The Great Escape

In this article we look at the practicalities of succession planning for private client firms, either through selling the firm or bringing in new partners – and what retiring partners need to do to plan their own future.

In the year to June 2018, 345 law firms closed and 154 merged or amalgamated. In September 2018, there were 10,456 law firms in England and Wales. Of these firms, we know that 2,392 are sole practitioners and that the distribution by turnover has a long tail – to get into the top 200 firms, you need a turnover of over £10m. The implication of this is that there are an awful lot of small to medium-sized (SME) firms out there, and many are ripe for merger or acquisition.

There is also evidence that law firm partners in most SMEs are getting older. Experience suggests that before the 2008 crash, many law firms were making good profits and some partners, then in their 40s, were not inclined to bring senior staff into partnership. The crash happened and life got difficult for many firms, and the overlooked aspiring partners left. This has now improved for most law firms, but those partners are now in their 50s and often have no succession plans, making them and/or their firms good acquisition targets for growing firms.

What is encouraging, however, is that experience suggests that niche private client law firms with a clear focus are particularly attractive to buyers.

Succession planning is an ongoing process, which must be planned for throughout a solicitor’s practising career. This article focuses on those looking to retire from practice (not necessarily through age!) by way of two approaches:

• merging (which is really a sale), or
• admitting new partners to replace those who retire.

It also assumes that the firm in question is a regulated firm that provides legal services through a traditional ‘collegiate’ model, rather than a more process-driven type of firm. The approach for a process-driven firm is very different and it may have a significantly different value.

Selling the practice

Where a firm has a substantial number of partners looking to retire, and no obvious internal candidates to take over the practice, selling may be the best option.

Ascertaining value

The starting point is a full and proper understanding of what the firm may be worth and what the respective partners’ interests in that firm may be. You may not get a straight answer from an accountant, other than “not as much as you may think”. Ultimately, the value is what a buyer will pay, so it is very helpful in any negotiations to understand the approach a buyer may take.

In broad terms, there are two bases on which to value a firm: an earnings basis; or a net assets basis. Unless there are genuine ‘super profits’ being made through the operation of a process which is not dependent on the skills of the partners (such as in a personal injury firm), there is unlikely to be any ‘true’ goodwill, and the overall value of the firm will be based on a sum of the realisable value of its assets.

In this respect, true goodwill is the market value of goodwill based on a multiple of super profits over and above a fair reward for the partners. It is not to be confused with the value of contingent work in progress (WIP), nor with what the partnership or sale agreement may specify for tax purposes. Indeed, it would be unusual for a private client firm to have true goodwill, as its profits are generated by the skill and effort of its partners – and not even a wills bank will have significant value.

The value of the firm’s assets will broadly be evident from the annual accounts – assuming, of course, that all assets are included there. In this respect, contingent work (of which there is unlikely to be much) is often not included in the accounts and will have to be valued. Fixed assets are unlikely to have any significant value (perhaps 10% of book value), while any historically purchased goodwill will be discounted to virtually nothing. A buyer will also be looking to reduce value by attributing amounts to onerous leases, professional indemnity claims, and potential liabilities under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE), among others.

Maximising value

The most effective way to maximise value is to go to market to a small number of potential acquirers, through a process controlled by a lead adviser. This will involve the production of an information memorandum, distributed to interested parties under strict confidentiality or non-disclosure agreements, and in accordance with a pre-defined timescale and process. Interested parties will be identified through the combined market knowledge of the lead adviser and the firm, and should be subject to the pre-approach vetting of matters such as financial strength, cultural fit (to the extent that it can be assessed), people fit, location, service offering and service approach.

This process creates a competitive market against which to assess not only the best price, but also less tangible issues, such as the best ‘home’ for clients and staff. The process is very effective in establishing in advance the strengths and weaknesses of the firm. It also enables a proper comparison of competing offers and, just as importantly, the ‘ideal’ attributes of an acquirer.

