From Accounting and Financial Planning for Law Firms, September 2012
The recent collapse of Dewey LeBoeuf has highlighted the importance of pre-merger due diligence. While I was not involved in the merger of the two firms, I did consult to both firms individually prior to their merger and was both sad at the demise of a great firm and (like many) dismayed when the details of the internal workings of the firm (and mistakes made during the merger that appear to have doomed the enterprise from the beginning) became public.
I reviewed my experience in law firm mergers and reflected on what worked and what did not. What practices and policies were beneficial to the success of a merger and what were merely “window dressing” or harmful to the success of the merger. This article is a compendium of my thirty years’ experience in law firm consulting and specifically law firm mergers.
A law firm should effect a merger or acquisition to achieve a specific, identified and defined benefit, typically these benefits include; improved client service, improved economies of scale, entrance into a new market or practice, or personal benefits to the partners and associates. Any law firm wishing to merge in the current shifting economic and professional environment must deal with four crucial ‑ and quite diverse ‑ issues, grouped under the following topics:
Practice integration issues
Performance and profitability
Each set of issues has its own unique problems and solutions; and many mergers address one, two or even three sets of issues. But, if your law-firm merger is to truly succeed, you must effectively deal with all four sets.
Practice Integration Issues
Perhaps the most frequently addressed issues in a law firm merger are those involving the merged firms’ practices. Most of the firms that I have worked with have analyzed, to some extent, their proposed merger partner’s practice. Many firms have also projected ways in which the firms can leverage each other’s strengths.
Two-pronged analysis. I believe that both of these activities are part of a larger and more comprehensive practice analysis that any merging firm should undertake during the preliminary stages. This analysis, which I call a “Cross Selling/Client Institutionalization” analysis, has two major, client-oriented objectives. The first objective is to identify the service needs of major clients, prospective clients and target markets of the new, combined entity, and to determine the extent to which the new firm meets those needs. Wherever the firm is not currently serving an identified need, but has the capability to do so, the firm should prepare a plan to introduce the client to the firm’s expanded capabilities. This plan should identify the client’s service needs, designate the partner responsible for introducing the client to the firm resource, and provide a timetable for cross selling of the service. These plans should be approved by firm management, and monitored by the appropriate departmental or practice-unit leader.
The second objective is to identify and quantify the increased number of contacts at each client that emerge as a consequence of the merger. These contacts will, over time, help the firm establish and nurture long-term relationships with the client (the “client-institutionalization” process).
Self-assessment. In addition to providing an opportunity to identify client needs and contacts, a merger also presents an excellent chance to analyze, in detail, the skill sets and experience possessed by the individual attorneys from each firm. Such an analysis would identify, for each practice area first, the various areas of specialization or expertise within a specific practice. Then, the analysis should assess each attorney’s experience within a given specialization.
One good way to assess the individual and combined strengths of merging firms is to develop the same type of matrix for each firm. When these matrices are combined into a single, composite matrix, the new combined firm’s significant “bench strength” will become immediately apparent. Similarly, this exercise also quickly highlights the new firm’s deficiencies, as well as redundant resources. Identifying such strengths and weaknesses early in the merger helps management pinpoint areas requiring immediate attention, and, consequently, allows them to prepare and ready remedial plans for implementation when the merger becomes effective.
Location. Another major issue that should be addressed during preliminary discussions involves the geographic location(s) of the newly merged firm’s offices. A merger provides an excellent opportunity to evaluate the economic viability of both firms’ existing offices, as well as the need for new office locations.
For example, combining two firms can create enough business in a given location to warrant opening a new office. When performing an economic viability analysis for an office, remember that it is critical to identify all the revenue generated by that office. In many instances, for instance, offices that do not appear to be paying for themselves actually refer a significant amount of business to other firm offices, either because the required expertise resides outside the referring office, or because the client needs to conduct business outside the office’s location.
Leadership. A final practice issue that should be resolved before a merger is finalized is the leadership of the new firm. Here, I am addressing the leadership of only the various practice groups within the new firm (the subject of overall firm leadership will be addressed in the section on administrative issues).
