Law Practice Management Asked and Answered Blog

Category: Partnership

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Jan 31, 2024


Law Firm Equity Partnership – Buy-Ins and Buyouts

Question:

I am the sole owner of a personal injury practice in Orlando, Florida. I am in my mid-sixties and am looking to transition out of the firm and retire in the next five to seven years. I have three associates in the firm. I would like to sell my equity to one of the associates that has expressed an interest and has been with me for many years. I would like to receive some value for founding the firm and my contributions over the past thirty years. I would like to see him a twenty percent interest initially and more over the next few years. I am trying to determine a firm value for calculating his buy-in. I would appreciate any thoughts that you may have regarding how buy-ins for partners are determined.

Response: 

Approaches to buy-ins and buyouts are all over the place in law firms. Here are a few of the common approaches:

  1. Naked in and naked out – given shares or percentage interest.
    No buy-in at all. A new equity partner is given a percentage interest or shares with no buy-in whatsoever. When the partner leaves the firm
    for whatever reason he or she is paid their share of earnings to date and that is it. No buyout for their interest.
  2. Naked in and naked out with cash-based capital contribution.
    A new equity partner is given a percentage interest or shares with a capital contribution in alignment with their percentage interest.
    When the partner leaves the firm for whatever reason he or she is paid their share of earnings to date and their capital account.
  3. Naked in and naked out with cash-based plus WIP and AR buy-in.A new equity partner is given a percentage interest or shares with a capital contribution and a buy-in the unbilled work in process and accounts
    receivable in alignment with their percentage interest. When the partner leaves the firm for whatever reason he or she is paid their share of earnings
    to date and their cash-based capital account plus their interest in accounts receivable and unbilled work in process.
  4. Purchased shares based on a valuation at the time the shares are purchased and sold.
    A new equity partner is sold a percentage interest or shares based on a valuation at the time of purchase. When a partner or shareholder leaves the firm for whatever reason he or she is paid their share of earnings to date and their shares are purchased based upon a valuation of the firm at that time. These valuations often include a goodwill value. Sometimes the purchase price is discounted for sweat equity – time that an equity partner candidate has been with the firm, etc.
  5. Founder Benefit.
    New equity partners are given a percentage interest or shares with no buy-in or a cash-based capital contribution in alignment with their percentage interest and paid their share of earnings to date and their cash-based capital account, if any, when they leave the firm. However, original founders, in addition to being paid their share of earnings to date and their capital account, are also paid a founder benefit often in the form of a multiple of their average individual earnings (compensation) for the past three years.
  6. Buyout based on firm cash-based valuation, plus accounts receivable and work in progress plus percentage of future collections from new business after the termination date for three to five years. This approach used in practice sale situations, particularly contingency fee firms, when a goodwill value is difficult to ascertain. The percentage of future revenue on future business after the termination date serves as a proxy for the goodwill value. This approach is seldom used in multi-partner/shareholder firms. In fact, many multi-partner/shareholder firms specifically exclude goodwill from any valuation.
  7. Buyout based on mandatory retirement and winddown.
    An approach used by some second-generation firms is a mandatory retirement program that can begin as early as age 60 and no later than 65. The program requires a five-year winddown program in which a retiring equity partner reduces his or her work schedule twenty percent per year and compensation draw, distribution, or salary. During this period the partner is paid their cash-based capital account and their ownership percentage times the collectable accounts receivable and billable and collectable unbilled work in process as of the date the winddown program commences. During the winddown the retiring partner is expected to transition clients and management responsibilities.

In the final analysis the value of the practice is what an outside buyer or an attorney working for the firm will pay for (or invest) the practice. A balance often has to be struck between valuation, affordability, and willingness to pay. The valuation process is simply a tool to use to help you begin discussions and get to this point.

