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May 05, 2021

Law Firm Succession Planning – How Important is a Formal Appraisal Valuation of the Firm?

Question: 

Our firm is an eight lawyer litigation firm in Portland, Oregon. We have three founding equity partners in their early sixties and late fifties, three non-equity partners, and two associates. Recently the equity partners began succession planning discussions among ourselves. Our preference would be an internal succession and transition to the younger non-equity partners in the firm. In our discussions we were discussing buy-in, buyouts, and valuation and one of my partners suggested obtaining a formal valuation. What are your thoughts regarding hiring a business appraisal firm to provide us with a formal appraisal/valuation of our firm?

Response: 

While I don’t wish to downplay a formal valuation, they can be expensive and I find often not really used in the final outcome, especially when it involves selling partnership interests to others within the firm.

Most law and other professional practices sell (to outside parties) for a multiple of annual gross fee income. Often this is discounted (sweat equity discount) when assets or shares are sold to other attorneys within the firm. Generally, this rule-of-thumb method of valuing a law practice is used to value the practice. However, the eventual value of a law practice comes down to what an interested party is willing to pay. 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. The valuation process is simply a tool to use to help you begin discussions and get to this point.

Many law firms with multiple partners view the law firm simply as a compensation vehicle designed to put as much income as possible in the pockets of the partners. They do not see the firm as an investment vehicle nor do the partners expect unfunded buyouts when they retire or otherwise leave the firm. These firms try to fund retirements with 401k and other retirement vehicles so there is no unfunded buyout upon retirement. The goal of these firms is to be in a position to acquire and retain top lawyer talent. Often these firms simply require an initial capital contribution and return cash-based capital accounts and earnings to date upon withdrawal or retirement. Sometimes a founder benefit is provided for the original founder(s) of the firm as a reward for their sweat equity establishing the make and making the initial investments. Such founder benefits are often a percentage based on an average of a founder’s compensation over the past three years.

Value in a law practice is largely personal to the lawyer and that individual’s ability to attract and retain clients. The lawyer has knowledge, experience, skill, judgment, and reputation—all elements of professional goodwill – not institutional or firm goodwill. As long as clients primarily hire lawyers, as opposed to firms, this will remain a guiding principle in valuing law practices. This is not to say that some firms have not created a “brand identity” that is separate and distinct to the institution. And in larger practices, the servicing team (including other partners and other practice specialties) influence the client’s selection decisions. Those firms are rare.

Often when selling partnership interests to others in the firm affordability and terms plays a larger role than valuation.

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

Apr 07, 2021

Law Firm Internal Succession – Non-Equity Partners and Business Development Ability

Question: 

Our firm is a twelve-attorney insurance defense firm based in Indianapolis, Indiana. The firm was founded thirty years ago by myself and two other partners. We represent approximately twenty-five insurance companies. Our lawyer headcount consists of three equity partners, four non-equity partners, and five associate attorneys. My partners and I are in our early sixties and just beginning to think about retirement. Two equity partners will retire in the next five years and the third is not sure of his timeline. We would really like to see an internal succession as opposed to a merger with another firm. We have yet to have any discussions with our non-equity partners and their interest in equity ownership. Frankly, we have never promoted any non-equity partners to equity partnership because none of them bring in any business and we have always thought this should be a prerequisite to equity partnership. Your advise and thoughts are most welcomed.

Response: 

I believe that for an internal succession strategy to be successful you have to start the transition early and the best way to accomplish this is to begin admitting others to equity partnership sooner than later, especially if you are expecting a founder benefit or buyout. While I believe that business development should be a major consideration when admitting equity partners this may not apply in your situation. If your non-equity partners are good minders, have solid relationships with your insurance company clients, and can hold the clients after the three of you retire this may be more than adequate for a successful succession strategy. I have worked with numerous insurance defense firms that are in their second generation totally serving clients that were originated by the original founders. Keep in mind that you are looking for an exit strategy.

By starting early and admitting them sooner than later you can implement a client and management transition strategy and determine if they are willing to buy-in and purchase an initial minority interest as well commit to purchasing your remaining ownership interests or paying your founder benefits.

