The majority of lawyers pursuing a career in private practice have their eyes firmly set on the partnership prize. Years of hard salaried slog, long hours and indulging of partner egos are endured for the chance to get their hands on a slice of the equity and a say in how the ship is steered. Given the preoccupation with making partner, it is surprising to hear that when many associates eventually achieve the goal they have been working toward their whole career, they are woefully underprepared and uninformed about what joining a law firm partnership really means – both in terms of the financial commitment they are about to make, and the changes to personal wealth management it requires.
“To my astonishment, so many lawyers about to enter partnership often have minimal understanding of the serious implications of the financial step they’re about to take, and rarely understand or ask the questions they should about matters that affect the economics of the firm,” says professional partnership specialist Tina Williams, senior partner at Fox Williams. “Questions like, what has the profitability of the firm been over the last three years? What’s the borrowing situation? What’s the firm’s professional indemnity (PI) cover and claims record? How many partners have left in the past two years? What’s the premises situation?”
the partnership model
Louis Baker, partnership tax partner at accountancy firm Horwath Clark Whitehill (HCW), agrees that lawyers joining a partnership often do so without any concrete understanding of the firm’s financial management record. “Many may have an inkling of how good the firm is at chasing bills and managing cashflow, but because they’ve always been on a salary and sometimes been working in the firm 10 years, that billing policy is all they’ll have known. Likewise, they may have an idea about the level of partner earnings, but this tends to be based on presumption rather than actual knowledge.”
Two of the most important considerations for any new partner are the way their particular firm funds its equity reserves and its partnership model.
Law firms rely on a mixture of long-term and working capital and the amount and ratio of these varies considerably. There are three traditional ways to fund these reserves – bank debt, partner capital and distribution of profit – and most firms use a combination of the three and mix and match, depending on their appetite for debt and attitude to growth.
Whether the partnership model is a seniority based lockstep system, or an ’eat what you kill’ merit-based approach, or – as is most likely – a combination of both, also has an impact on the financial considerations attached to making partner. “Traditionally, equity partners are required to contribute capital in proportion to their respective percentage entitlements to the overall profits, tied to the level of their capital contribution, whereas by nature fixed share partners aren’t normally required to contribute significant amounts of capital,” explains Williams. “There is now talk of certain firms – for example, DLA Piper – asking fixed share partners to invest more than the usual nominal amount.”
Most law firms today rely on lump sum capital injections from partners to fund long-term capital needs such as investing in new premises or expanding overseas. The day-to-day cash flow requirements of the billing and collection cycle, and general overheads, tend to be covered by partners taking profits on a deferred basis. “In days gone by, a new partner would simply buy their stake in the firm from a retiring partner,” says Baker at HCW. “While this may still happen occasionally in the smaller high street practices, by and large firms now simply require an amount of money to be put in to the firm and that same amount of capital comes back when the partner leaves.”
There are a variety of ways to fund the initial equity stake: by a lump sum cash payment, a personal loan, a loan arranged by the firm or by retained earnings. Most lawyers favour a centrally organised loan, as the firm tends to have access to preferential rates, but there are exceptions, says Withers partner Patricia Milner. “Some partners prefer to arrange a loan with their personal bank because they want to retain some confidentiality over their financial dealings,” she says.
According to Colin Ives, head of professional services tax at accountancy firm BDO Stoy Hayward, while the capital repaid when a partner exits has historically matched that paid in on joining the partnership, the recent squeeze on lending has led to pressure from banks for partners to reduce that capital loan over time. “Partner capital loans are definitely getting more difficult to obtain than a few years ago,” agrees Baker. “Banks are looking more critically at applications from new partners, and charging higher rates.”
Banks may be making borrowing more difficult, but from a tax perspective, explains Ives, partners are advised to take advantage of the full partner capital loan where possible because it is extremely tax-efficient. “Partners can claim 40-50 per cent tax relief on the interest paid,” he says, “with the firm normally covering the rest of the cost of interest through profit share.”