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John W. Olmstead, MBA, Ph.D, CMC

Oct 25, 2023


Equity Partners – Valuation of Shares and Affordability

Question:

I am one of three founding partners in a 12 lawyer general litigation firm in San Francisco. All three of us are in are sixties and are looking to begin admitting others as equity partners. We have three non-equity partners and five associates in the firm. The three of believe that we should receive some value for founding the firm and our contributions over the past twenty years. We would like to sell each of them a ten percent interest and we are trying to determine a firm value for calculating their buy-ins.

Response: 

In the final analysis the value of the practice is what an outside buyer or an attorney working for the firm will pay for (or invest) the practice. A balance often has to be struck between valuation,  affordability, and willingness to pay. The valuation process is simply a tool to use to help you begin discussions and get to this point.

I believe that firm value has to be balanced with affordability and a prospective equity member’s willingness and ability to pay for the shares. It all comes down to compensation. Generally, I find that a prospective equity member or partner must be able to see a significant compensation increase with a breakeven/payback period of around three years – no more than five. I also believe that when shares are seller financed the period should be no longer than five years. Many firms do not sell shares based on formal valuation – other methods are used.

Questions that equity member candidates usually raise:

  1. Is the breakeven/payback from the investment in say three years as a result of the compensation gap?
  2. How much more will he or she earn as equity shareholder?
  3. Can he or she earn enough more as an equity member to justify the investment?
  4. Can he or she earn more as a partner somewhere else with as an large investment, a smaller investment, or even with no buy-in at all?
  5. Can he or she earn more somewhere else as an associate or non-equity partner?

In many law firms’ compensation is based upon performance and contribution and ownership shares have little or no bearing on member or partner compensation. Their primary goal is to acquire and retain talent.

Use a valuation methodology as a starting point – such as a multiple of firm past five year’s average revenue and adjust for the affordability factor. Keep in mind that many of your competitors are offering equity partnership with no buy-ins at all.

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John W. Olmstead, MBA, Ph.D, CMC

Feb 02, 2023


Law Firm Compensation – Compensating New Equity Partners

Question:

Our firm is a seventeen lawyer insurance defense firm in Austin, Texas. The firm was founded by the two existing partners twenty-five years ago. In addition to the three founding equity partners we have five non-equity partners and ten associates. Non-equity partners and associates are paid a salary and a discretionary bonus. The two equity partners are paid their profit share based upon their partnership percentage which is fifty percent each in the form of distributions dependent upon cash flow. The two of us are considering offering partnership to two non-equity partners with a buy-in based on selling both a five percent interest based on a designed price per share. We would to maintain our same method of equity partner compensation based on percentage interest. We would appreciate any ideas that you have.

Response: 

This approach would be fine if the compensation numbers work. I  often find that at the lower end of partnership equity shares the compensation model that you have been using no longer works. The new partner simply does not have enough of an equity share interest to compensate him or her fairly and or be competitive with other law firms. He or she may ending up making less than they were making as non-equity partners. It may be time to at least shift to a compensation model for all of you where each of you are paid a base salary based upon your years of experience, billings, and overall performance and contribution to the firm, a bonus pool for exceptional performance or contribution to the firm, and the remainder distributed based on partnership ownership shares. Take a look at the non-equity partner candidates, their present compensation, what other law firms are paying that you are competing with for talent, and go from there. Also consider the buy-in that you are asking for and whether it is affordable and reasonable and how many years it will take your candidates to breakeven on the investment. Today we are finding that more and more non-equity partners and associates are saying “no thanks” to equity offers.

Of course there are many other approaches that you could take concerning compensation but this recommendation seems the easiest and closest to your present approach.

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John W. Olmstead, MBA, Ph.D, CMC

May 25, 2022


Law Firm Succession – Equity Partnership – Process for Admitting Equity Partners

Question:

I and another partner are the owners of a seven lawyer family law practice in Chicago suburbs. We started the firm twenty years ago after leaving behind a partnership in another firm. Of the other five attorneys there are three non-equity partners and the rest are associates. I am sixty three years old and my other partner is sixty. Both of us are beginning to think about retirement and how we are going to transition out of the practice. Two of the non-equity partners are well seasoned attorneys, have major case responsibility, and bring in client business. We have discussed equity partnership vaguely with two non-equity partners but they have been non-committal. I would appreciate your thoughts and advice on what our next steps should be.