The three of you should be giving some thought as to your financial expectations keeping in mind that valuation of the firm must be balanced with affordability and future equity partners ability to financially handle the buy-ins and buyouts.

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

 

Mar 10, 2021

Law Firm Non-Equity Partner Compensation

Question:

Our firm is a sixteen attorney full-service law firm in Denver, Colorado that works exclusively with small businesses. We have six equity partners five non-equity partners, and five associates. Three of our equity partners serve on the firm’s compensation committee of which I am one of the members. Our committee makes compensation recommendations to the partnership for equity partners, non-equity partners, and associates. Since forming the non-equity partner tier a few years ago we have not changed our method of compensating non-equity partners which has been salary and discretionary bonus. We are wondering what factors we should be considering and what some of the best practices are concerning non-equity partners. Your thoughts would sure be helpful.

Response: 

Non-equity partners’ salaries are generally based on a baseline of a predetermined billable hours multiplied by their general billing rates, plus an estimated overhead factor and incentives. The bonus threshold is generally based upon their billings and collections.

Below is a list of the factors that are considered in most firms when allocating salary increases and bonuses to the non-equity partners:

A goal should be for equity partners to earn 25 to 30 percent or more profit margin on work provided to the non-equity partners.

The firm should ensure that a profit-margin opportunity is not totally given away by virtue of the salary and bonus calculations that overemphasize billable hours and billings rather than collections.  Consideration must be given to firm overhead and profit margins.

If the work performed by the non-equity partner was originated by that attorney, it is reasonable that some portion of the fee generated be paid as a commission for originating that work. Originating the work and doing the work yourself is a common scenario. It is not unusual to see firms pay a 10 to 15 percent commission for that work.

If the work is originated by the non-equity partner but billed and handled by someone else, the commission should be lower (approximately half the normal commission or less).

All of these origination commissions should be built upon the expectation that the work is billed and collected at reasonable rates. There is little justification for paying for origination for work that is not profitable.

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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

 

 

Feb 02, 2021

Law Firm Compensation – Changing System to Incorporate Client Origination

Question: 

Our firm is a small insurance defense/corporate litigation firm in Los Angeles, California. We have six partners and 7 associates. Our partner compensation system is primarily based upon working attorney collections with no incentives or rewards for bring in clients – client origination. We have been thinking of including client origination as a new metric in our system. We would like to know your thoughts regarding client origination and partner compensation.

Response:

Here are my thoughts in general.

Pros and Cons of Origination Credit

Client or matter origination credit is a touchy subject. Some firm-first or team-based firms refuse to track it at all for fear that it will open a can of worms and will be divisive. At a recent bar association presentation, the presenter and managing partner of a firm stated, “one of the quickest ways to split up a law firm is to incorporate client origination into the partner compensation system” Other firms track origination credit and use it as a factor in subjective compensation systems but do not compensate origination directly or in the form of numerically determining partner compensation percentages. Many firm’s that use formulaic or eat-what-you-kill systems do not include client origination and only include working attorney and/or responsible (billing) attorney collections. Other eat-what-you-kill firms do incorporate client origination.

Personally, I believe that a law firm should track and recognize the importance of origination  and use that knowledge to determine attorney career advancement to the different tiers (non-equity partner, managing partner of an office, and equity partner) and to differentiate different levels of income among lawyers without pursuing a formulaic or commission approach to compensation. While I believe that origination should be tracked, recognized, and rewarded, it has not been my experience that a change in the compensation system will make rainmakers out of service partners or associates.

Tracking of Origination Fee Credits

There should be an expectation that an individual’s business origination efforts and results will improve over time. Fees collected should be the controlling metric used in determining origination. Origination should be tracked at the matter level as opposed to the client level. This provides greater flexibility to share origination credits. Tracking origination should not require a formal scorekeeping system. According to recent surveys less than half of the law firms grant formal origination credits.