Professional indemnity insurance (PII)

In 2020, the Solicitors Indemnity Fund (SIF) will close. Run-off cover has always been a problem, but with the end of the SIF, retiring partners will have to be even more careful. Usual practice is now to operate a law firm through an LLP or limited company, and for that entity to take out the required six-year run-off cover. Historically, at the end of six years, any subsequent claims have gone to the SIF. As this will not be available in future, those retiring should think carefully about:

• being extra vigilant that the firm’s terms of engagement with clients are contractually with the firm and not the individual partner, thereby limiting the risk of ‘piercing the corporate veil’, and protecting individual partners
• taking out additional voluntary run-off cover for a longer period for higher-risk areas, such as conveyancing (private client work tends to be lower risk, but it will depend on the size and complexity of cases)
• liquidating the LLP or limited company, but only after approval by the Solicitors Regulation Authority (SRA) and a reasonable length of time (perhaps at least six months) after the cessation of trade
• selling the entity to another firm which will become the successor practice – or, indeed, paying the other firm to accept such responsibility.

Practical issues

There are a whole host of other practical issues to consider, although many will be dealt with by the acquiring firm. These include client and market notification; SRA notification / approval; payment terms of the consideration and how that is controlled (especially if due on realisation); and office space and location. The issues likely to be most problematic in negotiations will be successor practice / run-off cover, lease commitments and TUPE.

One post-transaction issue that will also need to be considered prior to and during a sale / exit exercise is psychological preparation for exit by the individuals concerned. This must not be underestimated, but carefully planned for, with a clear strategy and plan for what life will be like after the exit.

Tax issues

These focus broadly on the corporate vehicle through which the firm operates, and the availability of entrepreneurs’ relief (ER) for capital gains tax, meaning tax is paid at 10%.

If the firm operates as a traditional partnership or LLP, then it is simply a matter of selling assets and allocating as much as can be negotiated (assuming ER is available) to goodwill. Strict rules do, however, need to be complied with to obtain ER, in terms of the length and size of the equity ownership. The firm must not recommence practising within two years, to avoid ‘anti-phoenixing’ rules applying.

If the firm operates through a limited company, there is the choice of selling the shares in the company or assets out of the company. A buyer usually wants to buy assets, but a seller usually wants to sell shares. There will be an impact on after-tax proceeds, and there is often a trade-off of one against the other, but the final position will depend on the relative strength of each party’s negotiating position.

Bringing in new partners

An alternative to selling the firm outright is to sell it in a phased way, by bringing in new partners. The same issues apply to valuing the firm, although if the new partners have been senior associates or salaried partners, there is an argument that they have created at least some of the firm’s value, and they may seek a reduction in value when buying in.

A typical way of bringing in new partners is by some form of lockstep arrangement linked to the capital that a full partner contributes, and to the phased increase (for new partners) and phased decrease (for exiting partners) in their points. It is common for a full equity share to be 100 points and to expect incoming partners to purchase, say, 50 points and to increase by 10 points a year, and for exiting partners to reduce their points beyond a certain age in preparation for retirement (although discrimination legislation must be borne in mind here).

Personal pension planning

One of the most important considerations for any exiting partner is whether they can afford to retire. A key factor must be what the partner can obtain from the practice on exit, through either sale, or repayment of their capital account.

Perhaps the most effective way of ensuring (at least partially) a financially secure retirement is to maximise pension contributions during your working life, although many would argue that this is impossible to afford and that, in any event, pensions are poor value. While this does nothing to undermine the tax benefits of tax-reliable contributions and tax-free growth, it may highlight the need for strenuous efforts to increase profitability. Further, the use of self-administered arrangements operated by independent providers of self-invested personal pensions (SIPPs) and small self-administered schemes, rather than traditional insurance company options, can be advantageous.

Current pension rules as of April 2019 allow for annual contributions of £40k and a lifetime limit of £1m. The carry-forward rule, if any existing pension arrangement exists, allows for three years’ tax relief. So, if no contributions have been made, £160k can be paid in. However, care should be taken to ensure these limits apply, as where income is in excess of £150k, the amount of the annual allowance decreases, to as little as £10k when income is £210k and above.

Investment in practice premises is often very beneficial. Within a SIPP, the premises can effectively be purchased at a discount of up to 45% and rental returns are often in the region of 5-7%, tax-free.

Finally, funds (if unvested) are inheritance tax-free.

Conclusion

In this article, we have looked at the two main ways in which partners should plan for their retirement. There is no right or wrong answer, but partners must be aware of the need for planning and to start as soon as possible.

This article was first published in the Law Society’s Private Client section in May 2019.