Response:

I believe that you have been two vague in your discussions. Your non-equity partners need to know what the deal is, what financial investment will be required, and what their expected return will be based upon the historical financial performance of the firm. It is hard for non-equity partners or associates to commit to equity and taking on the risk of ownership when they don’t know what the deal is. This is a scary proposition for them and they need detailed information so they can evaluate and make an informed decision. A vague discussion doesn’t cut it. I suggest that you put together an equity partnership proposal that includes:

  1. Profit and loss statements for past the five years.
  2. Balances sheets for the past five years.
  3. A current accounts receivable and unbilled work in process report.
  4. Tax returns for the past five years.
  5. Malpractice insurance application.
  6. Building and other leases.
  7. Proposed Partnership Agreement
  8. Proposed Equity Partner Compensation Plan
  9. Planned date of admission
  10. Governance and management plan
  11. Ownership percentage being offered
  12. Capital contribution or buy-in requirement
Meet and discuss the proposal with your candidates, allow sufficient time for candidates to discuss with their families and advisors, and set a timeline for their decisions. I think you will see a different reaction. If they still are unable to commit your may have to begin thinking about an external strategy and looking around for merger candidates.

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John W. Olmstead, MBA, Ph.D, CMC

Jul 14, 2021


Law Firm Succession Planning – Will Your Non-Equity Partners or Associates Simply Wait Your Out?

Question: 

I am one of three founding partners in a fourteen lawyer firm in Cleveland, Ohio. We are an insurance defense firm with three founding partners, five  non-equity partners, and six associates. We have three primary insurance companies that refer a majority of cases to the firm. All three of us founding partners are in our early to mid sixties and contemplating our retirement and departure from the firm in the next five to eight years. Our lease runs out in eight years and none of us want to sign another lease. Three of our non-equity partners are in their mid to late fifties and two are in their forties. All of our associates have less than five years experience. When and how should we begin planning for our retirements and exits from the firm?

Response: 

I suggest that you start now, especially if you are planning on an internal succession strategy. I believe that an internal succession should be your first step if you have the right people in place. When a firm has institutional clients such as you do with many different relationships within each client organization it can take time to transition relationships to the next generation of attorneys in the firm to ensure that clients stay with the firm when you retire. Transition to the next generation of attorneys usually involves legal skill development, management skill development, and client transition. We often recommend five years.

If you are looking for a buy-in for new equity partners you need sufficient time so new equity partners can pay for their initial ownership interests over time and acquire additional interests as they can afford to acquire more. Waiting too long can also create a situation where non-equity partners in the firm feel they can simply wait your out and inherit the clients without paying anything, or very little, for their ownership interests or buy-in/buyouts. Consider making a few folks minority equity partners as soon as you can.

This assume that any of your non-equity partners even want to be equity partners in the firm which is often the case these days. Three of your non-equity partners may also be close to retirement themselves and have no interest in stepping up to equity. If this is the case you will have to focus on the other two non-equity partners. I would begin a dialog with all of your non-equity partners to determine their interest level. At some point you will not really know until you present them will a proposal and appropriate financial information – initial buy-in if there is to be one and founding buy-outs if there is to be such.

If it looks like the interest or commitment level is not there in your non-equity partners you may have to consider an external option such as a merger. The timeline often can be much shorter in such situations.

