Types of Law Firm Structures
The legal profession has traditionally operated in a highly structured manner. Whether it’s a law firm or a solo practitioner, the rules about how legal service providers can operate have been strict – making it important for owners of legal businesses to understand what kind of business model they have in place and how that model will come into play when they decide to sell their law practice.
Structuring a new legal practice is often a challenging proposition, and it has become increasingly thorough as modern legal technology brings new opportunities to the field. Nevertheless, the vast majority of lawyers entering this field still find themselves working under one of the major structures of the past – sole proprietorships, partnerships and corporations.
These three categories function as broad distinctions, with dozens of possible variations that have cropped up across jurisdictions.
A sole proprietorship is essentially a company with one owner, although a sole legal practitioner may also have partners who are also employed by the company. This structure is almost entirely self-contained, and offers minimal protection from liability. This means that in many instances, the owner of the practice is liable for any malpractice claims against the company, as well as business debts. Because the company is so closely tied with the owner , any sale of the company is essentially one-to-one for the buyer. The buyer will take on not only the assets but also the existing clients and liabilities of the company.
Partnerships are a slightly different case, as they combine two or more principals under a single business model. Partnership prices and structures can vary widely, although they will typically consist of the division of ownership among the partners, as well as a series of operating rules that are expected to be followed by the partners. Because multiple people are involved, the prevailing model is that those partners who leave the company sell their ownership in order to transition out of the business. This means that, again, specific note must be taken of the vital structure of the business, as this will strongly influence the sale process.
The corporate model is similar to a partnership, but the framework allows for more owners and a greater level of separation of ownership and operations. Corporation models are aimed at limiting the liability of all owners, meaning that the company is technically a separate entity from the individual owners or officers. Again, the particulars of a corporation’s structure will strongly influence the sale process, and it is not uncommon for a corporation to purchase the assets of an individual officer who is retiring or otherwise leaving the firm.
Determining a Legal Business’ Value
The first step in the sale of any business is to value it. Of course, a legal business is a particular type of business, and the methods used to evaluate law firms may be different than those used for other types of businesses.
When dealing with the value of a legal business, whatever the type, most attorneys rely on two factors: asset value and the value of clientele (how much the clientele is bringing in). The combination of these two factors is generally how a law firm valuation agent evaluates the law firm. There are a number of methods that fall under the umbrella of "business valuation," including:
Asset-Based Valuation – This method basically determines business value by determining the fair market value of all assets, then subtracting liabilities.
Market-Based Valuation – This method determines the value of the law firm by finding companies of similar size and similar structure and evaluating them based on similar factors and the multipliers associated with the criteria.
Income-Based Valuation – This method analyzes information provided by the law firm owner regarding income, expenses and multiple indicators of excess earnings. It then assesses the business based on different multiples, often comparing it to earning levels for owning and operating comparable law firms.
Any of these methods can be used, but hourly billing practices can make this difficult. As mentioned above, the main concern is profitability, so you really want to work on increasing the profitability of your law firm as much as possible. The more you can bring in, the more you can sell it for later on.
How To Prepare Your Business for Sale
As you can imagine or, if you have been through the process, know, the steps required in preparing your legal business for sale can be many. And, while some lawyers may jump into the process of selling their law business (e.g., placing ads, hiring brokers), it is crucial and necessary to the overall process of obtaining maximum value that you first set the stage for a successful transaction. As discussed above, one of the first things that will be requested and reviewed by a potential purchaser’s counsel will be your (and your law business’s) financial information. Because your largest asset (i.e., your client base) will now be valued and transferred, getting your financials in order and performing an internal audit of your records will allow you to pinpoint any changes that may be needed and provide better documentation to support your revenue forecasts.
In addition to financials, your organizational and personal legal matters will be reviewed. These issues involve an audit of: (i) your law firm organizational structure (e.g., is your law business in your name or the entity you may have formed, and does the structure make sense for your retirement and ownership transition); (ii) review of all written agreements with employees, contractors, vendors, clients and others; and (iii) identification of intellectual property owned or used by your law business. Most buyers will insist that you have clear ownership over all assets, whether tangible or intangible. The more organized and accurate the information provided to a potential purchaser from the outset, the greater possibility it will lead to a successful deal and result in a closing.
Marketing Your Legal Business to Potential Buyers
Once you have a strategy in place to get your practice ready for sale, it is time to think about how to market your business to prospective buyers.
Be Confidential
Many law firms will just simply put up an ad somewhere to sell their practice. However, it can take 2 to 10 times longer to sell a practice that way and in most cases you would likely receive less than market pricing. Most buyers are business people so treat the sale of your practice like a business opportunity, not a "Fire Sale". Most likely you have clients you want to keep confidential. If you make your company confidential you will not scare away your clients.