It is important to clarify, early on, who will be the leaders of various practices or departments. Such clarification will facilitate the smooth integration of the practice groups and head off future misunderstandings. While some merging firms divide the practice-leadership roles equally or proportionately among the former practice leadership, I would strongly caution against such a course of action. A tremendous amount of additional work and responsibility will be required of the new practice leaders, such as developing new business plans for the practice, and helping partners develop their own business plans and evaluating the relative skills and abilities of all the lawyers in the group. This weighty parcel of tasks should be bestowed upon the most qualified partner, who may not necessarily be the most senior partner in the group.
Another large and complex set of issues that must be resolved before a merger is finalized; profitability involves analyzing many obvious, and some not so obvious but very important, concerns.
Some obvious issues include comparisons of the following items in each of the merging firms:
Average number of billable hours. Calculate those figures for billable hours recorded, billed and collected by partners and associates, (and by practice unit, if possible) for at least the last three years (five is optimal). This gives each merging firm a clearer understanding of its potential merger partner’s normal utilization, realization and collection rates (excluding one-time, non-recurring special situations), and highlights any positive or negative trends.
Projections and proforma financial information. These also should be prepared for three, preferably five, years. When conducting these comparisons, it is important to understand the basis for each firm’s accounting records. Most firms utilize a modified cash basis of accounting. However, this method is far from an exact science and there can be significant differences between one firm’s modified cash basis of accounting compared to another. Due diligence is typically performed on certain aspects of each firm’s historical financial data. I recommend that potential merger partners exercise great care in preparing comparable statements; and that they avoid circulating proformas to the partners until they have been reviewed and approved by qualified professionals. Once all of these documents have been prepared for each of the merging firms, consolidated proforma profit & loss, balance sheets and cash flows along with projected information can be developed.
Operating ratios. In addition, a three to five year comparison of the merging firms’ key operating ratios should be prepared. These ratios should include profit margins (for the entire firm, by office and practice area), time worked to cash-collection cycle, average days outstanding for receivables, client-fee ranking, fee and disbursement write-offs, credit-line usage, and partner capital in each of the firms.
Some of the less obvious, but crucial, items to be compared include:
- · Unfunded pension liabilities of each of the merging firms, percentage of future firm earnings required (e.g., by partnership agreement) to be devoted to future retired-partner payments, and any excess partner capital which may result from restructuring the capital requirements of the new firm.
- · Amount of bank borrowings currently held by each firm, as well as the firm’s ability to maintain its credit line in the event of a merger.
- · All major future financial obligations that could affect the new merged firm. Of particular importance are expiring office leases, planned major technology upgrades or office infrastructure, relocation costs, or upcoming balloon-loan payments.
- · Tax consequences of merging the firms, from both a firm and an individual perspective. If, for example, the tax year-end of the combined entity differs from the tax year-end of either or both of the merging firms, there can be significant tax consequences for the partners. (The tax law dictates the year end a firm must employ.) Similarly, if the merged firm uses different income tax accounting methods than that used by either or both of the merging firms, this too can affect the partners. Perhaps the most significant issue is state income taxes. If one of the merging firms has offices in more than one state, the partners of the combined firm will become subject to tax in each state in which the combined firm has an office.
- · Age of the major “rainmakers” for each of the merging firms. This comparison should also identify these partners’ significant client responsibilities, and what, if any, client-responsibility succession plans have been, or will be, put into place.
Billing and collection practices. These also vary widely among law firms. In some firms, clients are invoiced monthly, and invoices are prepared by a professional billing department. In other firms, invoices are prepared by the secretaries; in still others, the partners prepare the invoices.
There is also a wide disparity among firms’ collection practices. Some firms penalize partners who fall behind in their collections, while other firms merely give lip service to the function.
Again, there is no “right” answer to these different approaches to billing and collection issues. There are however, various ways in which different firms approach these matters and you need to understand the mindset that your potential merger partner brings to each.
