Investigate to avoid liability
24 March 1998
Prospective partners should thoroughly research the financial history and current status of their potential firm, says Philip Brown. Philip Brown is a consultant with Hodgart Temporal.
During the recession, press reports of partnerships going bust leaving partners with heavy liabilities were not uncommon.
As a result, when the offer of partnership is made today, a sensible lawyer will study the available financial information before signing. The partnership deed will be examined, particularly in relation to covenants and retirement policies and many questions will be raised.
It is quite right that those considering partnership should seek assistance from accountants or other professionals. But looking further than standard resources can also be beneficial.
Generally, the information provided to prospective partners fails to answer two crucial questions. Firstly, how does the firm make its profit? Secondly, is it going to continue to make profit in the same way in the future?
Audited accounts will not answer these questions. Deeper examination is needed into each of the following areas, preferably on a group or department as well as a whole firm basis and for at least the last three years.
Find out what fees were earned during each year. Get beyond the figure for bills delivered (or, in some firms, cash received) to get to the value of work actually done during that year. This is crucial as the figures shown in the accounts may be misleading (when work done in earlier years is not billed until later), showing an increase in bills delivered, when in fact the firm may be in decline. Lawyers usually measure the value of their services by the number of hours worked. Time recording is widespread and, even if billing is calculated on another basis, is useful for comparing performance.
Look at the chargeable hours worked on a per fee earner basis. Is it rising or falling? Are partners working more hours than other fee earners? If they are, where are the partners finding the time to carry out their other essential tasks, especially managing current clients and developing new ones? If, excluding trainees, the average hours worked are less than 1,200 per annum, it is unlikely that the firm will prosper in the increasingly competitive markets.
The ratio of other fee earners to partners is called leverage. It is difficult to sustain reasonable levels of profitability unless there are at least three fee earners to each partner. But leverage is only effective if fee earners are working efficiently. If they do not have enough work then high leverage can harm a firm.
If possible, find out at what average rate per hour the firm offers its services. Then work out how much per hour is actually being realised. How big is the gap? Is it growing? A wide gap between the selling price (the rate at which the work was recorded) and the realised rate may be a warning that too senior people are doing work at a rate which clients will not pay. Perhaps partners are hanging on to work which should be done by more junior people.
If a fee earner's billings are at least three times his or her salary, the firm is likely to be making decent levels of profit. But there is one caveat: you must give a notional salary to partners in order to get an accurate picture. The notional salary will depend on the firm but should relate to the salary and benefit package a partner would command if they took a salaried position. Figures range from £70,000 for smaller provincial practices up to £200,000 for the larger City firms.
Add the notional partner salaries to the other fee-earning salaries and work out the ratio between the salaries and the fees earned. If the firm has been earning £3 for every £1 of salary then, unless other overheads are completely out of control, it is likely to be earning sustainable levels of profit. If it is nearer to £2 there are probably serious problems.
How much overhead (all costs other than fee earner salaries) is each fee earner carrying? Is it increasing or decreasing? And what is the ratio of overhead to fees earned? If overheads are more than 55 per cent of fees, they are likely to be too high.
The firm's core client base, again over a three year period, should also be examined. How dependant is the firm on a small number of clients? If it is, how secure is the relationship and the client? Could it be the subject of a hostile takeover? Could the level of instructions suddenly decrease?
What kind of work does the firm do for its top 50 clients? Are margins on that work being squeezed? Could the work dry up?
Look at the top 50 clients over each of the last three years. How solid is that client base? If less than a third of clients appear in the top 50 in each of the last three years, examine how secure the client base is.
If very few new clients appear each year, is sufficient effort being made to grow the business? If a prospective partner carries out a financial analysis along these lines, he or she will have a good idea as to how the firm makes money.
Asking for such information may make you unpopular with the managing partner or finance director, but a well-managed firm will have this information. And if it is not available, you had better ask why not.