How to Make a Law Firm Merger Work: Dealing With The Finances

Editor’s Note: The author of this post is a partner with the law firm Blank Rome and previously headed its business department. This is the second article of a series he is publishing on Big Law Business about how to successfully execute a law firm merger. Read Part I here .

By Barry H. Genkin, Partner, Blank Rome

Last week I wrote about how a merger of law firms can only be successful if each firm’s culture aligns compatibly with the other. But as important as culture might be to creating a unified and focused firm, none of it matters unless the combined firm gains an economic advantage from the combination. In most cases, this beneficial financial impact drives the merger discussion.

For that reason, working out the financial business case should commence early in any merger process. Combinations can be accomplished with various financial constructs. The acquiring firm could receive the other firm’s work-in-progress (“WIP”) and accounts receivable in return for capital credit and other considerations (such as guaranteed compensation). Or the acquired firm’s partners could keep their WIP and receivables, and contribute a portion back to the acquiring firm as capital. There are a number of ways to structure a deal, but whatever the construct, it should be modeled at the outset.

And in any financial model there will be a multitude of inputs. These represent some of the most critical building blocks in any merger analysis. Again, these will vary by situation, by model and by construct, but some of the most important considerations are:

• What are the compensation levels for partners, other attorneys and staff? • Will compensation guarantees exist? If so, for how long and subject to what milestones, if any? (e.g., revenue and hours) • What expenses will be assumed by the acquiring firm? (e.g., leases, existing contracts) • What level of tail insurance coverage will be sought and who will bear the expense? • What will the integration costs be? • Will there be a physical move? What will the cost be? • Will the transaction be accretive or dilutive to the acquiring firm’s partners in year one? In the following years? • What redundant costs can be eliminated? • What capital will be contributed and when? • Is there a broker and if so, will that fee be expensed or amortized? • Will billing rates change? • Will there be reduced billable hours during the transition?

The modeling should include, at a minimum, a pro-forma combined income statement and balance sheet for the year of the transaction and the following year, a cash flow analysis for the same periods and key financial metrics, including Revenue Per Lawyer, Profits Per Partner and Profits Per Equity Partner, and a dilution analysis.

Invariably, one of the most sensitive financial considerations in any law firm merger will be compensation for the acquired firm’s partners. An important guidepost is how and where these new partners fit into the acquiring firm’s compensation structure. Straying too far from those benchmarks will likely create friction among the acquiring firm’s partners, even if there is a business case for doing so.

Although law firm mergers don’t come with the kind of paydays that owners of non-principal-service businesses might experience, the partners of the acquired firm often receive some kind of financial benefit in the form of goodwill. The goodwill can take different forms, including cash or capital, but whatever the form, it will come at the expense of the acquiring firm’s profits. Some of the hit can be mitigated with creative ways of providing capital. For instance, a “golden handcuff” approach may be employed, by providing that capital in the merged firm vests over a three to five year period.

Finally, the financial modeling needs to clearly show how a merger will prove accretive for both sides in the long term. Some initial dilution of profits and perhaps revenue might be expected, especially where the acquired firm has greater profit margins. There will always initially be redundant costs and one-time deal expenses. However, once operations have been fully integrated, and redundancies eliminated, the model should benefit from economies of scale.