The term “acquisition” is used quite often to describe the manner in which law firms bring in experienced lawyers. Sometimes firms describe the hiring of lateral partners as an acquisition and bringing in groups of lawyers or a whole practice group from another law firm is viewed as an acquisition. When the consolidation of two law firms is referred to as an “acquisition” it typically signals that one firm is larger than the other and will dominate the transaction. This means that the “acquired” firm is merging into the name, compensation system and legal entity of another firm. The successor of the consolidated two firms usually looks more like the “acquiring” firm than a blend of the two firms.
But rarely are any of these “acquisition” transactions where a purchase price is paid. Indeed, law firm mergers and lateral hires are traditionally cast as “cash neutral” events. Typically, all parties are considered to be bringing an equal amount of value on a prorated basis into the new firm and the management of most firms would be horrified at the concept of actually paying to acquire another firm. With mergers, this means that when the respective net worth of the two merging law firms is spun back to the lowest common denominator (per equity partner or per percent of ownership) the value of the two firms is roughly equal.
But law firm mergers are rarely as equal as they are designed to be and the result is that, in reality, one firm is frequently – but sometimes unknowingly – paying a substantial price to acquire (or be acquired by) the other. This is an issue because, as law firms are involved in more and more mergers, particularly a series of mergers with smaller firms, the impact on the combined capitalization of the successor firm can be significant. In fact, differences in the respective value of merger partners in the hundreds of thousand and, perhaps, even millions routinely get swept aside in the eagerness to do a deal and, perhaps, because even some astute business lawyers don’t quite grasp the concept of law firm capitalization.
The Value of a Law Firm
The value of any business is made up of four types of assets. Fixed assets (the depreciated value of furniture, fixtures, computers and the like), liquid assets (cash, inventory, accounts receivable, etc.), Good Will (the value of businesses reputation, name recognition and client relationships) and what some call human capital (the revenue producing capability of a firm’s personnel and their know-how (in a law firm, its lawyers). The fixed assets and liquid assets show up on the firm’s cash basis balance sheet. The subjective assets, Good Will and human capital, do not.
In some ways the process of merging would be easier if law firms were routinely purchased by an acquiring law firm. There would then be a standard means of valuing a firm based on any of a number of procedures but typically ending in the purchase price that correlates to the way other business sales work — a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). But with law firm mergers the vision is that both parties throw everything into a pot and assume that, unless there is some exceptional liability outstanding, the contribution of both firms will be prorated to their respective size. Unfortunately, it doesn’t always work out that way.
Two features that are fairly unique to the practice of law in the United States have an interesting impact on the values placed on American law firms.
1. Cash Basis Accounting. U.S. tax laws permit certain forms of business, including law firm partnerships and professional corporations, to report earnings on a cash basis. This permits firms to be taxed on the amount of actual cash received from clients and disbursed to employees and vendors, as opposed to most corporate entities that are taxed on the amount billed to clients and billed from vendors (the accrual basis). More significantly, tax laws generally require that firms file their taxes on the same basis as they use to keep their financial records. And, even though the IRS has pretty consistently ruled that this does not prohibit firms from keeping their books on an accrual basis, many law firms fear being accused by their partners of financial shenanigans if the firm prepared financial reports on a different basis than their tax return.
2. Lawyer Employment Contracts. Although courts consistently uphold non-compete agreements in every industry, including the medical profession, lawyers in the United States have traditionally been treated differently. Under the Rules of Professional Conduct, it is argued, the clients’ right to choose their own counsel supersedes any form of non-compete agreement. While there are a series of state court decisions that appear to be nibbling at a non-compete prohibition for lawyers, the non-enforceability of non-compete agreements is generally assumed in most law firm transactions.
Accordingly, if a law firm acquires another law firm, there is no guarantee that the acquiring firm will get anything beyond the physical assets together with the work in progress and accounts receivable. So an acquisition based on past earnings would be irrelevant because there would be no assurance that the lawyers who accounted for the earnings wouldn’t walk across the street and start a new firm.
As a result, two of the assets that create value, Good Will and “the Recipe” are not included in the value that is considered in the merger of two law firms. Since the cash basis of accounting causes firms to only look at things that involve cash, value is limited to specific assets and liabilities that can be precisely quantified. This means that the two features that most drive law firms — the quality and expertise of their lawyers and their client base — are ignored in calculating the respective value of the two firms.