For Williams, candidates pay far too little attention to the amount they are borrowing to fund partnership capital, because the interest payable earns tax relief. “Where it becomes horribly painful is if they have to pay that money back to the bank, and either the firm doesn’t have the money any more because it’s insolvent, or if repayment of capital can be deferred over a long period, and the partner’s making a lateral move and has to inject capital into the new firm,” she says.
Partnership agreements are usually drafted so firms are not placed in a cash crisis if partners leave unexpectedly, and for that reason it can take up to several years to retrieve capital. “There’s often a moment of realisation when a partner turns ashen and contemplates that they’re no longer eligible for tax relief in respect of borrowings to fund capital in their former firm, but may have to wait some time to be repaid,” adds Williams.
Tax is an area where newly made-up partners regularly come unstuck, says BDO’s Ives. “Salaried partners operate under PAYE, like any other employee, but as lawyers become equity partners they also become self-employed and subject to a totally different tax regime, which is often something of a mystery to them.”
One of the most important considerations at this point is whether the firm is going to retain tax on their behalf, or if they have to take over responsibility for it themselves. “If the firm is retaining tax then that’s one thing, but if not, and depending on when the firm calculates the financial year from, an undisciplined partner might be hit with a tax bill for up to a year and a half,
and if they haven’t been putting aside funds that can come as a nasty shock,” says Ives.
Another important consideration, often overlooked, is whether the firm has general partnership or LLP status. “In a traditional partnership, partners will be at the bottom of the queue of creditors and all partners are, by definition, jointly and severally liable,” says Milner at Withers. “A firm may have an internal policy where the more senior level partners indemnify new partners against the worst happening, but new partners still need to understand the value and scope of that indemnity.”
myths, wills and marriage
While making partner in an LLP may appear less onerous, the rights of LLP partners in a disaster scenario remain largely untested and there are other myths surrounding the security that limited liability status provides. “In the past, when most lawyers were practising in general partnerships, partners thought far more carefully about protecting their assets by putting them in trust or transferring to their spouse,” says Williams. “These days partners tend to think that none of that’s necessary because they’re protected by the LLP, but they’re mistaken.”
Withers partner Stephen Cooke agrees. “As an LLP partner you’re still liable for mistakes made by you to the extent those aren’t covered by the partnership assets or your professional indemnity insurance, so LLP status is far from the panacea people think it is,” he says. “Indeed, banks are also increasingly looking for personal guarantees from individual partners when lending to an LLP firm.”
Milner also points out that wills, surprisingly, are also regularly overlooked by new partners. “A young partner coming in might not have accrued considerable wealth yet, but being made up often coincides with other personal changes, such as getting married and starting a family, so a will is vital.” Some partnership agreements require that every partner has a valid will, says Milner.
“Often the partnership deed will specify that executors of the will have to accept the accounts published by the firm, which is not
a big deal with an LLP, which has to make the accounts public anyway, but can be significant when dealing with a general partnership.”
Marriage has considerable implications for wealth planning, says Milner. “Young partners, embarking on what is hoped will be a long and illustrious career, should think about prenuptial agreements if they’re planning on marrying soon, and when they do marry, their will is automatically revoked so they’ll have to draw up a new one. The same applies to a civil partnership.” Once married, inheritance tax relief also becomes much more important, as do life insurance, critical illness cover and pension arrangements, she adds.
“Membership of the staff pension scheme comes to an end on becoming a partner,” says David Lovell, director at financial advisory firm Saunderson House, “and lawyers have to consider carefully what to do with those existing accrued funds. If they’ve been part of a group personal pension they might simply maintain that account by continuing payments themselves. If it’s a large enough sum, say upwards of £250,000, they may be better to move it into a self-invested personal pension arrangement.”