Duration of Origination Credits

Origination policies can cause hoarding of client relationships and matters, creation of origination credit annuities, and divisive internal competition. To mitigate this tendency firms often limit the duration of the credit and sunset the origination credit after so many years – often five years. One option is to grant the origination credit on all matters opened for a new client for the first three or five years that the client is with the firm and after that time origination credit for new matters of a client would be credited to the firm, responsible, or billing attorney.

Origination Guidelines/Protocols

It is important that the firm establish written guidelines and protocols for allocating business origination credits whether the firm is using origination directly or indirectly in compensation.

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

 

Jan 20, 2021

Law Firm Merger – What’s in a Name?

Question: 

Our firm is a ten attorney boutique litigation firm located in Memphis with four partners and six associates. We are in very early discussions with another firm in town that has three partners and four associates. We believe that a merger would improve our lawyer talent base and help us grow. In our last meeting the topic of firm name was discussed and it was an unpleasant discussion and we are concerned that we may a difficult time agreeing on the name of the firm. Is this a common issues and problem?

Response: 

Yes. Deciding on a name for the new firm is another interesting reason why some firms decide not to merge. It is unbelievable how egos can override important business decisions when the time comes to choose a name for a combined practice. It is ludicrous for the receptionist to greet you with six names when you call a law office.

Nowhere in the business world should a caller have to wait that long before being able to ask for the person sought. The truth of the matter is that everyone remembers the first and possibly second name of most law firms, and this point should be dealt with in negotiations. The importance of the firm name in marketing and branding should also be considered.

If the combined firm is having trouble with the name of the firm, then obviously the firm is going to have a lot more trouble in the future. Where there are problems in selecting the name of the firm, I would recommend that the firms not merge because of the egos involved. It is a sure sign of future problems when people cannot sit down and immediately offer to give something up – such as inclusion of their name in the firm name. What is more important – firm security, bottom line, future growth, or “your name in the firm?” Some may say all four, but the point is to look at the business opportunity at hand.

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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

 

Nov 12, 2020

Law Firm Owner Succession/Exit Strategy – Admitting Associates to Partnership

Question: 

I am the sole owner of a litigation firm in San Antonio, Texas. In addition to myself I have two associates and three staff members. Both associates have been with the firm over five years. I am 66 and am just starting to think about my exit plan down the road. While I am not in a hurry to retire or work less I believe that I should at least be thinking about my options. I would appreciate your thoughts.

Response: 

I agree that you should begin planning for your eventual retirement and exit from the practice. Anytime a sole owner has associates on board I believe that an internal transition of the practice to those associates should be the first option explored. It can benefit your associates, your staff, and your clients. External practice sales, merger, and Of Counsel arrangements with another firm can be explored after you have explored the feasibility of transitioning your practice to your associates. This assumes that they even have an interest in owning a law firm. Often we find that they don’t.

You should begin exploring whether your associates have such an interest and you may want to consider selling them each a minority interest now so they don’t become dissatisfied and leave the firm and you empty handed. I don’t think I would wait until you are ready to exit the practice to offer them a partnership interest. Partnership is an important career marker for associates and many will move on if they feel their careers are stagnated and they are not advancing.

If you decide to offer them a partnership interest and they accept begin injecting them into client relationships and firm management. This will help ensure a smooth transition when you retire and exit the practice.

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

Oct 21, 2020

Law Firm Effective Communications – During and Post COVID-19

Question: 

I am the firm administrator of a sixteen attorney firm in Kansas City, Missouri. We, like many other firms, have done our best to face up to the challenges presented by COVID-19. For several months attorneys and staff worked remotely from home office using the internet, telephone, and video conferencing as the primary means of communications with clients and the office. To our surprise it worked fairly well but most of the attorneys were glad when they were able to return to the office. We have been having discussions as to the long-term impact of COVID-19 both in the short-term while we continue our fight against COVID-19 and in the long-term after COVID-19 has been defeated. I would be interested in your thoughts.

Response: 

For years law firms have held the attitude that employees – attorney and staff alike must been seen, observed, and on premises in order to be productive.  Law firms that have had and continue to have their attorneys and staff working remotely during COVID-19 have disproved this premise. They have found that not only have their attorneys and staff been able to remain productive but in many cases even more productive then when they worked face to face in the office. However, communications has been a challenge for many firms.

