The practice of charging an incoming partner for the “goodwill” of a firm is controversial, and not just for the new partner. Ultimately it is the firm that must bear the cost of paying out the partner upon retirement.
Consultant Duncan Hart, who was formerly the Melbourne managing partner of Dibbs Abbott Stillman, says that the need to pay out retiring partners is an increasingly common reason behind firms going into debt. “There are some firms where the demographic profile means that you can have a whole cohort of partners approaching retirement,” he says.
This is less of an issue for top-tier firms, which have largely adopted an “easy in, easy out” system where partners are not required to pay for goodwill, although payments for other reasons may be required. But should incoming partners be required to pay for goodwill at all?
One firm which says they shouldn’t is mid-tier firm Mills Oakley, where CEO John Nerurker has strong views about the idea of paying to join a partnership. “I think that unless you are joining a branded, top-tier firm, the goodwill of a firm actually belongs to its partners,” he says. “Laterally hired partners bring their own goodwill into a firm, and they take it away with them too – as is evidenced whenever clients follow a partner.”
It goes to the heart of that old chestnut: do clients come to a firm because of the firm brand, or because of the individual partner with whom they are dealing? Nerurker has definite views on the subject. “Clients don’t come to a mid-tier firm because of its logo. It’s because of a personal referral, or the relationship with a partner or partners. So why should a new partner have to pay the firm for goodwill that is already theirs?”
Mills Oakley has a different costing model for incoming partners. “There is a modest payment made by incoming equity partners, however it’s not a payment to existing partners for their goodwill, and is repayable in full when they retire,” says Nerurker.
“These monies are paid for the simple reason that an incoming practice results in work-in-progress and debtors that require funding. So in effect it’s a loan to the firm by the incoming partner to fund working capital, and not payments to current partners.”
Other methods
Some have observed that the goodwill system is not particularly prevalent in the legal industry.
“My impression is that it is uncommon for law firms to require new partners to physically pay for goodwill, as opposed to payment through ‘sweat equity’,” says Mark Pistilli, managing partner at Chang, Pistilli & Simmons and the former managing partner at Atanaskovic Hartnell. “Most practices see partners as only stewards of the firm for a time and then handing it to the next generation.” However, there are other reasons beyond goodwill and working capital for a new partner to make a financial contribution to the firm, on joining a partnership.
“If new partners are to share in existing assets of a firm, rather than
The mechanisms through which lawyers become partners in a firm are many and varied. ALB explores some of the more common – and controversial – methods at playjust sharing in assets which are created after they join, then it is unlikely they will be gifted such an interest,” says Pistilli. ”For example, a national Australian firm would generally carry tens of millions of dollars worth of work-in-progress at any one time, and in theory a new partner would be entitled to a share. So the new partner would either have to pay for that share or not share in existing assets.”
“Many firms, however, operate on a “no buy-in” and “no buy-out” model, in which there is no right to one’s aliquot share of net assets on leaving a partnership, as the price for not paying for a share of assets on the way in,” he says.
Pistilli notes that a variation of this approach is a “change in net assets” model, which sees partners only pay for net asset deficiencies, or be paid by the firm for net asset growth when they leave a firm, based on changes in net assets for such time as they are partners. He observes that many large and international professional services firms operate in a way where new partners provide funding, generally organised through the firm’s banks, which is repaid when the partner leaves the firm. ALB
“So why should a new partner have to pay the firm for goodwill that is already theirs?”
Elephant in the room
Lawyers normally like a bit of publicity, but there’s one particular subject about which you won’t find firms issuing press releases. Law firm debt is the elephant in the room – always there, but rarely discussed in the open.
From national firms to the mid-tier and boutiques, the mechanisms for incurring and controlling debt are a key part of prudent administration. “Firms may raise debt for specific purposes, such as to buy new premises or to buy in teams of lawyers, but generally law firms raise debt … to fund working capital and regular partner draws,” says Mark Pistilli, CP&S’s managing partner.
He notes that not all law firms need to operate a model which involves debt facilities, citing his firm as an example. CP&S only distributes profits to partners when there is available cash to do so, however, Pistilli suspects that these structures are in the minority with firms. It requires partners who are financially self-sufficient or who individually raise debt outside of the firm structure, which is not ideal.
“Some level of debt or debt facilities is needed to smooth out cash flow in most professional service organisations, given the timing differences between revenue collection and the payment of expenses” he says.
Musical chairs
In the previous feature, one source of debt for firms was the need to make payments to retiring partners under certain partnership models. Due to the controversial nature of this type of debt, it does not necessarily follow that partners will see it as their responsibility to pay it off, particularly if they dispute the circumstances which gave rise to the debt.
A common example would be a payment made to a retiring partner who has not, in the view of his or her colleagues, contributed satisfactorily to the partnership in the years leading up to retirement. “Because debt is often ‘parked’ when partners can’t agree how or in what proportion to repay it, managing debt almost becomes a game of musical chairs,” says Mills Oakley CEO John Nerurker.
The game can continue as long as the firm is expanding and adding new partners who offer debt and interest guarantees. But if the firm is contracting, no one wants to be the last man standing. “It can become a case of the last partner standing being responsible for this weight of amassed debt that he or she may have had nothing to do with accumulating,” Nerurker explains.
