Managing succession in large firms _ lockstep, stock and barrel

In the second part of a series about succession planning for law firms, Sam Coupland explains how to handle incoming equity partners.

When it comes to handling succession in larger firms, there are a number of facets that need to be considered. They include the transition of clients from one generation to the next, the evolving management of the firm and, of course, the financials. 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 is almost as numerous as there are firms. So here is a general guide to what happens.

Lockstep advantages

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 – that is, their profit points do not 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 and 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 more points until such time as they become a full equity partner, usually in five to seven years. Of course, there are many variants to this scenario.  Some firms will have longer or shorter timeframes to full equity, while others have performance gates at stages along the lockstep that one must satisfy to progress, or the starting points may differ.

Capital contributions

Capital contributions of larger firms range between $150,000 per partner to $500,000 per partner, with the average being $310,000. How this is paid varies between firms – from the firm’s bank making a facility available to new partners (and they, in effect, sign a personal guarantee) through to new partners 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 that it is 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 from firm to 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.

Funding expansion

Debt has also been used to fund expansion initiatives – both the infrastructure needed, as well as the operations of the firm. Lateral hires or tucking in a practice group will require additional funding of at least three months (or more depending on the 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 planning for unexpected events such as the loss of clients, the exit of a practice group or a 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 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, while 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, which has provided research, training and management advice to law firms throughout Australasia for the past 30 years.

www.fmrc.com.au