Target your Market
There are a variety of buyers for a law practice depending on the type of practice, but in most cases they fall into two categories which are as follows: Your business broker should qualify your buyers so that you can spend your time using other resources more wisely. You should know that as a result of today’s economic conditions as well as a law firm ownership transition being part of a very slow process, only an estimated 50% of law firms on the market will sell. Therefore, the importance of targeting the right firm cannot be over emphasized.
Legal Aspects of Selling Your Legal Business
One of the key elements in selling a legal business is to perform due diligence on the practice to be sold. For a buyer, thorough due diligence will identify risks and issues, as well as assist in the valuation of the practice. For a seller, complete due diligence can help provide critical information for purpose of negotiations and assist in the post-closing integration of the practice. Any sale will be subject to the professional conduct rules applicable to the parties’ governing law . These rules govern the limits on the disposition that can be made of lawyer-client relationships. In addition, if the seller is a professional corporation, there may be additional restrictions under corporate law as to the possible buyer. Regulatory approval may also be required to effect the sale. The parties should also carefully examine the existing contractual arrangements with lawyers, clients and others, to identify any potential issues or liabilities. These negotiations and the due diligence activities will assist in closing the transaction.
Negotiating and Closing the Deal
Once an agreement in principle for the purchase and sale of the firm has been reached, the lawyer’s representative will draft a formal purchase and sale agreement. As part of any agreement for the purchase of a business, the parties will negotiate the various terms of the deal, including how the purchase price will be paid, over what period of time, what conditions may delay or prevent the closing and how cash will be transferred at the closing. Subject to the recommendations of counsel, the seller’s objectives for the transaction, and the extent to which the parties are adamant on particular points, the parties will include those provisions in the purchase and sale agreement.
Any agreement for the purchase and sale of a law firm needs to provide that all the applicable rules of professional conduct regarding sale are satisfied. While these terms will vary state by state, they generally provide that a seller’s client may terminate the relationship immediately upon notice to the seller. There is much precedent on the appropriate treatment of client files in the sale of a firm.
In the final phase of the sale process, the lawyer’s representative will draft a set of closing documents to memorialize the closing of the deal. This will include the executed purchase and sale agreement, bills of sale, settlement statements, transfer orders, etc.
Depending on the nature of the agreement, the closing may not be a single event in time or place. The parties may agree to close in stages over a given period of time, or at a series of meetings. Although the goal is to reach a single closing, that is not always possible, or in the best interests of the parties. For example, it is common for the parties to reach an agreement sometime before the actual closing, in which case a purchaser may wish to practice law in the name of the seller firm for a period of time, as contemplated by the ABA Model Guidelines.
The closing process requires the special attention of the firm’s lawyer to make sure that majority ownership is being transferred to the retiring partner(s) as soon as the conditions of the agreement are satisfied.
Opportunities and Obligations After The Sale
When the deal is done, many attorneys wonder about non-competition restrictions. Most ethical rules dictate that a sold business can’t be subject to a non-competition clause. Including one in the sale agreement may give rise to discomfort or even disbarment. Issues of post-sale competition versus competition during the due diligence phase can be highly charged. However, the default position when selling an attorney practice: no non-competition clause will be enforced against an attorney.
So what’s left? Consider other ways to help future businesses. Non-solicitation clauses typically only have teeth for matters for two years. A better solution is to develop a customer information database. Transfer the ownership of this tool along with a software license of the program itself to the buyer (and limit access to active matters only). Alternatively, share the database without transferring ownership (sustaining your right to charge for maintenance/updates to software applications). In either case, limit the access to counsel who are "representing" the former and active clients, respectively.
On a related note, make sure to separate active from closed files, so that there are no inadvertent breaches of ethical obligations when a former client calls for an update .
Some businesses thrive on the number of professionals involved on a case. The knowledge and network of a successful attorney may be critical to the ongoing success of the business after the exit. At this point, it’s time to consider transitioning out by recruiting and training a replacement. This can be a period of an active "hand-off" of network and case information.
A useful tool for the seller is an annual addendum to the operating agreement which can be a development opportunity for a younger attorney to step into the business. Generally, you’ll want to offer to transfer, donate or let-go of physical assets such as furniture, office space and/or case management systems to the associate when he/she reaches the requisite level of expertise. Either the seller or buyer can track (via accounting software) the associate’s activities over a three-year period that can potentially qualify for several millions of dollars of business value.
It’s also a good time to look to residual income. It costs less to retain single or dual partner firms than it does to recruit a new business. Using a diminished payout model to incentivize and support the transition can yield long-term gains.