Are two better than one? Facing the challenges of the Legal Services Act

Considering mergers in the context of the Legal Services Act.

What might drive two firms to think about going through the considerable effort and upheaval of merging, particularly in the current and unpredictable economic climate? The more conventional and obvious reasons will always be relevant. Not only does a merger give a firm a chance of tapping into new clients, it can also create the opportunity for a firm to become more competitive by offering clients a wider, more efficient service. A less obvious reason is that a merged firm would be better prepared to face some of the challenges facing the legal sector in the coming decade as a result of the Legal Services Act. Consolidation may be necessary to create a firm that will have the sufficient capital and expertise to compete against the innovative firms that do obtain external finance.

Those firms seriously thinking about approaching external investors would be strongly advised to look at their management structure and market profile sooner rather than later in order to ascertain whether they are an appropriate target for investment. In order to attract outside investors, firms will need to show that their goodwill and turnover can be sustained in the long term, even if certain key individuals leave. Unless generalist firms can develop robust reputations independently, merger with a suitable practice may be the only way of improving the chances of obtaining investment.

Preliminary steps

Assuming partners have decided that a merger is the way forward, what are the preliminary steps to be undertaken? The obvious and main preparatory step is to identify a suitable merger target. Unless the choice is clear-cut because of common practice areas or similar geographical scope, it is more likely that an external consultant will have to be retained to research the market and identify a potential target. It will be prudent to undertake a due diligence exercise on the potential target which will focus on:

• Business fit – Will the merger enable the firm to attract greater, better quality, more profitable work? Or might the merger lead to more conflicts?
• People fit – Are the respective cultures of the firms compatible? If not, then can any differences between the firms be reconciled and how?
• Financial integration – Do the firms adopt similar remuneration structures? If not, the manner of calculating and sharing profits will have to be addressed carefully. Does the firm own any freehold properties? If so, will partners be looking to realise any value in such properties?
• Integration of IT systems
• Staff employment contracts (together with details of all contractual benefits including bonus schemes)
• Any pension schemes operated by the firm and in the event of a final salary scheme, it will be important to clarify whether the scheme is in deficit.

Negotiating the merger

Having finalised due diligence, and assuming the firms are still keen to do a deal, a number of issues will need to be addressed and negotiated which will form part of the merger agreement. In summary, these issues include:

Structure – Will the assets of one firm be transferred to another or will both firms transfer the assets to a new vehicle? Indeed, if both firms are general partnerships, it may be a good opportunity to convert to an LLP. Are all partners joining the merged entity?

Form of partnership agreement - Can the existing partnership or membership deeds be easily reconciled? This should not be too complex assuming early analysis concludes that both entities share a common cultural ethos.

Liabilities – Are all liabilities to be assumed by the new merged entity or will some be ring-fenced? This may not be such a critical issue if the merging firms are LLPs. Careful thought will also have to be given to any outstanding annuities payable to former partners. The terms upon which such annuities are paid will have to be reviewed to ascertain whether such obligations can be assumed by the merged entity.

Management – How will the new firm be managed and which partners will take responsibility? This will be important as it will be the management team that will be charged with driving through the merger’s objectives and goals.

Completion Balance Sheets - The basis of any completion accounts will have to be finalised. If one firm is significantly more profitable and/or valuable than the other, then remuneration structures will have to address such differences.

Finance – Agreement will need to reached on the valuation of each firm’s work in progress and capital is contributed the merged firm.

Common pitfalls
In any merger negotiations there are likely to be some problems that the two firms will encounter. Common potential pitfalls tend to centre on profit shares, staffing and partner requirements, property liabilities, management roles, areas of non-core business and professional indemnity insurance (including successor practice issues).
Assuming none of these prove insurmountable and can be addressed in a constructive manner, a successful merger may beckon.

Fergus Payne is a partner and Miguel Pereira an associate in the corporate Team at Lewis Silkin