This was the case with international firm Heller Ehrman, where the departure of key partners can cause a snowball effect which may ultimately send the firm into a downward spiral. It has been suggested by some that the demise of Heller Ehrman was due to the departure of a certain number of partners, constituting a default in Heller’s line of credit with its bank, effectively triggering liquidation.
Prosperous expansion
The current consolidation environment also presents challenges for law firms’ balance sheets. Those who are looking to expand will inevitably need to outlay cash to bring on lateral hires or facilitate a merger, and it may take some time for the benefits of this growth to become apparent in the firm’s revenue figures.
“When you employ new lawyers, obviously your wages and superannuation bill goes up immediately, but it could be three to six months before they generate any fees,” says Michael Kemp, partner-in-charge of Brisbane firm Rostron Carlyle’s personal injuries practice. “But growing a firm is a long-term investment – that’s the nature of the business.”
Mergers compound the problem of payments to retiring partners, as they usually result in a certain percentage deciding to leave the firm, precipitating a round of expensive payouts. “It’s almost inevitable – and desirable – that some people will leave,” says Duncan Hart, former Melbourne managing partner of Dibbs Abbott Stillman. “Mergers usually happen at a very high cost, when you take into account the people that leave and then the cost of rationalising premises, terminating supply contracts and so on.”
In response to these challenges, some banks have sought to make tailored offerings for law firms. Macquarie Bank, for example, has assisted firms in the funding of mergers, acquisition of practice groups, large capital purchases (such as office buildings and practice management systems) and general organic growth requiring working capital support.
Run a tight ship
Nerurker believes robust accounting practices, combined with strong client relationships, minimise debt levels – even in an economic downturn. And if Mills Oakley’s continual appearance in ALB’s Fast 10 is anything to go by, the strategy is working. “First and foremost, never distribute more than the firm’s profit in any one year,” advises Nerurker. “You can’t distribute more than you are making without going into debt or relying upon additional capital from partners.”
“It’s also a key to our financial success that pretty much all our client base consists of commercially-oriented businesses and individuals. We ensure, and particularly in an economic downturn, that our clients have the ability to pay before they incur any fees. We communicate with clients [and] we have strong relationships, and there are no nasty surprises when a Mills Oakley invoice is received.”
One problem – no doubt as old as legal practice itself – is the situation where a firm is unable to secure payment of fees in the short-to-medium term. This is best demonstrated in family law and personal injury areas, where a party may have a solid prospect of winning a substantial judgment, yet have no funds to pay his or her bills while the litigation is in process. The law firm is effectively carrying the party’s costs – not a good look if the firm needs to approach its bank for more funding.
It’s what Brendan Lyle of litigation funds provider ASK Funding refers to as a “lazy balance sheet.” “A small-size firm might have half a million dollars in fees outstanding, which counts against them when they try and raise more money on the overdraft,” he says.
It’s a familiar problem, made worse by the economic downturn. “I know of many firms that have tried to increase their overdraft but have been knocked back,” says Rostron Carlyle’s Kemp. “It’s not because the business is bad – it’s because banks are being more wary.”
Terry Lyons, who is head of legal industry at Macquarie Relationship Banking, agrees. “Much has changed during the last 12–18 months in terms of the business and financial environment. It would be fair to say that the lending practices of some [banks] may have been tightened, as appetite for risk decreases and cost of funding increases in uncertain times,” he says.
Value your assets
ASK Funding’s Lyle says that some banks have traditionally only understood law firm assets in a conventional sense – items such as furniture or technology – and have been slow to understand that the files also represent a commodity in themselves. He says this is a gap in the market which organisations like his are seeking to fill by lending directly to the litigant, thereby circumventing the need for firms to carry outstanding costs on their balance sheets.
Consultant Hart says that banks do recognise the value of files, but it comes down to a matter of the bank’s previous relationship with the firm and the confidence it has in the integrity of the balance sheet. “The banks will lend to firms based on their assessment of the work-in-progress,” he says. Law firms may have to jump through the hoops to gain funding, but ultimately the relationship is reciprocal.
“[Macquarie Bank’s] approach to our clients is relationship-based, meaning that we work hard to be a banking partner to our clients for the long term and to really understand the nuances of their business,” says Lyons. “This way we get to know our clients, their business and both the challenges and opportunities that they may face at any point in the market cycle. Our lending guidelines have remained consistent throughout the market cycle and this provides certainty to our clients.”
Personal injury is another area where litigants typically cannot afford to pay before settlement, leaving the firm to cover out-of-pocket expenses such as medical reports. “You might have a client who is potentially entitled to a very large award, but is under pressure to settle for substantially less. We provide the funding to see them through the litigation,” says Lyle.
Michael Kemp oversees Rostron Carlyle’s personal injury practice and agrees with this approach: “On average, it would be at least 12 months before the firm sees any fees from a normal claim,” he says. “During that time, you also need to outlay perhaps $3000 for reports and other expenses. Multiply that by the number of files and you get the picture.”
When Kemp was approached by ASK Funding with a proposal to lend money direct to clients, he jumped at the chance to free up this funding and reinvest the money in the practice. “We’ve been able to employ additional lawyers, expand into new areas and develop the firm’s practice,” he says.
Larger firms tend not to pursue the family law and personal injury market, in part because of these balance sheet issues. “Having a family law practice in a large firm also creates issues around commercial conflicts,” says Lyle, noting the number of boutique family law firms that have split off from large firms.