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John W. Olmstead, MBA, Ph.D, CMC

 

Jun 16, 2021


Implementing a Non-Equity or Income Partner Tier in a Small Law Firm

Question:

I am the sole owner of a five lawyer firm in Indianapolis, Indiana. The other lawyers are associates. Our firm focuses entirely on estate planning and probate and trust administration as well as elder law. I am 60 and do not plan on retiring for another ten years. Two of my associates have been with me for 8-10 years and are vital to my practice as well as my eventual succession and exit strategy. I do not want to lose them so I am considering making them non-equity partners and giving them the title of partner. I am not ready to have any equity partners at this time. I have a production bonus system in place for the associates so I don’t plan on changing their compensation or the system under which they are compensated. How can I make their promotion to partner meaningful?

Response: 

Here are some things you might consider:

  1. Really build up their promotion to partner.
    1. Press releases announcing their promotion to partner to the local media.
    2. Mail out announcements announcing their promotion to partner to clients, past clients, other lawyers and law firms, judges, referral sources, and family and friends of the new partners.
    3. List them as partners on the firm’s website, letterhead, and other promotional materials. (Some firms have even listed them in the firm name – I don’t agree with this)
  2. Include them in firm management and at least begin sharing some, even if limited, financial information with them.
  3. Consider providing them with additional perks.
    1. If your present bonus system is based on working attorney collections, provide a delegation component for fee collections/receipts from other attorneys or paralegals on matters that the partner is responsible for and is managing.
    2. Additional life insurance.
    3. Country or other club membership.
    4. Firm paid automobile.
    5. Gas card.
    6. Firm credit card.

The title of partner in itself is more important than you might think but it requires that a big a buildup. If you only do one thing – do the buildup announcement and secondly include them more in firm management.

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John W. Olmstead, MBA, Ph.D, CMC

 

May 26, 2021


How/When to Admit a New Law Firm Partner

Question: 

Our firm is a six lawyer family law firm located in the Chicago suburbs. There are two equity partners and four associates in the firm. Approximately five years ago the founder of the firm decided to retire and he sold the practice to myself and another associate in the firm. We just finished making our last payment the end of last year. We have an associate that we do not want to lose and he has inquired about his future with the firm and partnership. He has been with the firm for two years. My partner and I are considering offering him a partnership interest but do not know where to start. Any suggestions that you have would be appreciated.

Response: 

The two of you should start by asking yourselves the following questions:

The majority of firms that I work with regardless of size have a non-equity/income partner tier that an associate advances to prior to being considered for equity partnership. This gives associates the feeling of career progression, the title of partner which helps with client and peer recognition, additional responsibility in the firm, and additional compensation. Your associate may not even be expecting or be ready to become an equity partner – they simply want to know what the next step is in their career advancement and whether equity partnership is even possible in your firm down the road. Last week I interviews ten associates in a firm and six out of ten advised me that they had no interest at all in equity partnership. So, don’t assume that your associate is even interest in equity partnership.

I suggest that you give these issues serious thought before jumping off the cliff and prematurely admitting another partner. Adding another equity partner is a serious step and should be give appropriate due diligence.

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John W. Olmstead, MBA, Ph.D, CMC

Feb 10, 2021


Law Firm Partnership – Non Performing Partners

Question: 

Our firm is a litigation defense firm in the Chicago suburbs.  Four of us started the firm twenty years ago and we have since grown to a sixteen attorney firm consisting of eight equity partners and eight associates. The other four partners were initially associates and later admitted after they had been here for five to seven years. The other four partners bring in very little business and their production is dismal compared to the four founders. Our associates working attorney receipts are larger than a couple of our equity partners. Our compensation is a equal salary for all partners with remaining profits allocated to each partner based upon their ownership percentage which are 15% for each of the four founding equity partners and 10% for each of the other equity partners. They was no buy-in for the newer partners. Profits have been flat for several years and partner compensation as well. We would like to hear any thoughts that you may have.

Response: 

It sounds like partners are left to their own and are not accountable to other partners in the firm. Successful firms your size have performance expectations and guidelines for all attorneys in the firm with consequences for non compliance.

