiring owner and are often overlooked when retirement beckons. This can lead to a failure to successfully pass the business on and a failure to realise the capital value in the firm – or their share of it.
There are many firms, with older partners, perhaps sole traders, with capital tied up in their business, who eventually decide it is time to retire, look up from their desk and then look around vainly for someone to pay them out: only to find that no one is prepared to do so. We refer to a sole trader to illustrate the point but it can apply to any firm where there has not been any new blood into the business for several years.
For some firms, especially the larger ones, perhaps those in the top 200 by turnover, there are sufficient people coming through to provide a pool of talent, that can take on the challenges of equity: but those firms must still manage the process and get those people ready if there is to be a successful handover.
In recent years, the sole trader and partnership models have steadily declined and largely been replaced by the Limited Company structure, as illustrated in the table below.
Limited Liability Partnership
What we are seeing is the retirement of an increasing number of “traditional” sole practitioners and their businesses being aggregated into new entities. To some extent this has been accelerated by the complexities caused by increased regulation of the profession. It has – put simply – become too much for a small ‘one-man-band’ to handle. This process will accelerate due to the demographics of the profession, as illustrated shortly.
These retirements, with businesses being taken over by or converted to other legal vehicles, also have implications for the way in which succession will be managed. Banks view these entities differently and there are taxation issues that will need to be considered in full when managing succession.
In this article, we deal with the likely stumbling blocks to a successful succession and hopefully signpost ways of addressing them. Those issues are right across the board in law firms. Some people will initially only consider this a people issue, i.e. who is able to take over? While that is obviously a vital consideration, there are many factors at play here, including premises, IT security, PII and claims, finance, etc. Each succession is a jigsaw and each one is different. Planning for succession is very similar to planning for a merger. You need to get the firm ready and make it attractive. This takes time and requires the owners to put in that time. The key message is to think through all of the potential issues and start planning early!
This has to be the hardest part of the jigsaw to find. When looking for someone to take over the business, it is important to ensure that they are bought into the process early on. Just as you need to plan early, they also need time to learn how to run a firm. That means learning how to manage people, understand and manage its finances, what it is to be an entrepreneur and finding work. It is taken as read that they have the technical ability. These characteristics are not easily found in everyone.
The current generation of retirees are predominantly male. The graph below ¹, shows the demographic split of men, (left-hand-side) and women, (right-hand side), in the workforce and compares the latest data to the data from 2008, (black line). You can see that the age profile of men has – more or less – remained static. It also shows that there is a large number of men over 70, who still have practising certificates. On the right-hand side, there has been a marked increase in the number of women in the profession with practising certificates. As those women age and assuming they remain in the profession, they will eventually be in the majority in every age bracket.
This is an important point to bear in mind for succession planning: the potential successors nowadays are increasingly likely to be female rather than male. And that has implications for the way you search for the successor and the offer that is put on the table.
To maximise the chance of successfully passing their business on, the current equity owner must make the offer equally attractive to male and female candidates. This may result in more part-time partners or more flexible or ‘agile’ working practices being offered through your IT systems.
The cheapest way of ensuring a successful handover to the next equity owner is to ‘grow’ them from within. This has the advantage that they know the firm, its staff and clients and the way it works. A formal programme of education and providing them with exposure to the issues that they will experience in owning and managing the firm, will ensure that they are ready to take on the responsibility when the time is right. It may also provide them with the opportunity to realise that taking on the risks of equity ownership is not for them. It is better to train a small number of staff to be potential equity owners and allow some of them to realise that they not suited to entrepreneurial existence, than not to train them and have nobody ready to take over from you in due course.
All this takes time. There may be a couple of false starts. However, if you don’t prepare some staff for the opportunity, you may be left with the other possibility of hawking your firm around the local competition or to one of the many consolidating firms that are currently acquiring firms cheaply because the owners are left with no choice.
Larger firms obviously have the ability to develop people from post qualification and take them right through to equity ownership. This will be through a process of giving them supervisory experience, followed by team or department management responsibility. All of this should be alongside training in the necessary skills to manage the firm, such as people management, project management, quality improvement, risk management and personal management and skills training, (e.g. resilience, time management, business development and so on).
