Law Firm Acquisitions and Sales

In order to understand what it means for a law firm to be for sale, it helps to define some terms. Generally speaking, a "law firm for sale" is a firm that has retained a business broker to help in the process of selling the firm. The term "for sale" does not necessarily mean that the owner of the firm wants to sell, only that the firm has been placed on the market for sale. There are many reasons why a law firm would be placed on the market for sale. Frequently, it is due to what is typically called a "burnout" scenario. A firm owner may "burn out" from practice and feel they no longer want to or cannot continue to maintain the types of hours required to run a firm, sometimes due to health reasons or just a change in life circumstances. Many older attorneys who have a book of business decide to sell their firms due to a number of issues . Sometimes firm owners find themselves with one or more partners who are no longer up to the task due to health issues or retirement, and the remaining owners decide to sell a firm that is suffering from a reduction in available talent. Likewise, when practice areas go out of favor, headquarters offices are closed, and associate lawyers are laid off or asked to leave, a firm may have no choice but to reduce its size or dissolve entirely.
The sale of a law firm can be more complicated than selling most other businesses for a number of reasons. Law firms are unique in that their employees (the lawyers) are also the "clients" of the firm. Selling a law firm can cause internal friction if proper care is not observed. Also, the rules governing the ownership and operation of a law firm vary from state to state. For example, certain states have laws prohibiting non-lawyers from owning an interest in a law firm.

Law Firm Valuation

Once the decision to sell has been made, the solitary task of valuing the firm can begin. This is a pivotal moment in the process. Everything that follows – from the terms of purchase to sale price – is based on the value assigned to the business upon its evaluation.
Many factors are considered in valuation. Annual revenue, client base, practice areas, reputation and geographic location all play a role. The valuation process is an integral part of getting a practice ready for sale and should, ideally, be conducted well before a listing is made public. The law firm business model is ranked according the value of the firm’s assets. Intellectual property, tangible assets (like furniture and real estate) and the firm’s liability are assigned a dollar figure.
The most important factor in valuing a law firm is revenue, both annual and overall. The current and historical profitability of your law firm is key in order to garner top dollar during a sale. To determine how your revenue performance – based on billing hours per professional, costs per hour or other method of billing – measures up, you’ll have to examine your firm’s revenue per lawyer ratio. This number is calculated by dividing the number of attorneys at all levels by the overhead costs and total revenue. In most cases, a higher ratio is more favorable. Complexity of cases, overhead (estimates for this should be rounded down) and retention of long-term clients can also be considered.
Beyond revenue, a firm’s client composition and firm reputation are key drivers of value. To measure its client base – and to help determine how attractive it will be to prospective suitors – a firm should inventory its current and historical clients, the nature of the relationship with them, their strategic fit and potential for cross-selling. One of the best ways to add value is to develop a client roster that is diversified and not overly reliant on a small number of clients. Great clients come in many flavors and characteristics. They are not necessarily the same thing as a "preferred" client.
The president of a multi-billion dollar company, for example, may not be classified as the largest client of a major law firm. That prestigious business owner may be a great client, but it is her exclusive work with one particular attorney – instead of with the firm as a whole – that diminishes her value to it. Clients who pay the most should not always be considered the best. You can lose big clients and continue to prosper. Conversely, you can keep your biggest clients and eventually go under if you don’t supplement or replace them with others.
A client relationship is valuable to a firm if the lawyers’ primary point of contact is someone other than the client. It can be further enhanced if a relationship partner participates in other ways, such as sharing the duty of originating business, leading teams, developing cases or matters and supporting litigation and work in other offices. A client relationship may even be valuable when a partner visits occasionally to provide a very important service or product to a single office or department. But this type of client is not necessarily valuable to a firm if that sole attorney leaves to join another firm. Thus, a depth of client involvement adds value. Sometimes great client relationships can be found within the client’s organization, among other people besides your primary client. Not every client is a golden opportunity (perhaps 25 percent of them are) but even the most mundane sometimes prove to be a good value.
Beyond client relationships, a major indicator of firm value lies in the perceived value of the market for the kind of legal services it offers. A reputation for excellence, often developed through publishing, experience or unique skills, adds to your firm’s perceived value. The more capturing your firm’s niche, the more potential buyers will find it valuable.
Uncompromising focus on excellence, in recent years, has made competency an indispensable quality factor to retaining and attracting clients – and, by extension, elevating a firm’s value.