Below is what I refer to as the scale of communication media and richness of each:

1. Face to face
2. Video Conferencing
3. Telephone
4. Email and text

Face to face is the richest form of communication and should be used for sensitive communications such as performance reviews and other such discussions concerning performance, praise, training and mentoring, etc. It should still be used when ever possible in these situations.

Video conferencing using platforms such as Zoom, GoToMeeting, Team, etc. in the second richest form of communication and should be used when face to face would normally be used but is not possible.

Telephone is the third richest form of communications and should be used for less sensitive communications or for face to face situations discussed above when a face to face meeting is physically not possible.

Email, text, and other written communications should be used for routine communications such as assignment of projects and tasks, work instructions, etc.

Sensitive and difficult communications should be communicated through a rich medium such as face-to-face meetings or video conferencing and routine communications through a lean medium such as a memo.

Media richness is determined by the speed the media provides, the variety of communications channels on which it works, the extent of personal interactions allowed, and the richness of language it accommodates. As tasks become more ambiguous, you should increase the richness of the
media that you use.

Our law firm clients have advised us that after awhile they missed the face to face interaction and found that the major problem with working remotely was that the communication with other members of their work team took much longer than walking over to the next office or desk and was frustrating. While I don’t believe that traditional offices will completely disappear, I believe that law firms have learned lessons from COVID-19 and we may see the following changes in the future:

  1. One lessen that was learned was that law firms could trust their lawyers and staff to work and be productive without being on premises and being seen.
  2. More work and related processes will be reengineered. Law firms have identified work and processes that simply don’t need to be done or need to be done in different ways.
  3. More law firms will implement cloud-based practice management and telephone systems.
  4. Video conferencing is an effective communication medium replacement for certain face to face communications and will be use more frequently for team and client meetings as well as initial new client intake meetings.
  5. Law firms will be more willing to institute remote work programs.
  6.  Law firms will reexamine how they use office space and will consider alternative office space arrangements.
  7. Lawyer to secretary ratios will increase.

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

Sep 30, 2020

Law Firm Sole Owner Looking to Retire Next Year Looking for Options

Question: 

I am a solo practitioner in Southern Indiana. I have been practicing law for 43 years and I want to retire next year. My practice is a general practice firm although approximately 80% of my work is estate planning and estate administration. I am the only attorney in the firm and I am assisted by one paralegal that has been with the firm for twenty years. She plans on working for another ten years or so and will need a future home. I am not sure whether there is any practice value, whether I should just close the practice, or whether another attorney or law firm might be interested in my practice. Your advise would be greatly appreciated.

Response: 

A practice review would be required to determine the potential value and marketability of your practice. If your firm has generated adequate revenues, net earnings, and a diversified base of clients and or referral sources your practice should have an appeal to another attorney or law firm. The key question as to whether there is a goodwill value is whether future cash flows will continue from your clients and referral sources after you exit the practice. It has often been said that clients hire the lawyer – not the law firm. However, a well planned client transition with the new acquiring attorney or law firm can increased the odds of success.

I would only consider closing the doors and shutting down your practice as a last resort option. You will not receive any value for the sweat equity that you have invested in the firm or a home for your clients/referral sources and your paralegal. Before considering this last resort option I would begin a search for other candidate attorneys that you might be able to sell your practice or law firms that you might be able to merge with or join up with in an Of Counsel arrangement. An Of Counsel arrangement is often a solution in your situation. In essence you winddown your practice operation, bill out your work in process and collect your receivables, and take your clients and employee over to the other firm. After joining the other firm you work as long as agreed to and you:

  1. Transition your clients
  2. Integrate your practice
  3. Transition your employee
  4. Work until you are ready to retire
  5. Retire

Typically you will be paid under an eat-what-you-kill system based upon your fees collected based upon, working and originating attorney, while working at the firm and sometimes receive a goodwill value based upon a percentage of your client origination fees collected (past and future clients) after your retirement for three to five years.

Joining another firm would be a better option than shutting down if you can find the right fit.

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

 

 

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