As with the smaller firms, some people will fall by the wayside but those with the commitment to the firm and who demonstrate the requisite ability will be ready to take on the mantle.
Finally, in terms of growing your own successor, we are aware that anecdotally, fewer people these days want to take on the risks of equity ownership. They are not looking for a long-term career with the same firm but want to have a more portfolio-style career or change careers a couple of times in their lives, perhaps with travel breaks in between. So, while there are more people with practising certificates now than ever before, it is not a given that there will be plenty ready to take on the equity that is offered. Part of the training must be an honest explanation about the risks and rewards of equity. Every firm that is honest with its staff about the offer on the table will be more highly regarded than any that hide the downsides, while overplaying the upsides.
The other option is to find people from outside. This may be by private conversations with other firms or by asking a headhunter to find someone for you. The former may be cheaper and may provide you with a known entity taking on your business but will not provide the largest pool of potential talent. For example, if you know the partners in another local firm and talk to them, they can only decide if they would be interested; they are unlikely to speak for others within their firm or others outside their firm.
Using a headhunter will be more likely to identify individuals within their firm who are interested in progressing but being held back. They may well be interested in taking on your business. Only a headhunter, who perhaps already has a list of candidates for equity, or knows other firms who would be interested in your business, would be able to identify and approach those candidates for you. They have the great advantage of approaching individuals anonymously, so your retirement intentions remain secret – until a Non-Disclosure Agreement can be signed.
Professional Indemnity Insurance and claims
Part of the risk of equity ownership is the risk of getting things wrong. There are two options to consider here. Have you got someone to hand over your business to or not? First, let’s assume you have and you are able to pass on your business to a successor, who will take over your files with all the inherent risks of doing so. Your claims record may have been exemplary but even in the unlikely situation where you will undertake a 100% review of those files, you are not guaranteed to find all of the potential risks and hence claims lurking in there.
The risk of taking on those files would reflect in the price that anyone is prepared to pay for your business. This is especially true if they have not worked with you or your firm before. They would be more nervous about what is contained in your files if they have not seen your working methods, your attention to detail, contemporaneous file notes kept, CPD avidly undertaken and so forth.
In an ideal world, therefore, any successor would want to have been in the firm for a while, so they are more aware of what they could be exposed to. Therefore, you might want to introduce them to the clients, get them working on your files and learn for themselves where the risk areas are likely to lie and assess what level of risk they think they might be taking on. You can facilitate this by engaging them in an employed basis, so they are not – initially – taking on the risk: or if you are looking to pass the business on to another firm, you could have some form of association with that firm, where staff from the potential successor firm can work on your files, so again, they can assess the risk.
Any successor practice will need to liaise with their own PII brokers well before taking on any new firm. The work they do in reviewing your files, seeing your work and your processes will be hugely beneficial for them in helping them outline the risk to their brokers and ultimately to their underwriters. That in turn will determine – at least part – of the consideration they may pay for your business. The more risky it is, the less they will pay. So, it is in your interests to plan ahead and get good systems and processes in place now. That way, you will maximise what you eventually receive on retirement.
Secondly, the more negative situation is where there is no succession and no-one wants the business. In that case, the owner(s) will be forced to put the firm into insurance run-off. As most people know, this will require the owner of the firm to pay a further six years’ worth of PII cover in one tranche, to cover any future claims arising from those files. No one wants that – probably not even the underwriters!
This is why planning to find someone to take on your business is critical.
This is often overlooked when succession is being considered, until it is almost too late and becomes a problem for the potential vendor and the acquirer.
Naturally, the property could be leased or owned. If it is leased, the remaining lease term is important. An acquirer does not want to be bound into an onerous lease, either in terms of length of term, rent payable or other conditions: but on the flip side, the retiring party might consider that there is significant value in a long term lease or one with unusually advantageous terms, such as a rent payable below current market rents.
The retiring party will be the tenant and must make it sufficiently attractive to their successor to want to take over the lease. Otherwise, they will be stuck with the lease or may not be able to transfer the business at all. The expiry of the lease may itself be the trigger for retirement. The potential retiree must be aware of the lease issue and be ready to deal with this as part of the negotiations.
This situation is even more complicated if the premises are owned freehold by the retiring party(ies). They may well expect that the acquiring party will want to take over the premises. However, what if the firm has been using the premises rent-free? The retiring party, unless they are willing to sell the premises or are very generous, will expect to earn a rent. That will damage the profitability of the business and make it less attractive to any acquirer. In any event, the capital cost of acquiring the premises, alongside the value of the files, could well be prohibitive. And, in any event, in this age of open-plan and agile working, would the acquirer want those premises? They may be a millstone around the firm’s neck and preventing the firm from being as efficient as the best in the area. If the premises are to be sold, then the acquirer may ask for a discount on the capital cost of taking on the business, to reflect the increased rent that is likely to be payable once new premises have been found. All of this dents the potential pay-out to the retiring parties.
Once again, the main lesson is to plan ahead and have options available.
IT & IT security issues
Anyone taking over the entire business will either continue to run it using the same hardware and software or, in a merger situation, will want to integrate it into their own IT.
In the former case, the only issues are to ensure that the purchaser acquires all the rights to use the IT, e.g. ensuring licences are transferred and do not remain in the name(s) of the retiring party(ies) and that the retiring party(ies) are locked out of the IT after retirement.
Where on succession, the business is being merged into another business, there is more work to do, in mapping all of the fields in the retiring party’s database into the acquiring party’s database. This is critically important to ensure a seamless transition for the firm(s) and clients and therefore, expert advice should be sought.
There are many potential IT issues, depending on how succession is facilitated and engaging help to ensure all issues are covered off will reduce the risks of things going wrong.
This is the ultimate issue. Buying into equity in a law firm is usually expensive. Over recent years, the values of capital accounts and undrawn profits left in firms to provide finance have increased. Values of well over £250,000 are common in multi-partnered firms. Sole traders can have smaller balances, depending on what is in their firm’s balance sheet. For example, if the premises are owned, held within and being sold with the business, the value of those premises will increase the capital to such an extent that it could make it almost impossible for a single person to acquire that firm.
To successfully transfer your business, you may need to split the part of the business that does the legal work, from any property-owning part. The property-owning part may need to be sold separately. That will make financing the legal part easier. Obviously, discussions will need to be had with your successor(s) about whether they would want to continue in the premises or move elsewhere.
A discussion with the bank about how to provide equity capital to the firm will usually be met positively but they will want to see things like business plans, cash flow projections, budgets and may want to discuss personal guarantees.
If you are selling, you can make the hand-over easier by introducing your successor as joint equity owner first, taking a proportion of the equity: and then selling on the rest in stages or at a later date. Furthermore, staying as a consultant is a popular way of ensuring the goodwill in the firm is retained, notwithstanding that the equity has been transferred. Again, taxation and financial planning advice must be sought in these circumstances.
There is a sea change in the profession. It has been gathering pace over the last few years and because of the increase in regulation, fewer people wanting to take on equity, being risk averse as regards being in business, combined with the demographic changes already underway, the profession will face more consolidation and probably a continued reduction in the number of firms, despite an increase in the number of solicitors with practising certificates. We will have fewer – but larger – firms.
Some of the smaller mergers in recent years have taken place with little due diligence and the issues outlined above have come back to bite the new owner of the equity. That may be through a very large increase in the PII premium, significant claims being suffered, difficulties in integrating the IT and accounting, problems monitoring quality across all files and loss of key personnel. Even worse, some owners have had to suffer the PII run off premiums of – often – nearly three times the annual premium.
Finally, every succession issue is unique. There is no template. This is why proper planning is important, both for the potential retiree/vendor and for the successor owner/firm. It is almost identical to ensuring a firm is ready for a merger. That means that the firm must be run well by continually addressing the issues above.
A well-run firm will have more value than a poorly run one. So, there’s your incentive!