When it comes to succession in larger firms there are a number of facets that need to be considered – transition of clients from one generation to the next, the management of the firm and of course the financials, or transaction of succession both in and out. This article looks at the financial side and only from the perspective of an incoming equity holder.
Almost all larger firms (and an increasing number of smaller firms) have some sort of lockstep arrangement for incoming equity partners. There are two broad components to a lockstep system, the lockstep itself and the capital contribution. Not surprisingly there is no one size fits all approach and the number of different systems are almost as numerous as there are firms. So here is a general guide to what happens.
By way of background, there are a number of reasons why lockstep entry to equity has become a cornerstone in many practices. This includes:
- Ensuring senior people are not adversely affected by admitting new partners given the (likely) discrepancy in relative contribution – i.e. their profit points don’t become diluted
- Making it affordable for new partners to ‘buy-in’
- Progressing people up the equity ladder with reference to their contribution
- Ease and fairness in introducing a differential compensation regime if that is what is wanted
- Ease of entry and exit from equity – these firms have no ‘goodwill’ so a valuation is not necessary, exiting partners just have their capital contribution returned
The lockstep itself is relatively straightforward. Generally, incoming equity holders will be issued with a reduced number of equity points. For example, full equity partners may have 100 points and new partners come in at say 50 points and as such will earn half the amount of profit of the full equity partners. Annually the new partner will acquire new points until such time they become a full equity partner, usually in five to seven years. Of course there are many variants to this. Some firms will have longer or shorter timeframes to full equity, others have performance gates at stages along the lockstep that one must satisfy to progress or the starting points may differ.
Capital contributions of larger firms range between $150,000 per partner to $500,000 per partner with an average of $310,000. How this is paid varies between firms ranging from the firm’s bank making a facility available to new partners and they in effect sign a personal guarantee through to a new partner having to source the funds themselves. Many firms pay interest on the capital contribution.
The capital contribution serves two purposes. The first is to provide commercial focus, the second and most important is as a key funding component of the firm to cover the firm’s operating needs, growth plans and unexpected events. The day to day operations of a firm are usually funded by a mixture of debt and equity. The financing needs will vary by firm, but will usually include the firm’s billing and collection cycle, some asset purchases and a cash reserve.
Capital contributions usually cover about three months of operating expenses which does not leave much room to fund expansion. Debt is often used to cover asset purchases or fund office fitouts with the amortisation of the debt being aligned to the depreciation of the asset which makes for relatively painless repayments.
Debt has been also used to fund expansion initiatives – both the infrastructure needed as well as the operations. Lateral hires or tucking in a practice group will require additional funding of at least three months (or more depending on practice area) before the new hire or group generates sufficient cash to cover expenses.
Most firms have set their capital structure based on business as usual with little plan for unexpected events – loss of clients, loss of practice group or general economic downturn. In each of these instances there will be cash constraints unless the firm is able to reduce expenses in line with any revenue loss. There have been a number of instances, not necessarily among the firms reviewed, where following a downturn borrowings were used to support partner compensation. Over the long term this is a ticking time bomb.
Maintaining a financial cushion in terms of real equity capital on the balance sheet should be a goal for all firms. This is easier done by retaining profits during buoyant times. Unexpected events will arise, some will cause a cash crunch others may be an acquisition opportunity. In either case having a strong balance sheet will make it easier to cope.
Sam Coupland is a director of FMRC and works predominantly with small partnerships. Sam is considered the foremost authority on law firm valuations and would value more law firms than anyone else in Australia