Locating Law Firms for Sale

There are many sources for buyers to locate a law firm for sale. First, as our title indicates, are law firms put on the market by their owners or management. There are also numerous professionals, brokers, and other resources that focus solely on assisting buyers and sellers of law firms.
Once a seller has decided to explore either a merger, an acquisition, or a succession plan, an experienced business broker will either reach out to their network of potential buyers or advise the client on general pricing. Brokers typically charge the seller a fee, either on a retainer basis and/or a success fee for a firm with revenues above a certain threshold, i.e., $500,000. In larger transactions, some mergers and acquisitions brokers are paid a retainer of up to 50% of seller’s legal fees, plus a success fee on closing equal to 5% of the total consideration, whether paid in cash or in other assets, and received no later than five days after closing.
There are also a number of online sites where sellers list their firms. They can be found by searching the term "law firm for sale" on Google or the other search engines. These sites also sometimes include general advisory information relating to selling a law firm.
Finally, there are lists of law firms for sale in trade publications, magazines, and directories produced by organizations that serve a particular niche of the legal community.

Legal and Practical Issues

When considering the purchase or sale of a law firm, there are a number of legal and ethical considerations must be taken into account. At the forefront is the consideration of client confidentiality. Simply put, under the Texas Disciplinary Rules of Professional Conduct, an attorney cannot reveal information relating to a client’s representation without the informed consent of the client. In the case of a sale, the client’s consent to disclosure must be in writing and signed by the client. See Rule 1.05 b (6). Further, an attorney cannot use information to the disadvantage of a client, unless the client consents after full disclosure. See Rule 1.05. Consent may be implied when the information is used to carry out the representation. See Rule 1.05. Not surprisingly, the consent rules have been the subject of a number of cases related to the sale of a law firm. See e.g., Texas Ethics Opinions OP-673 (2003) (firm could take two years to transfer client files as long as client names were not disclosed), TEXAS ETHICS OP. 490 (1989) (new attorney firm has possible duty to inform former clients of retiring attorney’s plans to open own practice); and THE CONSTITUTIONALITY OF LAWYER NONCOMPETITION AGREEMENTS IN TEXAS: AN EXAMINATION AND PROPOSED SOLUTION, 2 HOUSTON BUS. & TAX L.J. 337 (Spring 2002).
Another factor to consider is the transfer of client files. Commonly, all client files are purchased in a transaction, but Texas has adopted firm-specific rules for the transfer of client files, including the requirement that a lawyer notify the client of the intent to sell client files, and a provision allowing the client to object to the transfer. See (Rule) 1.17-3. Client files may also require special consideration such as certain Medicare/Medicaid transfer requirements. See, e.g., 42 C.F.R. §411.359.
Perhaps one of the most significant issues to address is the ethics of marketing the sale of a law firm. This is addressed in Ethics Opinion 418 of the State Bar of Texas Ethics Committee (Texas Ethics Opinion 418). That Opinion notes, "The Texas Disciplinary Rules of Professional Conduct prohibit attorneys from making false or misleading advertisements or communication." A lawyer considering the sale of a law firm must comply with the rules of his or her bar association. In state and local bar association rules, language similar to the following typically exists: (d) A lawyer shall not give anything of value to a person for recommending the lawyer’s services. However, a lawyer may: (1) pay the reasonable cost of advertisements or communications permitted by these rules; (2) pay for a law practice in accordance with Rule 1.17[^157 "Prohibited Transactions"] and all applicable rules and laws. (Emphasis added.); TEXAS ETHICS OP. 490 (1989) (new attorney firm has possible duty to inform former clients of retiring attorney’s plans to open own practice; in other words: No disclosure without informing the clients).