Since we don’t consider the subject non-cash assets in valuing a law firm, it makes it more important that we get the math right. On a cash basis, the net equity of a law firm is equal to the assets minus the liabilities. It’s that simple. [see figure 1]. As an equity partner, therefore, the value of my ownership of the firm is the net equity (assets minus liabilities) divided up by whatever means is determined by the partnership agreement. While it could be equal distribution or some fixed capital percentage, in most firms the value is divided by the same percentage by which the profits are divided.
The Traditional Approach
The significance of law firm cash basis accounting is that it drives the way firms look at everything else, including the amounts equity partners pay in capital contributions. Historically, law firms were envisioned as places where lawyers were employed directly from law school and worked for a period of time as associates until they earned an opportunity to become a partner. At that point, new partners either made a cash contribution to the firm’s working capital or it was deducted over a period of time as undistributed income. In most firms, the capital required of a new partner is a cash amount that is either a fixed dollar amount or in some way related to proportionate compensation (a percentage of cash earnings or a dollar amount based on a partner’s percentage of ownership). In other firms, there is no capitalization required of partners and, instead, the firm’s capital comes from what is effectively retained earnings.
This system worked fine in the traditional firm because new partners were viewed as having paid a portion of their capital contribution through their years of work in the form of “sweat equity.” But as firms began bringing lateral partners into their ranks and consolidating with other firms, a problem was created. The actual prorated value of a firm owned by a partner is substantially different from the amount of the cash capital contribution.
Consider the following example: Two lawyers, Moe and Curley, start a law firm. They each chip in $10,000 in working capital. The firm is successful and over time they buy equipment and build up unbilled time and receivables totaling $300,000. They have taken some loans to help with cash flow and equipment purchases that total $100,000. So their net equity is now $200,000, i.e, if they liquidated the company tomorrow their $20,000 investment would have grown to $200,000.
Moe and Curley decide to bring in Larry as an equity partner. Assuming Larry will get an equal share of the profits, how much should he pay for his partnership? He contributed nothing to the past sweat equity that built the firm’s value tenfold but, in most law firms, he would be asked to invest $10,000 and the net equity would grow to $210,000. Larry’s investment would have grown to $70,000 and Moe and Curley’s would have shrunk from $100,000 each to $70,000. The assumption is that the clients and expertise that Larry brings to the firm is worth the $60,000 net acquisition price that Moe and Curley have paid.
In truth, Larry should have been asked to invest $100,000, the equal to what Moe and Curley had invested, but with law firms that rarely happens. As a result, the value of most firms, by any proportional basis, decreases as it adds lateral partners because it often takes months for a lateral partner to reach the point where the value of his or her billings covers the cost of their compensation and practice. Recouping the capital investment may take years.
The complexity of this issue magnifies as merger partners become larger and span the country or are international. Partners hate contributing after tax dollars to the capitalization of their firm and frequently argue that law firms can borrow less expensively than can individual lawyers. As a result, we see huge disparities of net equity in what would otherwise appear to be similar firms as they sit down to discuss a merger.
Pricing an Acquisition
This is not an insolvable problem, however. It requires that the parties must go through the full mechanics of calculating the net equity that each firm is contributing on some proportionate basis. This is accomplished by using the analysis outlined in figure 1. Some warnings:
1. It is very easy for an advocate or opponent of a merger to subconsciously make adjustments that distort the analysis. Consider using an independent accountant or consultant.
2. Devote appropriate attention to accounts receivable and work in progress. During merger discussions firms will often agree to some arbitrary reserve standard for work in progress and accounts receivable, e.g., amounts over 120 days old or a percentage that approximates annual write-offs or write-downs. In the current economy, the unbilled time invested in transactions that will never close or contingent litigation matters that are years from settlement can distort the value of assets by millions of dollars.
The same is true with accounts receivable. Because accounts receivable don’t appear on cash basis financial statements, there is little motivation to write off doubtful accounts.
In the final analysis, the per partner or per compensation unit difference in the net equity of the two firms must be reconciled in some manner. Either the partners in the firm with the lower equity must write a check (or carry a negative capital account) or the firm with the higher equity must realize that the amount of the difference is the price of the acquisition.
The issue is not that law firm mergers should only occur among firms with identical net equity or that a merger in which one firm pays an acquisition price is not a highly valuable transaction. The point is that the dollars involved can be very large and in the current economic environment, taking rapid advantage of opportunities can be a driving influence for taking action. An acquiring firm has to take a deep breath and consider whether the value of the subjective assets justifies the acquisition price.
Calculating Net Equity