Insurance arrangements also need to be reviewed. “New partners also need to make sure they have cover in place for everything they can’t afford to lose and should take advantage of the firm’s competitive rates and do it as early as possible, while they’re young and fit,” says Lovell. “Firms usually have a level of automatic cover in place for partners, but sometimes that cover isn’t enough and individuals may have to add to it. Some firms even offer additional discretionary tiers to top up cover.”
While it is imperative that newly made-up partners get their finances in order, the wealth management considerations of partnership don’t come to an end when this checklist is completed.
Recession has led law firms of all sizes to reconsider and restructure their capital arrangements, forcing partners to do the same with their own personal finances. Many have found their drawings deferred for longer and longer periods, or had to extend their partner capital loans to bolster the firm’s capital base, in a far less favourable lending climate.
The last 18 months has seen record numbers of firms undertaking capital restructurings, including Clifford Chance, which raised £60m in its cash call of November 2008, Pinsent Masons, where partners were asked to inject an additional £2,500 per equity point, and Denton Wilde Sapte, which conducted a £1,000 per equity point cash call in May 2009. The rise can be explained, in part, by the number of firms that have converted to LLP since the last recession. “This time their financial dealings have been laid bare and conducted out in the open, whereas in the past there has been far less known about how a firm’s capital base was affected by a downturn in revenues,” says Ives.
In previous crises, law firms have tended to rely on delaying profit distributions to cover their increased need for cash. The requirement to contribute additional capital is a relatively new phenomenon, and one that Williams of Fox Williams agrees is a sign the world of law firm finances will never be the same again. “In previous recessions, firms didn’t talk about figures in this way, but because so many are now LLPs and have to file accounts publicly, there’s far more transparency,” she says.
Another reason behind the rise in cash calls is a squeeze on bank debt, which has become more difficult and expensive to secure. Hit particularly hard have been those firms that enjoyed increasing profits over the last few years, but didn’t increase their capital base accordingly.
And there are more cash calls to come, predicts HCW’s Baker. “When the downturn hit and bank finance almost totally dried up, firms raised what they needed on an immediate basis,” he says. “It’s now clear that the economy will take some time to recover and so many firms are looking afresh at their cashflow forecasts and may be forced to make another call to reset their capital base for the longer term.”
With firms everywhere reassessing their capital structures, understanding the financial implications of making partner has never been more crucial. “Lawyers approaching partnership need to recognise that the world has changed,” says Baker. “Until recently, being offered partnership was what associates always dreamed of, a total no-brainer, but today they need to be asking serious questions about what taking that step will mean to them financially.”
Nick Holt, partner at SR Search
A new partner will want to know many things about his or her new firm. At the top of that list should be capital. The following questions should be raised at as early a stage as possible:
- How much do I have to contribute, both on initial admission to the partnership and at any time in the future?
- Where do I get the money to fund my required contribution?
- Am I entitled to interest on my capital?
- When and how do I get my capital back when I leave or retire from the firm?
The answers to these questions should be studied carefully – in recent months a number of firms have substantially revised their capital contribution criteria, often ’inviting’ existing partners to contribute additional capital to their firms, either by way of capitalising undistributed income or by an injection of
Most firms will have more than one class of partnership, with a distinction being made between equity and non-equity. The titles may be different according to the firm, but a new partner needs to take time to find out precisely what sort of partnership is being offered.
Non-equity or salaried partnerships have historically not come with a requirement to contribute capital, but some firms, in an attempt to ensure that the interests of all its partners are more closely aligned in challenging economic times, have recently asked salaried partners to make capital contributions. £25,000 is the sort of amount that previously salaried partners have had
Equity partners will be required to contribute capital, with the amount to be contributed varying from firm to firm. As a general observation, the larger City firms have historically required their partners to make a one-off initial capital contribution and no more. This is simply paid back on retirement or when the partner leaves the firm. In other cases (and this will often apply to the US firms in London), the amount is linked to compensation. For example, some firms require equity partners to contribute capital equivalent to 35-40 per cent of their annual compensation. As compensation increases, so does the capital requirement, which will usually be effected through a deduction from compensation. Would the capital requirement be relaxed in the event of either a decrease in compensation, or if a partner is de-equitised, both of which are more common these days?