The Purchase Agreement

After the expression of interest, the next step in the negotiation process is the drafting of a term sheet and a purchase agreement. The term sheet outlines the key terms and conditions of the proposed sale. The practice of lawyers tends to be more intangible than other businesses, which makes the drafting of the term sheet and the purchase agreement somewhat different from other types of business negotiations.
The price is a key component of the term sheet. must consider what he or she believes the practice is worth, based on factors such as the goodwill of the clients, the location of the firm, number of years the seller has built the firm, and the risks associated with the future of the practice. If desired, a valuation may be obtained from a third party. This is an additional cost to the seller, and may not be necessary for smaller practices or where there are other well-known metrics of valuation.
In addition to the valuation and purchase price, the term sheet will outline how the seller will receive payment. For example, will the seller be paid in full at closing, or will the sales price be paid in installments over time? Because much of the value of a legal practice is associated with the client base, the terms of payment must include protection for the seller in the event that a large number of clients leave after the change in ownership .
A strong term sheet will also cover the transition of ownership. Will there be any transition period, during which the seller remains at the firm? Will the seller help to transition the practice to the buyer? What happens if a key employee leaves shortly before closing? If the seller intends to stay at the firm for a year or two, how will the buyer be compensated if the seller leaves early?
Another key component to the term sheet is a non-compete provision. For the buyer, this provision protects against loss of income if the seller decides to start a new practice and hire away the client-base or employees. For sellers, the non-compete is as important to ensure that their investment in the firm does not walk out the door to a rival firm.
While it can be tempting to skip the term sheet and move directly to the purchase agreement, completion of the term sheet allows all parties to consider terms, negotiate points that need to be improved, and add additional issues that may not have been considered before preparing the term sheet.

The Importance of Due Diligence

Due diligence is a critical part of the process of buying a law firm. Sometimes it can be strained by emotions, particularly if the buyer and seller are from the same firm. Given that most law firms are bought and sold behind the curtain, a thorough due diligence process is important in order to ensure that the transaction closes. If the seller fails to fully disclose all the pertinent information, then there could be a chance that the transaction will not close. In the event that the transaction still closes, a failure to disclose could lead to post-closing litigation and/or lead to a significantly diminished value of the firm.
Due diligence is a systematic review of a business or an individual before a prospective buyer invests money or time in a transaction. As such, it is important that due diligence be handled by an attorney independent of either party’s ongoing representation. While the issue of privilege will be discussed later, the lawyer should have sufficient background knowledge of the field in order to competently handle any issues that arise during the review.
There are two ways lawyers can generally conduct a due diligence review. The first is a "field trip" to the target firm’s office. The second is through the written word. While we can all focus on the written word as we craft our review, as compared to the oral deposition and interviews, the writer finds the field trip far more informative. Unfortunately, these field trips are not possible for every transaction – this is particularly true for multi-office firms.
What the buyer is looking for during the due diligence review is a frank and transparent disclosure of the firm and its finances. Unlike most elements of a law firm, what the buyer is looking for (and should hope for) is not glamour. Luckily for the buyer, or the seller for that matter, everyone is awful humble in the review process. Not only is the seller providing only useful and accurate information of the firm, he or she is providing only the best description of the firm’s books and records. Although the seller does not have it to give, the buyer is also presented with everything he or she wants to see regarding the Bar’s disciplinary record. Ultimately, the buyer and seller have the highest opinion of the target firm.
While the writer does not particularly believe in the tooth fairy, there are two statistics that he does find intriguing. The first is that 10% of all firms lie in the sale process, and the second is that these firms are found out 100% of the time. The writer personally believes that 100% of firms lie in the sale process (but believes that 100% are found out given the public nature of the available data). For example, the writer recently conducted a deal in which the seller claimed to bill over a 70% realization. That firm, however, had only a 58% realization when the writer was done with his due diligence review and the relevant discovery.
To prevent the buyer from discovering too much about the firms’ dirt at the due diligence stage, sellers should organize their documents in preparation for sale of the firm. The writer recommends organizing files, including:
The writer also recommends drafting a comment on the firm’s filings. This comment should highlight the positives – defense verdicts, client diversity, etc. It should also be prepared to address any negatives – errors and omissions claims, billing issues, etc. The writer believes that it is acceptable to submit a list of disclosures that the buyer will discover. Of course, part of the writer’s job is to act as a mediator when dealing with the buyer’s "due diligence person," and, of course, to defend the seller’s disclosures, whether known by the buyer or not.

