Andy Poole, Legal Sector Partner at Armstrong Watson, explores the succession options for small law firms.
During the years after the 2007/08 recession, profits dipped for many firms, and cash dipped further still. From around 2014/15 up until the COVID-19 pandemic, profits recovered in the main, but cash lagged behind, and only started to improve for many from around 2016/17 up until spring 2020. That meant that partners’ capital accounts increased, because firms couldn’t pay out all of their profits as drawings.
At the same time, new partner admissions were restricted due to lower profit pools; lack of talent; and lack of risk appetite by potential new partners.
When you combine all of that, even pre-COVID-19 the profession was faced with a huge succession issue - an ageing population of partners; fewer potential new partners; and the need to find cash to pay out the larger capital account balances for retiring partners.
COVID-19 has heightened those concerns. Instructions have fallen, especially for smaller high street practices, and cash has either already become very tight or will become so once the government support measures are switched off.
Smaller practices especially worry about these succession factors. This is intensified due to the fact that expensive professional indemnity insurance (PII) run-off cover would need to be acquired in order to cease practising. Run-off cover premiums tend to be around 2.5/3 times the annual premium, and so can be costly. In addition, there are other costs of closure, such as onerous leases, redundancies and file storage.
The run-off cover issue tends to apply more to sole practitioners who have nobody to succeed them, although we are now seeing it increasingly in larger practices where there is no will to succeed nor anyone who wants to be the ‘last man standing’ that becomes responsible for the run-off cover.
With COVID-19, this will become a real issue for many more struggling practices, and even before the pandemic we were seeing many insurers of merger successor firms refusing to take on the successor practice status that would have prevented run-off cover from being required.
So, what are the options?
Merger / sale of the practice is the obvious option for a sole practitioner when looking to retire.
The legal sector market has been undergoing a period of consolidation for several years, driven by the vast number of changes faced by the profession and by opportunities created by floated firms, private equity-backed firms and consolidators. Competition between acquirers created more multiple-based goodwill valuations, particularly for larger, commercial or niche firms.
Immediately pre-COVID-19, we were engaged to advise in 20 separate live law firm mergers, more than we had concurrently for some time. Around half of those have paused due to COVID-19. There is a high chance that the numbers of mergers will increase markedly once the real impacts of COVID-19 begin to be felt as support measures are switched off, most probably in autumn 2020, although there is a risk that acquirers will be hesitant and could wait to see firms fail before picking up the more valuable pieces.
Given all these issues, it would appear to be a buyer’s market, and little goodwill may now be paid, certainly for smaller, particularly general, practices. It can be difficult for sole practitioners to claim that their practice has goodwill, since they are the business and, in most cases, the clients instruct their practice because of the sole practitioner personally. The goodwill therefore rests with them as individuals rather than their practice.
Goodwill would only exist if the clients were to continue to instruct the merged practice and if the profits generated from those clients exceed the net asset value of the practice. Both of those factors are questionable right now, although where they can be demonstrated, then goodwill could still be a factor.
When looking to value a business, an acquirer will look at the income stream that the acquisition will generate for them and by income stream, I mean the residual bottom-line profits. Any valuation calculations are therefore based on what the residual profits are expected to be, with adjustments made for the risk of clients not moving to the new firm and the cost of employing fee-earners to undertake the work performed by the selling party.
A multiple is then applied to the underlying profitability to provide the full value of the practice. Goodwill is the element of that full value less the value of the net assets of the practice. Multiples applied in practice have varied widely in the past couple of years from 0 to 7, with most where goodwill can be attributed falling in the region of 2.5 to 4 other than for acquisitions by private equity-backed firms or floated firms, which have been a little higher.
Given the current risk factors noted above, it may be that traditional multiples may be replaced by an earnout based on actual performance post-merger.
I am often asked whether the value of will banks of established practices will add to the value of a practice. If taking the goodwill valuation approach outlined above, then there is an argument that the value of a will bank is already included, since you would expect the will bank of an established practice already to be contributing to the profits of the practice.
If that is not the case, then an analysis of the wills can be performed to ascertain what future income might be expected from them, and I am aware of law firms that are looking to acquire firms with will banks.
The notes above are generic in nature and the exact value will be determined by the specific circumstances of the selling and acquiring parties.
When selling to another firm, the Professional Indemnity Insurance (PII) impact will need to be determined. The acquiring firm may become the successor practice and remove the need for the selling firm to pay for the run-off cover. In some cases that I have advised in, that has happened and that saving has been used as the deemed value of the practice, with the trade and net assets then being acquired for £1.
More often, the acquirers are now insisting that run-off cover is still paid for by the selling party as they do not want to take on the risks of successor practice status.
Where the valuation of the practice is lower than the net assets value, deals are often agreed to base the value on the work in progress (WIP) or potentially on recovered net assets by merging balance sheets. That is a common route, particularly with the large number of enforced closures that we are currently seeing, but also with those firms looking to exit the personal injury market.
It is possible to have an orderly closure of a practice and avoid an SRA intervention. With orderly closures, a number of separate deals tend to be agreed to sell the WIP to a number of separate firms and use that income to pay any creditors and for the PII run-off cover. The Law Society has a practice note on closing down your practice.
Internal succession is also a possibility, although given the points I’ve raised, that may not be an option.
Although there are difficulties for smaller practices and sole practitioners faced with succession / retirement issues, there are options and we are arranging solutions for the benefit of many firms right now. The key is not to leave it too late and to make the practice appear in the most positive light possible to any acquirer. There are ways of doing that and we are often engaged to prepare firms for sale a long time before they need to be sold.