The core topic discussed at our recent Legal Business Leaders Lunch was the ownership structures of law firms and the implications that the various different structures have.
We talked about five different structures:
- Publicly Listed Company,
- Private Limited company;, and
- Employee Owned.
For senior equity partners seeking to maximise and extract the value locked into their law firm, flotation is attractive to bring cash into the law firm and release some of the capital value held by the members. For the next generation of partners and up and coming associates it can be a signal that their future at the firm might not be as bright as they had hoped; that a proportion of their revenue will go to non-contributing shareholders and that the grass might be greener elsewhere.
The conventional partnership and LLP structures both suffer from a disincentive and consequent disinclination to reserve profits. Partners naturally want to distribute as much profit as possible and anything not distributed and they will be taxed personally in the current year on anything that is reserved.
A services company supporting the LLP may make the law firm’s tax position a little more advantageous but it doesn’t address the structural resistance to keeping cash in the business. In some firms the year end sees all profit distributed and the first quarter or so of trading in the following year funded by overdraft facilities.
The main purpose of incorporation for most participants was the attraction of locking in and ultimately benefitting from capital growth in the business while continuing to draw profits at or about the same level as presently. As a short term measure this is a clearly attractive step to take but because it so clearly only benefits one generation of partners it may ultimately be self-defeating as the next generation vote with their feet.
Law firms do not have the best of track records when using corporate structures or behaviours to support their growth. In 2007 Dewey & LeBoef issued $125,000,000 of bonds in addition to a bank credit line of $100,000,000 and went on something of a spending spree; making very large numbers of lateral hires for stratospheric sums with very little or no business case analysis, propping up the balance sheet with junior partner’s capital contributions and simply failing to ensure that revenue remained ahead of expenditure with all too predictable results.
Slater & Gordon’s use of capital raised through flotation to purchase Quindell was demonstrative of an urgent drive to deliver growth to the shareholders of the company rather than a sensible commercial investment.
There are no absolute answers but there are choices and the decision a law firm makes about its future structure is probably going to be based around considering what the firm is intended to be: if a cash and income generating machine is preferred the LLP structure is probably best; if a vehicle for exit at value a private or public corporate structure will serve.
Just as a firm’s purpose will guide structure the structure will guide the culture of the firm. Taking all of the value out of the business will lead to increased staff turnover and because it is usually the best and brightest who find it easiest to move; standards will lower over time.
Here is a summary of the advantages and disadvantages of the structures of law firms:
1) Listed Firms:
The ability to raise significant capital when required.
Capture and crystallise value in the business for the existing equity and where appropriate fund exits.
Grow through acquisition(s).
Provide share options to staff and partners; perhaps through an Enterprise Management Incentive (EMI) scheme.
Difficulty retaining high performing individuals who need to see a direct connection between their revenue generation and remuneration;
The notion of generating revenue and profits for non-contributing shareholders could disincentivise some individuals.
Share volatility and negative reporting of trading blips creating staff/client uncertainty.
The added management and reporting costs of trading as a PLC.
2) Private Limited Companies:
Capital growth for the equity partners of the firm.
Retirement relief from CGT for exiting partner.
The ability to retain profits without individuals being taxed on the retained element.
Makes the firm an attractive / easy acquisition target for a PLC.
As with the PLC model this structure provides the ability to offer share options to staff and partners.
This is a one-off win: one generation captures and extracts most of the capital value of the firm.
Seen with significant cynicism by the lateral candidate market place.
3) Limited Liability Partnerships
Relatively easy to add to and vary membership.
Flexible reward structures available.
Sense of shared endeavour.
The need to recognise W.I.P. on the balance sheet artificially increases the size of capital contributions required to join the equity.
A tax environment that discourages profit retention and therefore the ability to invest in growth.
No ability to capture capital growth in the business and therefore limited opportunity to exit on attractive terms.
4) The “John Lewis” ownership model.
Staff at all levels motivated to drive the success of the firm.
Reduced risk of internal conflict.
Improved client experience through cooperation and collaboration between partners and teams.
Within a corporate vehicle captures the benefits of a private corporate structure while managing many of the negatives.
Administratively burdensome: the need to grant and divest shares whenever an employee joins and leaves requires effort and internal support.
Needs careful internal messaging to ensure that junior staff have a collective voice.
5) Conventional Partnership
Simplicity and clarity of vision.
Principally unlimited personal liability for commercial losses and the uninsured portion and any deductible relating to professional negligence claims.
We will be discussing the structures of law firms in further detail at our upcoming conference. Contact us for more information on this.