Many firms your size use a compensation committee to determine partner compensation and performance peer reviews – – both written and face to face interviews are conducted with each partner in the firm. Partner performance reviews are often avoided like the plague by many firms. They are time consuming and it is hard to give candid feedback to colleagues. However, without partner performance reviews neither the partners nor the firm will reach full potential. When partner performance reviews are used not only to review performance but to set measurable goals this data can be incorporated into the compensation system and provide additional hard data for providing a true measure of partner contribution and value.

You may have to consider changing your partner compensation system or changing nonperforming partners status to non-equity partners or associates.

You must muster up the courage to confront underperforming partners but before you do that you have to determine what the baseline performance expectations are for the firm, communicate them, and put in place consequences for non-compliance.

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John W. Olmstead, MBA, Ph.D, CMC

 

 

Dec 16, 2020


Law Firm Equity Partner Buy-ins and Buy-outs – Pros and Cons

Question: 

Our firm is an insurance defense firm based in Denver, Colorado. The firm was founded in 2015 by two founding partners and we have grown to a firm of twelve attorneys – two founding equity partners, three non-equity partners and seven associates. Non-equity partners are included in firm management and the non-equity partners serve as members on the management committee. Non-equity members are compensated in the same manner as are equity partners – salary and bonuses determined by three year moving average ratios of weighted working attorney and originating attorney collections. Partner ownership interest does not factor into equity partner compensation. The firm does not have a partnership agreement. The firm is currently considering admitting qualified non-equity partners as equity partners. We are considering having a requirement that new equity partners purchase their shares via a buy-in tied to a firm valuation that includes a goodwill value.  Our initial discussion with the equity partner candidates that we are considering has not been positive. They feel there should be no buy-in and they don’t see any benefit to being an equity partner. We would like you thoughts and opinions on this matter.

Response: 

I can see where there is little distinction in your firm between equity and non-equity partners. I encourage firms when creating a non-equity tier to resist the temptation of giving away the farm and not retaining some incentives for non-equity partners to want to become equity partners. Typically, I suggest that there be a different compensation structure for equity partners than non-equity partners so that there is a compensation component for bearing the risk of ownership for equity partners. Often I suggest that non-equity partners come under a different compensation structure than associates, be given a few additional perks, and be included in partner meetings to a degree but not having a vote.

Approaches to buy-ins and buy-outs are all over the place in law firms. Here are a few of the common approaches:

  1. Naked in and naked out – given shares or percentage interest. No buy-in at all. A new equity partner is given a percentage interest or shares with no buy-in whatsoever. When the partner leaves the firm for whatever reason he or she  is paid their share of earnings to date and that is it. No buy-out for their interest.
  2. Naked in and naked out with cash-based capital contribution. A new equity partner is given a percentage interest or shares with a capital contribution in alignment with their percentage interest. When the partner leaves the firm for whatever reason he or she is paid their share of earnings to date and their capital account.
  3. Naked in and naked out with cash-based plus WIP and AR buy-in. A new equity partner is given a percentage interest or shares with a capital contribution and a buy-in the unbilled work in process and accounts receivable in alignment with their percentage interest. When the partner leaves the firm for whatever reason he or she is paid their share of earnings to date and their cash-based capital account plus their interest in accounts receivable and unbilled work in process.
  4. Purchased shares based on a valuation at the time the shares are purchased and sold. A new equity partner is sold a percentage interest or shares based on a valuation at the time of purchase. When a partner or shareholder leaves the firm for what ever reason he or she is paid their shares of earnings to date and their shares are purchased based upon a valuation of the firm at that time. These valuations often include a goodwill value. Sometimes the purchase price is discounted for sweat equity – time that a equity partner candidate that has been with the firm, etc.
  5. Founder Benefit. New equity partners are given a percentage interest or shares with no buy-in or a cash-based capital contribution in alignment with their percentage interest and paid their share of earnings to date and their cash-based capital account, if any, when they leave the firm. However, original founders, in addition to being paid their share of earnings to date and their capital account, are also paid a founder benefit often in the form of a multiple of the average earnings for the past three years.

