How to maximise your succession options and practice value…

Readers will have noted that many small practices are being absorbed into other firms, usually with the appearance at least of very little money changing hands.

This short article is based on an assumption that some practitioners still would like to see their firm continue after their retirement.

I will look at how to establish options for succession from within, and also at why the steps taken to do so can result in a better financial result from an outside purchaser if no internal succession option comes to fruition.

Clearly the two issues of succession options and practice value are closely intertwined.

We all recognise that very often if your options for potential buyers are limited, no matter what you are selling, there is a good chance that will have a downward impact on the value you can derive for what you are selling.

In my 39-year experience lawyers often (read “usually”) spend most of their career principally caught up with being a lawyer, and don’t think strategically about maximising their succession options and the value of their practice interest.

Often they address the issue when they have left it way too late, and consequently get very limited options!

My experience in New Zealand is that many practitioners are seemingly resigned to a belief that their interest will have no significant value, much more so than in Australia. All too often practitioners are simply hoping that a suitable younger person will be prepared to take over the practice to keep it going.

Clearly many larger firms have specific arrangements in place dealing with succession, and payments to retiring partners for their interests, and I’m not going to attempt to canvas what the “best” arrangements are.

The greatest number of firms is quite small however, and I simply want to create discussion around having multiple viable succession options where you can, because that helps to increase the chances of getting what your interest is really worth.

You set up your structure and operations in looking after clients superbly to maximise what your practice interest is worth, and seen to worth by the different potential buyers.

Here we’re talking “goodwill”, and of course we all know that there are arguments that many legal practices have none, but I see goodwill in law firms bought and sold every week!

Some practices are structured to deliberately recognise no goodwill, but unfortunately many smaller practices have little perceived goodwill because they are not very profitable.

Even then, an astute external buyer can often see a way to use the client base and fee flow to significantly improve the profitability of their existing practice.

The key to setting up well in advance to get good value for your interest is in understanding what the different types of buyers will be looking for, as that obviously influences their willingness to pay.

Most will be looking at likely genuine profit stream after deducting a fair salary for what they, or their employees, will be doing in the firm going forward.

Obviously they look at what’s happened in the relatively recent past, two or three years, and use that and other information to help them decide how likely it is that the observable profit stream will remain stable, increase or decrease.

Each buyer is different, but well advised, they almost all come from the same perspective…is it worth it to me to pay $X…given what I will expect to get from the practice to pay me back $X in a limited period, and leave me with a continuing sound business thereafter.

They’ll also be looking at factors that should be considered as lifting their risk, and making the period it takes to be repaid potentially significantly longer.

In making it clear to buyers that the value you are asking for really is there you need to make it clear their risk is minimal in as many areas of concern as possible.

In small firms most buyers are very concerned that the goodwill is heavily reliant upon you, and will evaporate or be heavily affected if you are not around.

These days a big proportion of small practices that are sold in this way have an arrangement to obviate this. Either a lump sum is paid up front, and the balance paid over a year or two as the fees actually flow, or as often as not no lump sum is paid at all, and the only funds passing beyond any ongoing salary if you stay as an employee for a period, are as a percentage of fees collected from clients identified as having been introduced to the practice by you. The buyer really takes no risk on the goodwill at all.

So, the practice fees must not be too dependent upon you...and here where another solid benefit of having a strong team comes into play.

Profitability is almost always much better in firms with excellent leverage, so you earn more as you go along, and the goodwill value is also higher.

Those of you involved with clients selling or buying businesses know that reliable documentation, proven marketing systems and quality databases are all-important in underpinning value.

Yet so many law firms have quite inadequate databases, and cannot adequately demonstrate important things like regularity of spend on fees, average spends in different types of matters, levels of client/prospect response to targeted offers etc.

When planning well ahead to maximise the value of your interest, establishing and maintaining a really good database is very important, especially to any buyer who recognises it’s value to you and the value to them of using the database resource perhaps even better than you do!

Gradually more and more law firm aggregators are entering the market, providing additional options for vendors.

They are looking to expand quickly by acquisition, and while they have greatly varying business models, one or more may be one of your eventual succession options if internal succession does not eventuate.

Some of these practices are insistent upon retaining capable principals for a good period of time, and make payment arrangements with you accordingly…some cash now, some cash after a couple of years of sustained planned performance, and the rest in shares in the overall entity, often designed as a form of “golden handcuffs”.

You get paid a salary to perform a role and, if the whole operation goes well, you are eventually able to sell out and receive the final part of your asset through sale of your shares.

Rest assured that the price you get paid in cash for your goodwill will be calculated carefully and commercially after proper notional salaries are deducted.

If you have been earning not much more than a notional salary for some years, or working far too hard to get the true profit, you will struggle to get paid much, assuming you are attractive enough as a proposition for the aggregator to still be talking to you!

Internal sales are usually likely to produce close to the real worth of your interest, because the purchaser(s) should have had plenty of opportunity to observe closely how the firm works, understand (with your assistance) the profits made, and how they’re made, and to be able to see readily that you have set the firm up so it is not, at least not any longer, heavily dependent upon you!

Take the time to educate potential partnership candidates early about the true profits because it’s in your interests to do that, and it speeds up the sale process if they do not have to go through a steep learning curve at the last minute.

Transparency is important. Show them what your salary is and why, and the ballpark of what theirs will be after an ownership change, and what profits the business generates thereafter. Do it early so you are not “jammed” for time and lose bargaining strength.

Over the years one factor I’ve found very irritating is employees wanting a very significant discount of the agreed goodwill value because they argued that they created that part of it while employed.

The unstated “threat” is that if they decided to leave rather than purchase equity, they could take that amount of goodwill with them.

Leave aside the morality issues for now.

You need to ensure you don’t allow this to happen, and trying to deal with it when it arises is not the best approach. It must be nipped well before the bud so to speak.

I prefer to see it dealt with in the Employment contract. Make clear that you expect employees to build their reputation as part of their job and part of what they are properly remunerated for. They are expected to learn how best to engage in Business Development, and to be active in using the necessary tools in a suitable proportion of your time, on your wages, for the benefit of the firm.

Spell out in words of one syllable that properly carrying out these duties of an employee in your firm does not entitle them to any discount of agreed goodwill value should they be invited to purchase equity.

As a matter of course the Employment contract will set out things that employees may not do during their employment that may be likely to damage the employer’s business.

Of course the contract will also set out proper consideration for the employee entering into a fair and reasonable restraint of trade, so the idea of the employee working elsewhere in breach of the legitimate restraint, or setting up in competition, during the restraint period, and taking a decent slab of your goodwill, simply should not arise.

In theory, and usually in practice, what you can get paid for your goodwill by an arm’s length buyer is a close reflection of what your share of the perceived sustainable super-profit is after your notional salary.

Clearly… the more obviously sustainable the super-profit the better…and the higher the super-profit the better!

Both these factors depend on good systems and structures in the business, and the longer they have been there and working very well the better.

Plenty of leverage of employees, operating sound systems not heavily dependent upon you, is important, and equally important is your ability to demonstrate the stability and profitability position fully and convincingly, to reduce the elements of risk the buyer may otherwise be concerned about.

Start early and plan well. There are no guarantees, but your chances of keeping the practice going when you want to retire, or of getting proper value for your interest externally, will be better.

This article was first published in NZ Lawyer Magazine on 19 April 2013