George Bull, head of professional practices, Baker Tilly
Opinion: Consider structural changes before LSA forces you to
29 November 2010
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Most firms are adopting a ’wait and see’ approach to the impact of the Legal Services Act 2007 (LSA) on the legal market, confident that the big bang will turn out to be a small pop.
In any event, the Solicitors Regulation Authority’s response to the Optima Legal/Capita Group deal (The Lawyer, 9 August) highlights the restrictions on implementing any tangible preparatory steps. The true impact of the LSA will not be felt until alternative business structures (ABSs) become a reality. But whether it is the advent of ABSs, or more likely the recession acting as a catalyst for firms seeking economies of scale, increased consolidation is inevitable.
Management should be considering what should be done to meet the challenges of the new regulations.
Most readers are likely to be practising through LLPs, typically operating on the tenancy partnership model whereby partners receive high income distributions throughout their terms but no capital growth. However, a number of firms are moving towards equity participation structures in which capital value is allocated to partners in quantifiable shares.
Combining commercial and tax benefits, the LSA will be used by many to drive a capital/equity interest into their existing structures.
These equity interests could be traded internally and externally, entitling holders to participate in any capital profits generated by the sale of the business of the firm, or any of its capital assets. Benefits include the incentivisation of partners to grow capital value and more favourable capital gains tax rates.
This can create tensions between generations of partners. Also, it is notoriously difficult to broker a merger between a firm with a goodwill scheme and one without.
The biggest hurdle for firms will be reaching agreement on price. How will the partners value their share of the goodwill and what is the market? In other words, what is the firm worth and who will want to invest? The valuer’s appraisal of underlying profits plays a critical role in a valuation.
The tough bit is to unstaple the remuneration partners receive as ’salary and bonus’ from the compensation reflecting their capacity as shareholders. This can easily lead to friction, making
any valuation challenging.
It is much easier to consider these complicated issues objectively without the pressure of a material capital event in prospect and/or its impact on individual partners’ interests. A merger could fail if these issues are not addressed in advance.
A significant amount of work will be necessary to introduce any form of capital exit for partners or investors. Structural, governance and constitutional changes will be necessary. Firms that have addressed these issues in advance will be more stable and thus more likely to succeed in a sale, merger or flotation.
The recession has highlighted how many professional services firms were undercapitalised, so the days of the ‘full distribution’ model of partnership remuneration may be numbered.
But retaining profits to stabilise the firm, capitalise the business for the LSA and/or prepare for a capital event may not be tax-efficient, so some firms have been looking at admitting limited companies as ’corporate members’.
Many firms could benefit from a review of their structures. Regardless of the ultimate impact of the LSA, it is much easier to carry out such a review, and implement any changes, in advance of a material capital event.
Addleshaw Goddard managing associate Jonathan Cheney assisted with this article