The spectrum of law firm valuation and withdrawal entitlement theory can be characterized by two polar positions. The first considers the firm as a means to generate income (i.e., compensation), with modest, if any, value beyond the cash basis capital account. This is the dominant view currently in the profession and has resulted in the vast majority of firms valuing only the cash basis balance sheet for internal withdrawal rights. The second considers the firm as an investment, much like most other commercial endeavors.

I have many firm clients that are in their firm generation with original founders that have been in practice for twenty years and these firms have substantial institutional goodwill. Some of these firms sell shares to equity partner candidates based upon a firm valuation including a goodwill value. Other such firms take one of the other approaches. Often the problem with this approach is affordability.

Personally, I believe there should be some skin in the game for a non-equity partner to become an equity partner or shareholder. In your situation you are a young firm and acquiring and retaining lawyer talent should be your primary objective. Therefore, rather than selling shares I believe that you might want to  consider approach number two – naked in – naked out with a cash-based capital contribution that is affordable. If cash is a problem for the candidate have them pay what they can with the remainder payable on a capital (promissory) note paid over a one to three year period. Then have the partnership agreement provide for a founder benefit for the two founders as discussed above (say 1.5 multiple) upon retirement.

Do all that you can to fund partner retirements through 401k plans and other vehicles.

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John W. Olmstead, MBA, Ph.D, CMC

 

Aug 27, 2020


Law Firm Partnership – How to Admit Associates to Equity Partnership

Question: 

I am the owner of a six-lawyer law firm in San Diego, California. Our firm is a business litigation boutique firm. I founded and formed the firm nineteen years ago. The other attorneys are all associates of which one has been with me for over ten years, one over five years, and the other three less than two years. I am 56 and still plan on working another ten to fifteen years. However, I don’t want to lose my senior associates and I want them to be around in ten to fifteen years to take over the firm, I also believe that they should be partners. The firm is presently a sole proprietorship. I would like to extend an offer to the senior associate now and possibly to the other senior associate in a a couple of years. How do I get started? What are some of the issues that I should be thinking about?

Response: 

If you have never had a partner in this firm or another firm in the past this will be a new experience for you. Law partnerships are like marriages and choosing the right partner is essential. Not only should the lawyer be an exceptional lawyer as far as legal skills, client satisfaction, fee production, and client origination, he or she should have similar values and goals for the firm that you do. Will you mesh well? At least the associate is somewhat of a known quantity since you know the associate and have worked with the associate for several years. However, the experience will be different. Being a partner with someone is different than a boss-employee relationship.

Here are a few ideas you might consider:

  1. Outline you goals and expectations for the relationship.
  2. Meet with your associate and identify his/her goals and expectations for the relationship.
  3. Determine how much control over the practice and decision-making are you willing to give up? Share?
  4. Determine how much and for how long you are willing to make less?
  5. Determine if the associate will be expected to bring in business? When/Timeline?
  6. Think about the firm you want to build – firm-first or lone ranger (team based or individual practices)?
  7. Decide on firm name – will it change? Should it? Impact on image, clients, etc.
  8. Decision as to capital contribution or buy-in? Yes or No? How much? Timeline for payment?
  9. Ownership percentages
  10. Voting
  11. Compensation
  12. Withdrawal arrangements

I suggest you think about your succession and eventual exit from the firm and what, if anything, you are looking to receive (goodwill value) in monetary terms when you leave the practice. Rather than having a large buyout upon your retirement/exit from the firm tie this to the value per share or unit of ownership interest and establish this is the purchase price as ownership shares are acquired.

Since you are a proprietorship you will need to change the structure of the firm to a multi-owner structure such as PC, APLC, or LLP. (LLC’s are not permitted in California for law firms).

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John W. Olmstead, MBA, Ph.D, CMC

 

 

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