Equity partnership may be many lawyers’ Holy Grail, but rushing in before considering the implications could leave you vulnerable, warns Nigel Rushton

Equity partnership is the goal for many lawyers. However, there are several key financial and management issues that should be fully explained before either side signs on the dotted line.

There is increasing competition to secure the most able candidates for equity partnership, but in the increasingly regulated and litigious environment of modern business, there is also greater demand from those candidates for information about the rewards and obligations their new status will bring.

The law firm itself will have very strong views on the amount and type of information they wish to reveal to non-equity partners, who may be in a poor negotiating position and unable to dictate terms in the accession process, yet will expect to receive clear and accurate information on which to base their decision to sign on the dotted line.

As firms will want to be seen to have addressed all the areas of a prospective equity partner’s concerns, their considerations will be similar to those of candidates when deciding who to offer equity to and what information to disclose.

Progression to partner

Perhaps the most common route to equity partnership is to progress from employee to salaried partner, and then to equity partner within the same firm. The term ‘salaried partner’ includes the ‘fixed share’ or ‘prior share’ partner, who will be treated slightly differently to a traditional salaried partner for tax purposes.

Clearly, partners approaching the accession process from within will already have a view of the firm and the way it runs. However, they will not necessarily know how the role of partner differs from that of employee. They may also have some preconceptions about the financial implications of partnership that will need to be clarified.

The second route, which is certainly more prevalent now than it was a decade ago, is to be invited to join a partnership anew as an equity partner. This may happen, for example, when a senior individual leaves one partnership and is invited to join another at a similar level. It may also occur when an individual joins a partnership from a senior external non-partnership position, such as industry or local government. Lateral hires do, of course, come with experience of partnership or a similar senior position, but individuals will be concerned about cultural and financial differences between firms.

Financial considerations

In terms of the information that prospective equity partners need, financial information will be at the top of their lists. They will look for solid indicators of profitability and the capital base. They will be concerned about the funding of the business, whether by loan or overdraft, and any unreasonable borrowing or long-term commitments.

The terms on which the partnership premises are occupied and for what period may also be significant. Although new to the equity, the incoming partner will want to know about exit strategy, not only for themselves, but also for other partners and especially about their exposure to funding retired or retiring partners’ annuity payments. Increasingly important are the firm’s professional indemnity insurance arrangements, the adequacy of the cover and the claims record.

Another immediate concern is the pound in their pocket. The incoming partner will often have a change of tax status and be treated as a self-employed taxpayer rather than an employee. They will also be affected by the firm’s drawings policy and details of this should be clearly understood, particularly the timing of profit distributions and any provisions that allow a reduction or suspension of drawings payments.

The provision of benefits from the firm, such as membership of a private medical scheme, which they enjoyed as an employee may now be charged to their current account. They may be required to fund a loan to meet the firm’s capital requirement. They will need to understand how taxation is dealt with, whether there is a tax reserving policy and, if so, on what basis.

Other considerations

More general issues surrounding partnership can be to do with the culture of the partnership itself. If the partnership is not a limited-liability partnership (LLP) it involves having joint and several liability for commitments entered into by the other partners.

Both the firm and the incoming partner must be comfortable with this commitment. The firm must also decide if the incoming partner can review the partnership deed and, if necessary, take legal advice before signing it. They should understand the profit-sharing arrangements and be sure the system will reward them fairly for their contribution.

A potentially contentious area is the provision of information on the financial position of existing partners. While current partners may not wish to release details of their personal balance sheet, an incoming partner would want to know if, for example, they have entered into an asset protection arrangement. It should be said that most firms do not provide this type of information and it is becoming less relevant with the increased use of the LLP model.

Many firms do provide incoming partners with information on management and strategy, such as the way in which the management board operates and the firm’s internal organisation. Targets and performance hurdles should be delineated and management responsibilities falling on the new partner should be documented. Performance reviews are often a bone of contention and incoming partners need to understand the way in which their contribution will be measured.

The above considerations remain relevant in the LLP model. However, within the LLP the level of exposure will be capped, subject to any ‘duty of care’ liability, by the level of investment in the firm. Prospective partners need to consider the LLP’s set up and the terms of its engagement with clients, suppliers and landlords.

They should be aware of potential liabilities going beyond the LLP and any personal guarantees that partners have given in connection with the business. The limitation of liability through the LLP structure has proved to be attractive in the legal services sector.

For both the firm and the partner, the decision on equity partnership is a weighty one and requires an open exchange of information from both sides. However, the biggest considerations remain age-old: for the firm it is the maintenance of equity between partners and for the lawyer it is “where do I sign?”.

Nigel Rushton is a senior manager at Smith & Williamson