Partners no more

In a typical law firm partnership, partners finance their share of the capital account and all of the profits are distributed each year. The partners often earn high revenues through their working life and, at the end, they walk away with nothing other than their share of the capital account.

This traditional business model allows for a constant succession of owners where the incoming owners are not required to compensate the outgoing owners for the value of the brand or the goodwill. This model has persevered because the legal profession has traditionally been restricted in both the nature of the activity, restricted to the provision of legal services, and the ownership of the equity, which has been restricted to the fee-generating lawyers. Remove one or both of these restrictions and new opportunities and pitfalls arise.

The Legal Services Act received Royal Assent on 30 October 2007. It sets out the framework for a reform of the provision of legal services which includes the introduction – anticipated in 2012 – of alternative business structures (ABS), which will open the way for multidisciplinary firms to emerge and for non-lawyers to own law firms in which lawyers ply their trade.

These changes, once implemented, will remove the traditional restrictions and are likely to prove to be attractive to law firms. Accordingly we can expect to see mergers of professional services firms from different disciplines, the transition of law firm partnerships into corporations with third-party investors and, possibly, the listing of a major London law firm on a stock exchange.

While these changes are eagerly awaited by some, there is no hint in the Act of the potential pitfalls of exploiting these potential new opportunities. These difficulties will arise both from the impact of developing a business that recognises goodwill and value beyond its ability to produce a current income stream, and the introduction of non-lawyer shareholders.

Asset management
Despite the traditional restriction of the activity to the provision of legal services, many law firms have experienced the difficulty that may arise from the ownership of a valuable asset (typically a building). Similar issues have arisen in so-called offshore law firms, where the partners have developed peripheral businesses in company and trust administration, fund services etc.

In such situations, sooner or later, the equity holders believe they should be compensated for the value they have created, while the new partners are not prepared to pay the full value for the assets (or participate in them at all). This leads to an asymmetry in the interests of the partners that can often only be resolved by disposing of the assets or dissolving the partnership. The changes brought by the Act introduce a third alternative in the form of the ABS.

It is likely that the adoption of an ABS in one of its forms would involve a change from a profit-distributing partnership to a model that seeks to pursue shareholder value.

Converting from a partnership to a company changes the nature of equity from being a counter in the relative share of profits in a business that regularly distributes all of its profits, to a share of the capitalised value of that business.

The first issue to address is the conversion ratio. Are the closing partnership equity ratios a suitable basis on which to crystalise the equity on conversion to a company? If not, what will be the alternative? A related issue is the mechanism whereby new participants would become equity holders in the converted firm. This cannot be the same basis as in a fully distributing partnership without becoming an obstacle in the pursuit of value.

Changing status
The second issue is management. While many partners of large London law firms have grown used to functioning under the yoke of the management structures that are necessary to run what have become multinational corporations, they are still ‘partners’ in more than just a nominal sense. As soon as the participation of a third-party capital provider is factored in, however, even this meager comfort is going to be stripped away. A new world will dawn where the former partners are employees, where the profits are shared not only between peers but also with passive providers of capital, where former partners start making pension contributions and paying National Insurance. A world where a portion of the net revenues would need to be left in the business to build shareholder value and bonus payments will compete with dividend demands.

The challenge will be to persuade the equity partners to accept less revenue in exchange for a promise of dividends and growth in the value of their shares. This will clear the way for external capital that would allow the firm to achieve growth from which all shareholders benefit. The prospective equity partners would need to be persuaded that there is a new, yet valid equity path, which those on the cusp of equity will find most difficult to accept.

The mindset of lawyers will need to change. They are used to being part-owners and having a high degree of autonomy, only accountable to their partners. Now they will be more directly accountable to management and will lose their independence. They will feel disenfranchised and uncertain.

Law firms wanting to follow this route will need to be mindful of the issues they will encounter on this journey and will need to prepare the ground carefully if they are to achieve the necessary degree of buy-in from the partners.

Steve Georgala is managing director of Maitland