A final cultural aspect that should be explored before a merger is the work ethic of each firm. In some firms, partners record 1600 or fewer hours per year with little or no consequence. In others, partners regularly record 2000 or more billable hours. Prior to embarking on a merger,
it is vital to establish the degree of commitment that the new firm will expect from its partners, and all prospective partners should commit to meeting these goals.
The numerous administrative issues that must be addressed before a merger include who will assume the senior-management responsibilities of the new firm, how the practices will be organized, and who will lead them. In addition, the firm-governance documents (such as
partnership agreements, and compensation and retirement plans) may require extensive amendment or redrafting.
Leadership. The administrative leadership of the new firm should also be decided upon. Similarly, the Executive Director, CFO, CIO, Director of Finance and the various administrative department heads should all be identified, and their new roles and responsibilities defined.
Infrastructure. The firm’s IT staff should evaluate the administrative infrastructure (networks, server platforms and desktop applications) to determine if these components can handle the increased volume, and to decide which systems will be used after the merger. A comprehensive plan to migrate to the survivor systems (including estimated costs and conversion work plans) should be prepared and approved.
Any evaluation of the administrative infrastructure must also include an assessment of the merging firms’ accounting and management reporting systems. A detailed work plan must be developed for integrating these systems as quickly as is feasible. Similarly, plans must be developed for integrating any intellectual-capital-management systems, and extending the resulting system throughout the new firm.
The merger could also serve as a catalyst to critically evaluate all existing administrative-support systems in both firms and selecting new, superior ones. The merging firms can gradually migrate to the new systems, enhancing the level of support provided to the merged firms’ attorneys and further “cementing” the merger.
Often overlooked until the very last moments in the merger process, cultural issues are commonly bypassed as the firms’ management deals with the more tangible issues discussed above. However, delaying discussion of these topics until the end of your merger discussions is a mistake and not dealing with them at all can be fatal.
You cannot assume that your potential merger partners see the world the same way you do. Firms that outwardly appear very similar are often in fact quite different. Typically, detailed discussions of cultural issues must be undertaken to reveal how a firm truly thinks about and deals with these matters.
Some of the most important cultural issues that need to be addressed in a merger discussion include:
Firm-governance and partner-admission practices. How your prospective merger partners view their role in their firm’s administration is very important. Some firms have a very democratic history, in which no major decisions are made without first consulting the partners, building a consensus and then obtaining a “super majority” of at least 75 percent of the partners’ vote. In these types of firms, the partners view themselves as active participants in the day-to-day administration, expecting the firm to operate like an Athenian democracy.
Other firms have a strong leadership style. In these, once the firm management is elected to its term in office, few if any decisions are brought back to the partnership for a vote. Most communications to the partners are after the fact and for information purposes only. Partners are not expected to be involved in the decision-making process; they function more like a board of directors, setting policy and leaving the implementation to the elected management of the firm.
Neither of these approaches (nor the multiple gradations in between) is the “correct” approach for all firms. Governance style is something that is very peculiar to an individual law firm. What works in one firm will not necessarily work in another. The issue that you must address is: “Can this approach work in our new firm?”
Finding the Right Solutions
At SB2 we believe that a successful merger is one in which each firm is aware of what both it and its partner contributes to the new enterprise. We also believe that, in many situations, using the same outside consultant for both merging firms helps maximize the consistency and objectivity with which each firm is assessed. Similarly, the consultant helps maintain this consistency through the creation of the new firm, thus significantly facilitating the transaction. The role of this facilitator is to:
-Assist in keeping the management of the two merging firms focused on the real objective: a merger that will benefit both firms in the long run. Remember, sometimes one plus one equals four.
-Understand the motives, desires and fears of the partners on both sides of the merger, work with the management of both firms to address partners’ concerns in order for management to develop a strong consensus among the partners for the merger.
-Help ensure that all data, reports and projections are prepared in a fair and consistent manner so that both merging firms rely on the same information. Discussions over the numbers should be about their assumptions and projections, not about the reliability of the numbers or the motives of those who prepared the information.
-Assist in developing a comprehensive partner capital plan that apportions the equity of the new firm among all partners of the new firm. Keep in mind that partner equity need not necessarily be commensurate with partner compensation.
