Planning Your Exit Strategy - By Bill Brennan
A successful law firm owner in his late-60’s asked me if I could prepare a formal valuation of his small personal injury law firm because he intended to retire and sell his firm. His law firm enjoyed an excellent reputation due to his 35 years of hard work in the community, combined with a continuous branding campaign via radio, highway billboards and church bulletin advertisements. He made a high six figure profit every year. He was proud of his firm’s accomplishments and considered himself financially successful. Unfortunately, he had just been diagnosed with inoperable cancer. He was the sole owner of the law firm and had no exit strategy in place. He asked for a proposal to provide the services he described. A few days later he was rushed to the hospital in an ambulance because his health deteriorated suddenly. He called me from his hospital bed to change the timing of the consulting project and our first meeting was held in the hospital. This was a difficult assignment because every meeting and phone conversation was overshadowed by his impending death. As you might expect, it was a highly emotional engagement.
During our first meeting I explained to him the subtle, but important, difference between a business valuation project and the sale of his practice. The objective of a law firm valuation is to determine the hypothetical fair market value of the law firm using standard business valuation methodologies. A formal business valuation requires a formal written report that is comprehensive and covers all risks to which the business is subject. This type of project answers the question: “What is my law firm worth?” Projects of this nature are complicated and take considerable time to complete. Law firms involved in litigation with departed partners, or partners involved in a marital divorce, may need a formal business valuation report. It is common in those instances to have the business valuator testify at trial as a law firm valuation expert. In contrast, a consulting engagement focused on selling a law firm is intended to find a qualified buyer and to negotiate a fair price and terms of sale that both parties are willing to accept. That is, a valuation engagement determines the hypothetical fair market value of a business whereas an engagement to sell the firm is focused on identifying a specific interested buyer and agreeing upon a specific price and deal structure acceptable to both parties. Clearly, this particular lawyer needed the later, not the former, and fast.
Many baby-boomers became lawyers in the 1960’s or 1970’s and achieved considerable success in their careers but, like this lawyer, have not adequately planned their exit strategy. Founders of small law firms who plan to stop practicing in the next five years may be wondering how to craft their own “exit strategy” to implement when they stop practicing. A lot is at stake. Selling an ownership interest in a law firm puts the firm in a vulnerable state since the firm’s most confidential information must be disclosed to prospective buyers.
If the individual lawyer is a partial owner of a law firm the options available to sell the ownership interest are generally determined by the provisions of the firm’s partnership agreement or shareholders’ agreement. If there is no formal written agreement between the partners/ shareholders the relevant provisions of the respective state’s Uniform Partnership Act (UPA) or Revised Uniform Partnership Act (RUPA) may apply. Since the options available to partners and shareholders of a law firm are normally delineated in the firm’s legal documents, this article will focus on situations where there is less clarity.
There are numerous options available to solos and retiring partners seeking to sell their ownership interest in a law firm. They can sell their ownership interest to either: a) non-partners in the firm; or b) lawyers in a different law firm. The choice between the two usually depends upon the retiring partner’s assessment of the younger lawyers in the firm. Most solos prefer to sell their ownership interest to younger lawyers in the firm because they believe it is in the best interest of the younger lawyers to do so, and they feel a sense of loyalty, sometimes even an obligation, to sell to them. Of course, that assumes the younger lawyers are reliable, responsible, deliver quality legal services, are able to generate new business and can afford to finance the expected purchase price. Otherwise, the option defaults to selling the ownership interest to lawyers in a different law firm.
Benefits of selling to younger lawyers in the firm include:
- The seller knows them and their capabilities;
- Presumably, they share a mutual trust in each other;
- The seller knows how much they have been earning;
- The seller has a reasonable idea of the purchase price they can afford to pay;
- The seller has a basic understanding of their aspirations for the future;
- The buyers understand the firm’s practice;
- Clients already know the buyers and, presumably, are comfortable working with them;
- The seller does not have to invest a lot of time and money in finding a buyer for the firm;
- The risk of the buyers subsequently suing for misrepresentation of the offer may be reduced because of the buyers’ familiarity with the practice; and
- The firm continues to exist with most of the same employees.
In contrast, the benefits of selling to a buyer other than the younger lawyers in the firm include:
- The younger lawyers may not be viable buyers for a particular reason(s);
- The purchase price does have to be limited to a price the younger lawyers can afford;
- A “strategic buyer” who will realize extra synergies by acquiring the firm can afford to pay a higher purchase price;
- The emotional issues of dealing with a loyal associate(s) are avoided; and
- Presumably, the outside lawyers have experience in successfully managing a law firm.
Regardless of who the buyer is, sellers want the transaction to be successful for everyone, including the new owners. The sales price must be high enough for the seller or there will not be a sale. A transaction that is based upon a sales price that is too high will ultimately end up not working out, which will likely result in the buyer(s) not paying the full purchase price. Unless it is a “win/win” transaction, it is likely to fail. In my experience, retiring partners who sell to younger lawyers within the firm derive pleasure from seeing their firm continue under new ownership. They often want the new owners to earn more money post-sale than they did before the change in ownership. These transactions generally involve friendlier negotiations than sales to third parties, with more of a willingness to make concessions for the benefit of the buyer(s).
A solo who is seeking to sell his/her practice retiring outright can focus strictly on negotiating a sale price. If the solo wishes to continue practicing for a period of time under new ownership before retiring the negotiation is somewhat more complicated. In addition to determining the sales price of the ownership interest, it is important to clarify what services, if any, will be provided to transition clients to the new ownership team as part of the sales price, and what services are not included as part of the sales price. If additional services are to be rendered by the seller after the effective date, now is the time to negotiate how those services will be compensated, not later.
The sales price of a retiring lawyer’s practice varies greatly. Some law practices have very little, if any, value. No two law firm practices are exactly the same, which is reflected in the respective value of each. Buyers of a law firm, or a partial ownership interest in a law firm, want the “free cash flow” that will be generated in the future, or how much profit they will receive in the future. Having performed many similar engagements in the past, I have developed a methodology that has been proven to “thread the needle” and satisfy both buyers and sellers. This methodology takes into consideration historic profitability of the law firm, expected changes in the near future, risks to which the law firm is exposed and my professional judgement based upon 25 years of consulting to law firms.
The successful law firm owner with a dire health problem mentioned in the beginning of this article decided to sell to several of his loyal, long-time associates in the firm. The methodology mentioned above was used to establish the sales price. The solo passed away within a few weeks of the transaction. The former associates, now owners of the firm, paid the purchase price of the firm to the solo’s estate over the course of the next few years and enjoyed considerable increased compensation from the time they became partners in the firm. It was a successful transaction closed in the nick of time. In light of the significant value an ownership interest in a law firm can be to a solo’s estate, it would be wise to develop an exit strategy now rather than later.
Note: Reprinted with permission from the 2017 issue of The Legal Intelligencer. © 2017 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved