JEFF GILLINGHAM PUBLISHED BY IN ASSOCIATION WITH SSG Legal
is published by Ark Group UK/EUROPE OFFICE Ark Group Ltd 266/276 Upper Richmond Road London SW15 6TQ United Kingdom Tel +44 (0)20 8785 2700 Fax +44 (0)20 8785 9373 info@ark-group.com NORTH AMERICA OFFICE Ark Group USA 4408 N. Rockwood Suite 150 Peoria IL 61615 Tel +1 773 529 5750 Fax +1 773 529 5760 info@ark-groupusa.com ASIA/PACIFIC OFFICE Ark Group Australia Pty Ltd Main Level, 83 Walker Street North Sydney NSW Australia 2060 Tel +61 1300 550 662 Fax +61 1300 550 663 aga@arkgroupasia.com Commissioning editor Anna Shaw ashaw@ark-group.com Head of editorial Kate Clifton kclifton@ark-group.com Head of production Danielle Filardi dfilardi@ark-group.com Publishing director Lucy Brazier lbrazier@ark-group.com UK/Europe marketing enquiries Adam Scrimshire ascrimshire@ark-group.com US marketing enquiries Daniel Smallwood dsmallwood@ark-group.com Asia/Pacific marketing enquiries Jo-Anne Rowland jrowland@arkgroupasia.com ISBN: 978-1-906355-47-0 Copyright The copyright of all material appearing within this publication is reserved by the author and Ark Conferences Ltd 2009. It may not be reproduced, duplicated or copied by any means without the prior written consent of the publisher.
JEFF GILLINGHAM PUBLISHED BY IN ASSOCIATION WITH SSG Legal
Chapter 1: Why law firms should consider merging THERE IS a simple rule that should apply to all mergers, including law firm mergers. This is the absolute need to produce a merged entity that is better in some way than if the two parties had stayed separate. This means that the merger creates value. You will hear many reasons for commercial mergers. When organisations say that they wish to reposition themselves, obtain new skills, get new products, enter into new markets, protect existing markets, etc., they should understand that any of these reasons must really be about increased partner/shareholder value. Shareholders must benefit from sustainable, better dividends or long term increased equity value, or both. If these results are not achieved then what is the point of merging with or acquiring other entities? There are many analysts who will disagree with such a simple vision and in today s world they need to be acknowledged. The concept is that there are a number of stakeholders in a merger, beyond equity holders, and these stakeholders need to be recognised. Stakeholders in a law firm include: Partners; Lawyers, fee earners, legal secretaries; Practice manager and staff; Families; Lenders to firm, partners and staff; Clients; Suppliers, creditors and landlords; Community; Government and the Law Society; The media and analysts; Accountants and auditors; and Alliance partners. What do these stakeholders want out of a relationship with a new firm? Most of them certainly need financial stability, and so increased profit and equity value are of vital importance, but they also seek many soft benefits that are not quite so obvious. Most legal practitioners seek challenging and interesting work; they want a collegiate environment that provides access to precedent, training and a variety of work. Staff require stability, recognition, training, career opportunities, good pay and benefits and, above all, respect. Suppliers require an honest deal and payment within their terms. Clients seek a sound deal with fair prices and the best advice. So in law firm mergers we should consider these outcomes as part of the third reason why mergers should be considered as beneficial. This means that there are three main considerations when examining the strategic reasons for a merger: Increased and sustainable profits The most commonly used KPI in the legal profession is profit per equity partner (PEP). The fact that it is the most commonly used measurement is no coincidence. Simply put, it is the essence of legal practice measurement and one that is recognised by 9
Chapter 1 everyone involved including families, bank managers and other vital stakeholders! Increased and realisable assets Acquiring assets is not normally considered important to law firms. Law firms do have assets and they include debtors, WIP and cash in the bank, but when a merger occurs a line is usually drawn where such assets remain the property of the partners of the legacy firms. However there will be assets that are not usually discussed let alone examined. For instance, Will Banks can have a huge latent value. Consider that a client s last will and testament is held by a law firm naming a solicitor in that law firm as executor so probate fees are normally received by the same firm. A Will Bank of 5,000 current wills could attract fees of, say, 7,500 for each will which amounts to a staggering 37.5m. If that is not a tangible asset then what is? Increased people satisfaction Organisations that deliver service are in the people business. So the complete service delivery operating model does not work without people dealing with people. Just about every legal service is similar to a retail type model. The service provider has someone who deals directly with the customer. A failure with this connection provides a bad result. Often such connections can be judged as being good or bad by people experiencing the same level of service. Why is that? The answer is usually associated with personnel wellbeing and morale. Most of us know how dispiriting it can be to deal with a call centre. Here you, the customer, are dealing with a human being who has no interest in your problem and at the same time has no motivation. If a merger does not improve morale it will be noticeable to the clients and other stakeholders. So if a law firm merger is going to improve morale and partner and staff expectations then that is a good result. Chapter 6 on stakeholder management discusses this matter at length. The reasons given previously as arguments for mergers are valid, for example, marketplace repositions, obtain new skills, develop new products, enter into new markets and protect existing markets. However, they are all subservient to one or more of the three strategic reasons given above. For example, entering into new markets is probably a consideration because profits are waning in current markets. So the real reason is one or more of the above strategic reasons. The right reasons to merge and the rules that should apply The actual business of practising law is convoluted and fraught with many difficulties. Basically we have a profession that is relied upon to guide clients through life s events and commercial interaction in a fashion that protects the clients and their assets, families and businesses. Solicitors interaction with their clients is regulated, policed and ethically bounded in a way experienced by no other profession, and so it should be! Solicitors guard their professional ethics and maintain standards that are centuries old. Considering their numbers there are few transgressors. This is reassuring and means that there are sound controls in place to manage risk and quality. General industry and commercial experience has shown that growth by merger and acquisition (M&A) activity has often resulted in the dropping of standards and the gaining of an over-optimistic view of financial performance. This is usually caused by shareholders being given unachievably 10
high expectations of the newly formed entity; the root cause for such optimism is the need to encourage investment and maintain share value. Enron and Lehman Brothers are but two examples where standards had slipped and greed had overcome sensible management and reporting. On the other hand, organic growth is usually achieved by the use of product excellence and focused customer service. Risk is managed and expectations are controlled. The paramount law about a merger is that high delivery standards must not be jeopardised by forming NewCo. Measuring return on investment Before returning to profit considerations, return on investment (ROI) should be mentioned. ROI is a normal measurement for commercial organisations and, whilst not traditionally used by law firms, it is a measurement that will become more important as their business models change. ROI is one of several approaches to building a financial business case for a merger. The term means that decision makers evaluate the investment potential by comparing the magnitude and timing of expected gains to the investment costs. This approach has been applied to asset purchase decisions, to go/no-go decisions for programmes of all kinds including mergers, and to more traditional investment decisions. Law firms might argue that their model is less demanding and that mergers are paper based with less demand on funds. However, there will always be the need for managing partners to meet expectations. Further, as certain parts of the sector become less regulated and ownership rules allow for commercial ownership, the legal sector will find itself subject to normal commercial pressures. Already we are seeing legal mergers creating mega-firms and a common cry that size is important. Simple ROI works well in situations where both the gains and the costs of an investment are easily known and where they are clearly a result of an action. Other things being equal, the investment with the higher ROI is the better investment. The ROI metric itself, however, says nothing about the magnitude of returns or risks in the investment. Nor does it usually take into account the so-called secondary cost savings and value-add revenue generation often experienced in merged environments. In complex business settings, like law firm mergers, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them, and this makes ROI less trustworthy as a guide for decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or indirect costs, which are probably not caused directly by the action or the investment. Merger type investments typically involve financial consequences extending several years or more. In such cases, the metric has meaning only when the time period is clearly stated. Shorter or longer time periods may produce quite different ROI figures for the same investment. When financial impacts extend across several years, moreover, a decision has to be made whether to use discounted (net present value) figures or non-discounted values. The second financial consideration that must be applied is the time to reach breakeven point. This is the effect of cumulative cash flow as illustrated in Figure 1. 11
Chapter 1 150 100 50 0 (50) 2002 2003 2004 2005 2006 Figure 1: Cumulative cash flow The graph in Figure 2 emphasises the point. If the upfront investment takes too long to recover then the investment becomes unsustainable. This becomes particularly obvious when using present worth calculations whilst simple ROI calculations can hide the effect of breakeven points. There is also a school of thought that investment programmes need to reach breakeven within two financial years or the investment is deemed retrograde by equity shareholders. Evaluating cost The final financial consideration that needs to be explored is cash flow. It must be understood that the actual transaction has a cost that will be above and beyond normal trading and it will take some time to get the cash back, the cash coming from profitable trading. The actual costs of the merger can usually be capitalised so the effect on profit can be spread over a number of years. However, the money will still flow out. Many of the costs are going to occur in the early days of the initiative and therefore the transaction is going to need cash. The cash is going to come from cash flow, partner capital or bank lending, or a combination of the three. Either way the money needs to be found. This requires a cash flow forecast that is put together after detailed analysis and with a clear understanding that clarity and accuracy are essential. The following are the main costs that should be considered. Legal costs It would seem strange to advocate that lawyers will incur legal costs for a transaction that is in-house, but it is not in-house and it involves another party. For all of the reasons a good lawyer will tell a client Merger outgoings Increased profit Breakeven point Figure 2: Cash flow illustration of return on investment 12
that he or she needs to receive advice and to be represented on a matter, the same applies to a merger between two law firms. It is unlikely that this advice will be heeded but, at the very least, law firms entering merger agreements should obtain advice on the final documents before execution. This particularly applies to partnership and limited liability partnership (LLP) agreements. It would be expected that fees would be payable 90 days post-merger. Severance packages A merger will involve a Transfer of Undertakings (Protection of Employment) (TUPE) process and this could result in some people deciding not to move to the new firm or people being found surplus to requirements. This will result in severance packages. It would be expected that these payments will be made around the time of merger. Repayment of capital It is likely and normal for some partners to take the opportunity to change their status at the time of a merger. The merger provides a good time to exit the legacy firms. Partners can retire, change to salaried partner or become a consultant to the new firm. Either way they will be expecting to collect their capital. This might be in tranches but it would be expected that the money should be paid out within one or two years maximum. Rebranding costs Most law firms have a large investment in marketing collateral. This includes everything from business cards and brochures to websites and signage. The work will require changes to market perception and involve press releases and client briefings. Almost all of the work must be done around the time of merger and the costs will be incurred at that time. Consultant costs There are a number of areas where outside help could be used to streamline the initiative. There are consultants that facilitate mergers by providing research and introductions to potential merger partners. These people act as deal makers and are involved from conception through to completion. Other consultants provide specialised help and advice in such areas as IT, finance, HR and marketing. This consulting work is mainly completed premerger but can continue for up to six months after the merger. Accountant costs Both legacy firms need to involve their accountants. They also need to appoint one or other as accountant to the new firm. The legacy firm accountants need to prepare merger documents detailing all of the assets and liabilities of both firms. This should include detail such as asset registers showing the written-down detail of the assets. The accountants also need to work with both firms to determine the valuation of WIP and the ageing of debtors. There is also a considerable amount of due diligence to be completed. The accountants are also the normal advisers on partnership agreements and need to be involved in determining the content of a new agreement. Initial costs increase but should decrease when NewCo is operating with one accountant. Salary and benefit rationalisation Employment regulations will force some changes in the way that staff are paid. TUPE regulations will determine that the firm with the best pay conditions will determine standards for the new firm. This will probably cause an increase in staff costs. These costs will occur from day one after the merger. 13
Chapter 1 Lease exits It is quite conceivable that rationalisation following a merger will include the closing of some offices. Again this has a potential drain on cash if leases have to be paid out or sub-tenants found. This might also apply to equipment leases for such items as IT hardware and telecommunications gear. The time of the cash draw can be controlled but the transactions should be recorded on the cash flow forecast. Infrastructure reorganisation The movement of people and their furniture, equipment and files can be quite onerous. All this work takes time and is expensive. Again the cash draw down should be reflected in the cash flow forecast. Write-offs There will be assets that can be written off at merger time. These are items that will be surplus to the new firm. Some assets will be disposed of at less than book value so they will generate cash but reduce profit. The assets that are sold for more than book value will generate cash and increase profits but incur capital gains tax. All that caution aside, mergers do have their place in the business model and we are going to see more and more of them around the world. The winners will be those firms that merge for the right reasons and manage the process to achieve the most beneficial outcomes. 14