Do not be embarrassed

KEY POINTS

• The Legal Services Act will present opportunities for partners in law firms to realise a capital value from their firms. Similar opportunities arise for partners in other professional service firms.
• Inter-generational fairness is an issue which should be discussed openly.
• Anti-embarrassment clauses may be part of the solution.
• Well drawn provisions can make post-retirement capital gains extremely tax efficient.

Entrepreneurial lawyers taking the risk of setting up a law firm today might be considered mad to deal with profit sharing in the same way as established law firms. Why? One reason is that law firms have traditionally ascribed a nil value to goodwill and consequently failed to credit partners with any rights over the goodwill of the business. Instead, the model has been for partners to contribute a capital sum on joining a partnership and be repaid the same sum when they leave. If they are lucky, this may earn interest at a rate roughly equivalent to a savings account. In effect, their return on investment is limited to the profit shares they earn while partners. Under this model, if the business is sold a day after a partner leaves, any proceeds will be paid to those lucky enough to be partners on the day, who may not be those primarily responsible for having built up the goodwill over the years.

This state of affairs was unimportant when law firms, being people businesses distributing their entire profits annually, were perceived as having little capital value. But this has not been true for some time. Factors such as restrictive covenants, client panels and better branding have helped firms to institutionalise clients, giving them a value independent of their individual partners. Legal service providers undertaking high volume, low value work have created value through investment in IT. Some firms retain part of the annual profits to invest, for example, in establishing foreign offices. Regulatory changes mean that from October, 2011 the potential pool of purchasers of a law firm will dramatically widen. Together, these factors mean that the prospects for a sale or external investment have dramatically increased.

The issues described in this schedule are equally relevant to partners in other professional service firms.

Partnership agreements have yet to catch up with reality. In principle, it seems unfair to exclude former partners from sharing in a capital gain for which they are partly responsible. However, few firms currently have a legal obligation to share any gains with former partners. Partners at the time of a sale may argue that they are the ones who have secured the opportunity for a capital gain and who must, by their continuing efforts, assure any earn-out and give up a proportion of future income to an outside investor. This is all true, yet in the company context many do not begrudge former shareholders sharing in a gain in these circumstances.

One firm has publicly stated that it reviewed as an option inserting an ‘anti-embarrassment’ clause into its partnership agreement, although in that case the status quo has, for now, been maintained. It would be surprising if more firms did not now actively consider including such a clause.

How should such a provision work? Some guidance can be found in anti-embarrassment provisions in share sales, where a seller of a company may secure the right to share in the proceeds of sale if the buyer sells the company on for a higher price within a year or two of the purchase. Often this is structured as a contractual right, rather than a continuing equity stake and may be subject to various conditions, such as excluding any increase in the Company’s value due to the buyer’s investment.

Alternatively (or in addition), the approach adopted by private equity houses towards their partners may find favour, in which partners’ interests in the capital value of the firm vest over a period of years and are subject to ‘good leaver/bad leaver’ provisions, with former partners potentially losing their interest if they compete with their former firm. Some adaptations would be necessary since, unlike private equity funds, which have a limited lifespan, law firms would need to incorporate provisions to taper former partners’ capital interests over time, to make room for other retiring partners and to ensure that the ongoing partners’ capital interests are not devalued to an unacceptable extent.

It is also possible to structure anti-embarrassment provisions in such a way that retired members can continue to enjoy entrepreneurs’ relief on their share of any capital gains.

Designing a fair system is a task that lies somewhere between very difficult and impossible. But designing a system which is fairer than the current norm should be relatively easy. Even though an anti-embarrassment clause may prove time-consuming to negotiate and even ultimately redundant, it could help a firm to prevent tensions arising. At its worst, the absence of such a provision might result in partners nearing retirement lobbying for a sale earlier than the ideal time, or hanging on as partners in the hope of being in place to share in the proceeds of a sale which appears not too distant. Even if a firm has no present intention of seeking external investment or putting itself up for sale, airing the topic may prove beneficial. Moreover, it will be far easier to reach a consensus when a sale is not in prospect than when a pot of gold is in view.

Tina Williams is a Partnership Law expert and Senior Partner of Fox Williams LLP.

A version of this article appeared in Managing Partner magazine.