The more capital invested in the firm then the more attention a partner should pay to the provisions dealing with repayment of capital on departure or retirement. The law is now an increasingly mobile profession, and with more and more lateral moves, the departure provisions are often key. Some firms now attempt to use the return of capital as a lever when it comes to matters such as compliance with restrictive covenants and other post-departure obligations such as a non-solicitation obligation. A partner who is deemed to be non-compliant can find that capital is returned over a far longer period – five to 10 years – than one who is.
When it comes to interest on capital, some firms may pay interest on all or a part of the capital, others pay none. It is clearly sensible to check this point if you are taking out an interest-bearing loan to fund the capital.
Looking forward, there is no saying how the traditional law firm capital structure will be affected by the implementation of the Legal Services Act provisions that will allow external investment. Partners may well see their capital contributions become equity shares with some form of market value, in which case a whole new set of considerations may apply.
An offer of equity partnership to an associate in a firm was, until recently, met with an instant positive response. Apart from a perceived rise in status within and without the firm, the offer contained an increase in income, albeit implied, and an influence as an owner of the business on the firm’s direction and policies. Most accepted without too much deliberation.
The situation has changed dramatically in the last few years. There is the realisation today that law firms, like any business, carry financial risks and the owners of the business share those risks. The economic recession has brought home to many partners that profits can go down as well as up and partnerships generally have not been good at building up reserves.
This recession has also highlighted another risk and that is the failure of the firm with the loss of capital and, possibly, the need to fund a financial deficit. Both in the US and the UK this has occurred to a number of firms over recent years. Partners might find a role with another firm but they might also have to pay off their share of the debts owing by their previous firm.
The current economic climate means that associates who are considering equity partnership in any firm need to be much clearer about their income prospects and the capital arrangements than ever before.
So what does this mean today for associates who are having the prospect of equity partnership dangled before them?
Our checklist of precautionary issues is as follows:
1 Obtain the last three years’ financial and management accounts. Have an accountant or consultant assist you if necessary in identifying negative or positive trends in how the firm has been generating profits. Look for things such as changes in utilisation and average realised billing rates. Look at the changes in revenue and costs and the underlying profits. Understand the profitability of the different parts of the business and question management about areas that have low or no profits.
2 Obtain the cashflow statements for the last three years. Have borrowings increased over the period? Have they increased as a percentage of revenue and of partner capital? What is the source of borrowings and what are the security arrangements – is the partnership the guarantor or are partners required to give personal guarantees? Is the firm efficient in billing its work in progress and collecting monies owed by debtors?
3 What are the lease arrangements and what security is in place? If the firm is an LLP are the partners still required to give personal guarantees? What obligations does a partner have in terms of the lease?
4 Obtain the balance sheet for the last three years. Has the firm been operating with sufficient working capital? Has the position 4 improved or worsened over the period? Have partners had to provide additional capital over the period and, if so, how was that managed? Did they have to raise it from external sources or was it a conversion of undrawn profits? What contingent liabilities exist such as professional indemnity claims or other outstanding claims?
5 Obtain the partnership agreement. Ensure you understand the profit distribution policy. Are distributions paid before or after tax? Are there quarterly distributions and what are the circumstances in which they might be withheld? What arrangements are in place to fund the capital required and what amount is required? Does the capital required increase over a number of years? What special arrangements are in place to assist partners in funding a capital demand outside the norm?
6 Within the partnership agreement, review the procedures for repaying capital and undrawn profits for a retiring partner. What is the position if a partner resigns to go to another firm? How might a partner be removed from the partnership and what is the position then in regard to capital repayments and undrawn profits?