-Assist in quantifying the costs of the merger, the preparation of comprehensive integration-merger work plans and defining the roles and responsibilities of the new firm management in the execution of those plans. Establish 90-day, 180-day and 1-year goals for the new merged firm. Circulate these goals to the partners and report progress against them, on a regular basis.
Some Final Recommendations.
Cash is king. Always remember, in a merger situation, to beware of inordinate capital expenditures. More often than not, no matter how precise the estimate of your merger costs, unforeseen circumstances are bound to arise and the merger will cost more than projected. In view of this, you should aim to strengthen your balance sheet and, if possible, reduce your debt load. For example, take the opportunity afforded by the merger to launch a billing-and-collections campaign in your firms.
Do it quickly. The longer it takes to consummate the merger, the more objections your partners will raise. After all, lawyers are trained to look for potential flaws in an agreement. On your end, recognize that no merger document or plan can or will be perfect. By the same token, don’t try to write the perfect merger agreement. Instead, realize that your plan is, by and large, a set of guidelines to help you navigate the merger process. The merger negotiations should follow a logical pattern, resolving the identified issues as quickly as possible.
Most firm management significantly underestimates the degree of internal focus by their partners and associate during merger negotiations. The internal focus will have a negative impact on your operations. In addition, external forces, such as executive search firms and other law firms, will try to capitalize on the uncertainty of the situation. If enough damage is done, the merger deal could be called off and each firm could be seriously weakened by the resulting situation.
Don’t neglect clients. Be sure to keep your clients informed of your plans and progress, particularly the major clients. You must handle your own merger the way you deal with client matters: quickly, professionally, as efficiently as possible, and without any sacrifices in client service.
You can acquire a business, but people must merge. Regardless of the relative sizes of the two firms and the agreed-upon new leadership, any law firm merger will only be successful if key partners and associates are retained and become committed to the vision for the new firm.
Potential deal breakers
Based on our experience, there are various issues that can be critical to a law firm merger. For example, the alignment of varying capital amounts pose difficulties. How will the excess capital of one firm be paid out? Immediately by taking on additional debt or in future years, assuming predetermined profitability hurdles are met? Likewise, how will the partners of the new firm be compensated? Merit based, “lock-step” or a hybrid thereof?
Significant adjustments resulting from conversion to a comparable basis of accounting can also create problems. For example, going from or to a full accrual or modified accrual basis vs a cash or modified cash basis could result in very different operating statistics than originally viewed.
In a similar manner, if goodwill is involved in the transaction, how will it be computed and what impact will it have on future operations and cash payouts?
Still another key issue is whether the billed and unbilled receivables of each firm should be contributed to the new firm or liquidated under the former individual partnerships. For income tax purposes, the resulting consequences may be the same regardless of the accounting treatment. Also, if the receivables are contributed to the new firm, how should the estimated collection reserves be computed?
Likewise, dealing with differing partner retirement plans can create more challenges. For example, one firm may have a fully funded plan vs. another which may have an unfunded plan or no plan at all.
Another example of a potential critical issue is if one firm has a favorable office space lease and the other has one at or below market; how will this be addressed?
Basic operating cycles may be at odds. For instance, some firms collect receivables and distribute earnings relatively evenly during the year. Others rely heavily on revolving credit lines to finance their operations during a portion of the year (typically the early portion of its fiscal year). These firms often collect a very significant amount of its receivables (up to 40% – 60%) during the last two or three months of its fiscal year. Sometimes this situation exists due to the nature of a firm’s practice and sometimes it results from the operating style of the partners. The question arises, how will these significantly varying operating styles be reconciled for the new firm?
There are numerous other issues concerning a potential law firm merger, many unique to a particular firm or situation. Regardless of how much experience a law firm may have in connection with M&A deals for its clients, the merging of professional service firms can be very different than that of two corporations. The use of professionals who have dealt with this unique area can be very beneficial.
Merging two firms is not an easy business, nor is it a panacea that will solve all of a firm’s problems. However, if a merger makes good strategic sense, is thoughtfully planned and relentlessly executed, the results can be more than worth all the effort.