Financing the Acquisition

Financing the Purchase of a Practice
Traditionally, law firms seeking an acquisition have financed that acquisition using their own "equity," such as retained earnings. However, a recent trend has seen law firms seeking alternative methods of financing their acquisitions, such as bank loans, private investors and seller financing. Each of these methods are discussed below:
Bank Loans — Banks are willing to finance acquisitions both because of their commitment to local entrepreneurs and the commercial advantages of financing. Bank financing is usually secured to avoid personal liability. Interest rates are usually a bit higher than the prime rate. A bank will require detailed financial projections for the first two years following the acquisition.
Private Investors – See Selling a Practice to a Third Party with Cash Consideration below.
Mergers — A relatively new form of financing requires no cash outlay. The buyer agrees to merge the acquired practice with its own. The former owner becomes a partner and shares in the profits and losses of the combined practice as long as he or she continues to supply clients and/or generate new business. When the client base is deemed stable, usually after a year or so, arrangements can be made to buy the interests of the seller. This method also works well for a dentist wishing to retire but who is concerned about leaving his clients in the hands of a stranger. The dentist can merge with the successor but the buyer must be selected carefully to ensure compatibility. This method is, however, not appropriate for every practitioner because of the pressure it creates for the former owner to be productive even if he or she is no longer interested in work.
Salary Guarantees and Performance Bonuses — Most lawyers expect to receive a salary guarantee during the transition from practice ownership to employment. This is a good idea, especially if the buyer intends to exclude the seller from the management of the practice. If the seller is included in the management team, on the other hand, the mechanics of the deal can sometimes be better served if the seller is compensated according to the achievements of the practice.
The price for a dental practice is usually based on a percentage of average net or gross revenues calculated over a five year period prior to the sale. A bottom line needs to be established for the professional corporation through buttoning up tax and insurance planning. No taxes or insurance can be deferred when there is an ongoing professional corporation and no income is siphoned off for vacations, fringe benefits, etc.
Seller Financing — If the firm has the necessary funds, it may be able to pay cash for a practice or offer all cash in consideration for a percentage of moves, files or partnerships. Sometimes a seller wishes to participate in the former firm’s success through a share arrangement including some link between the new firm’s success and a bonus paid annually to the old firm.
Clearly, there are risks associated with cash and cash flow financing as opposed to seller financing which carries no risk. Primary considerations when choosing a method of financing include how quickly the buyer can get the money after the transaction is completed, what kind of money the buyer has available to pay taxes with or use for in-house expenses, and when the buyer expects to see the greatest return from the practice.

Closing the Transaction

When enlisting a broker to assist in selling your firm, it is likely that the final steps for closing a law firm sale will be handled by your representative. If you are making the sale on your own, "closing" the deal means signing over the deed. The buyer and seller (you) are present for the meeting with the closing attorney to sign the final documents. These documents include ownership transfer agreements, purchase agreements, bill of sale, and other legal provisions necessary to finalize the transaction. All financial information must be settled, including payment if the transaction is being handled in installments . If there are any liens on any assets being transferred to the buyer, these must also be settled. Disbursements on your behalf are finalized, as well. Closing a law firm sale entails the flow of funds to the purchasing attorney so that he or she can pay off any liens on your assets and give you the cash you need to finalize the sale. Sellers may also be provided a promissory note that outlines the payment terms of the sale if it was an installment transaction. Once the final documents are signed, the attorney goes through them to ensure they are correctly filled out. When satisfied, the final documents are sent to both parties for signatures. Funds are exchanged, the deed is transferred, and the sale is finalized.