This column is by Janet Stanton, Partner, Adam Smith, Esq.
Why doesn’t $$ change hands when law firms merge or when one takes over another? (We’re not talking about solo or tiny practitioners selling their practices to a successor; that’s like buying the corner newsstand for a future personal income stream; we’re talking about firms with at least a handful of partners.)
This question has been bugging us for a while; we’ve asked some smart people and not yet gotten what feels like a satisfactory answer.
The explanations offered have ranged from “it’s just not done” (which is merely a fact) to something about partners trading their shares in their “old” firm for shares in a new, larger enterprise. But we’ve written about how partners’ “equity” in law firms bears not the remotest resemblance to equity as economists and corporate finance professionals use it.
One of the more diabolical hypotheses was that managing partners embark on mergers to institute otherwise-wrenching organizational change–primarily pruning deadwood–that would be impossible in the ordinary course of business. Highly creative indeed, but we are loathe to posit a closet Machiavelli in very many managing partners.
To us, this state of affairs makes no sense. Outside Law Land private companies buy private companies all the time; including professional service firms – which like law firms have only “elevator assets.” Moreover, there are established rules of thumb for valuing privately held professional services firms (usually a single-digit multiple of revenue). Also, outside Law Land even distressed or failing companies often sell off attractive pieces and parts. But that same logic did not apply when Morgan Lewis took on a material portion of Bingham in the form of a massive lateral partner acquisition. Certainly that group of a dozens and dozens of lawyers had a non-zero economic value?
Well, many of those former Bingham partners got short-term guarantees, right? So aha! That was money! Not exactly, and not the way we mean it. The guarantees were hardly an unconditional lump sum cash payment tendered upon the deal’s closing. They were merely a (largely unenforceable) expectation of continued going-rate compensation if you kept doing what you’d been doing for a living and didn’t decamp to the beach. Did we forget to mention that not a nickel of those payments went to the Bingham “estate” nor to a partner who didn’t sign on with Morgan Lewis?
One theory I have is this practice can underscore the (often spurious) notion is that “this is a combination of equals.” Another theory has to do with firms not willing/unable to put a value on themselves (Bruce, our resident economist reminds me that everything can be valued, including bankrupt or insolvent enterprises).
An unfortunate outcome of no money changing hands is that law firms are way too promiscuous about merging. An especially droll law firm COO we know well described the shock of discovery he experienced when he entered Law Land from public accounting a couple of decades ago: “Wow, I can buy a competitor for nothing! Free money!”
But back to the original question.
And you know the drill: Supplemental editorial notions and commentary go in the, where?, “Comments” box below:
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Courtesy NASDAQ
Part of the answer relates to the unenforceable nature of non-compete agreements for lawyers. No rational buyer would pay cash to acquire a practice when the practitioners can decamp the next day, perhaps even financing a boutique with the proceeds of the purchase price. This is particularly acute with lawyers who, as noted frequently here, are autonomy-seeking creatures by nature. Although I have no definitive data, I suspect most compensation arrangements with partners who are acquired are structured to resemble deferred purchase price – somewhat above what the pure metrics would dictate, with bonuses that function as earn-outs, to provide incentives to stick around.
Could it be argued that this shows a law firm is not really a single business but only a collection of individual businesses operating under the same name. So when a partner moves to another firm (whether individually or as a group), then the partner is the one that receives the payment for the ‘sale’ of his or her business (the business literally being himself or herself). The remaining partners don’t get anything, because they aren’t part of the business being sold.
It may well be that a ‘sale’ of a group of partners results in a higher value than the sale of one partner alone; just as a sale of 5 adjoining blocks of land in one lot may result in everyone getting more than if all 5 landowners sold individually. But each partner (or non partner – it doesn’t matter in this scenario) gets his or her own allocation of the sale proceeds as an individual, just as each land owner does.
And by sale proceeds, of course, I mean the additional future income the partner receives over and above what the partner believes s/he will receive if they stay. Or, in some cases, some non monetary benefit that is of value.
Chris: Great hypothesis. I think lots of lawyers think this way, and indeed many MP’s we talk to describe their firm as competing less on a firm-wide than on a practice area basis. In particular they talk about practices where they go up against middle market peers and then a few others where they go against Kirkland, Proskauer, etc. (they always like to brag about the latter group).
If you push this not very much farther at all, it means “The Firm” is more akin to a corporate-world holding company, providing common management to a portfolio of essentially stand-alone businesses, which generate little or no mutual synergy and whose partners may not encounter each other in a business context for years at a time.
The holding company model only works, of course, if you can acquire and divest businesses relatively frictionlessly, which is anything but the case for law firms. Maybe this is the poison in the chalice of being highly competitive in a few, but not all, practice areas.
I would say that there is often value in a law firm as such (i.e. the whole is often greater than the sum of the parts) but the problem is that its successful transfer is typically dependent on a large proportion of the equity partners sticking around and enthusiastically doing things over a period to generate value.
I think this basic point is the same irrespective of whether one’s view of law firms tends more towards the Gesellschaft or Gemeinschaft end of the spectrum.
It would seem likely to be counterproductive to pay such partners unconditional sums which give them no incentive to do these things.
I would therefore tend to turn the assumption round and ask “How on earth could it make sense to pay a lump sum to buy a law firm from its partners when their continued activity constitutes much of the value?”
I can think of some possible scenarios in which it would make sense to pay cash, e.g.
1) an operation in which most of the value lies in the continued involvement of people who own no or little equity i.e. highly corporatised targets;
2) a firm in which the value lies in portfolios of similar business executed systematically – like the sort of UK personal injury firms that Slater & Gordon acquired back in its glory days – though even then, there was significant conditionality – https://www.lawgazette.co.uk/practice/slater-and-gordon-snaps-up-pannone-in-33m-deal/5038978.article
But I would say that these are exceptions which prove the rule.
A couple of other UK examples which may be interesting to think about –
a) The “holding company” theory makes a certain sense to me and there was a certain vogue for it in the UK a few years ago (the Integreon shared services deals with CMS, DAC and Osborne Clarke) but it seems to have fizzled out.
b) So far as I can tell, the acquisition terms offered by cashed-up listed law firms in the UK still tend to be highly conditional – e.g. https://www.legalfutures.co.uk/latest-news/gordon-dadds-keeps-acquisitions-coming-third-deal-month
None of this is to suggest that there aren’t other factors – including psychological ones – going on here. But this comment is already too long.
The value of the firm can be disaggregated into the discounted present value of each partner’s earning streams standing alone (partner and group of associates, or possibly practice group) plus the goodwill of the firm — the discounted present value of the higher profits that the brand and organizational support afford to the partners.
For the most part, each partner is paid roughly the full amount of his/her profit after a rough allocation of firm expense (otherwise the partner goes to another firm, which about 50% according to ASE do each seven years). An acquirer will have to continue that, so the price an acquirer will pay won’t reflect much if any partner value .
What’s left to be acquired is goodwill. For most firms except at the tippy-top of the hierarchy that’s not a big deal. Clients hire lawyers with reputations, not firms, until you get to the top 10 of the pyramid. And those top 10 firms have no incentive to be acquired.
Once in a while there may be a “synergy” such as eliminating competition or a sustainable reduction in costs, but those are rare.
So there are incentives to buy profitable partners to increase scale and reputation, but few incentives to buy firms.