Law firm transitions: the buyout of senior partners

What are the steps CFOs can take to smooth the departure of partners?

One of the biggest financial challenges facing law firms today is the retirement of senior partners and the buyout of the capital accounts and equity positions in their respective firms. With Baby Boomers set to retire in record numbers over the next few years, the capital outlay to transition firms to the next generation of equity partners will be significant. The primary challenge is in paying for that transition without overburdening the financial viability of the firm.

For CFOs of law firms, the best advice is to plan carefully for the retirement of a law firm partner. This will not only put a drain on the intellectual capital of the firm but can also present a significant financial burden. Establishing reserves to handle this outlay or placing a limit or cap on how much will be paid out to retiring partners in one year are some ways to lessen the cash flow burden.

"You don't want to find yourself in the position where three or four partners are retiring all at once, and the firm does not have the financial reserves to buyout the partners, or even support the debt service requirements of the term loan needed to complete the transaction " David Coughlin, Senior Vice President for Specialty Lending at SVB Private, said.

How equity changes hands

When senior partners leave a firm, they sell their equity back to the firm. Unlike most medical practices, which often sell to other doctors, law firms like to retain the partnership structure, so they usually buy back the shares or equity of the departing partner.

"It's not like a house you are selling or publicly traded stock," Don Murano, Senior Vice President for Specialty Lending at SVB Private, said. "Making that liquid is a challenge."

Law firms can either pay for the shares out of the working capital of the firm or through a credit line, typically a term facility. Unlike the loans individual partners obtain to finance their purchase of equity in the firm, the term facility to pay departing partners is taken on by the entire firm, with the partners also individually guaranteeing repayment of the facility.

Coughlin said that if a firm anticipates several partners leaving, it makes sense to build reserves over a period of time and reduce the amount of money the firm needs to borrow.

"Conservative firms often distribute 70-80 percent of their earnings on an annual basis, but that retained 20 percent is fairly significant and accumulates quite quickly," Coughlin said. "It's the firms that take out 100 percent of earnings that get in trouble financially."

The length of the credit facility depends on a number of factors, such as the cash flow of the firm and the type of business the firm is engaged in. For example, a firm of real estate lawyers might have a shorter repayment period if their industry is experiencing a downturn, Coughlin said. Usually the repayment period is not longer than five or six years.

"The aggregate debt can be quite high because the capital accounts of individual partners are normally in the six figures, sometime in the mid-six figures," Murano said. "If three or four partners retire at the same time, you're talking about a capital outlay of over $2 million."

Having the right partner and succession plan

The firm's CFO or managing partner should be sure it has a well-thought-out succession plan in place before retirements or partner departures begin to happen.

"I think it needs to be a carefully considered approach to how to bring in younger talent, while at the same time taking care of retiring partners in a way that doesn't jeopardize the ongoing viability of the firm," Coughlin said.

In choosing a bank to partner with, it's important that the institution not be too small and unable to handle complicated financial situations comfortably, but not too big, which risks the firm's ability to develop a meaningful relationship with the right financial institution.

"They need a financial partner with whom they can have regular talks and communication about the financial condition of the firm," Coughlin said. "They can help you bring in and support new partners, take care of the old partners and also be a financial partner who can look at the situation and not be afraid to say, 'Look you are taking on too much debt, we're concerned about this.'"

With the right succession plan in place and a financial partner that knows the firm well, the forthcoming departure of its largest earners does not have to be as traumatic as it might have initially seemed.

The views expressed in the article are those of the author and/or person interviewed and do not necessarily reflect the views of Silicon Valley Bank, a division of First-Citizens Bank and First Citizens BancShares, Inc. The materials on this website are for informational purposes only, are subject to change and do not take into account your particular investment objective, financial situation or need. Since each client’s situation is unique, you should consult your financial advisor and/or tax planning professional before acting on any information provided herein.