The Dollars and Sense of Successful Succession Planning
The Dollars and Sense of Successful Succession Planning
Mar 15 2010, 12:25 PM
Joined: 17-July 09
Member No.: 125
Call it a sign of the times – a new proposal before the State Bar of California Bar Board of Governors that would require lawyers to have an “estate plan for the law practice” providing for succession in the event of a lawyer’s death or disability. Leaving aside the merits of the proposal, it is yet another indication that the law is an aging profession. Karen Mathis, when chair of the American Bar Association several years ago, often emphasized that 400,000 lawyers of the Baby Boom generation and older will likely retire in the next 10 years, a number equivalent to the entire membership of the ABA.
The law, of course is not the only business sector so affected – estimates are that more than seven million Baby Boom business owners will retire during the forthcoming 10 to 15 years. And studies by MassMutual, Marquette University, PriceWaterhouseCoopers and others show that 75% of these business owners have no idea how to financially plan for and handle this transition. This figure surely applies to lawyers in sole or small firm practices, who typically are not known for financial foresightedness.
Ethics and Fear
Unlike other business owners, however, these lawyers face significant ethical consequences for failing to plan for a practice’s future. Failure to plan for how clients will be taken care of as a lawyer approaches retirement age can, according to some authorities, be construed as reckless disregard for client welfare – a true ethical violation. In a number of jurisdictions, if a practice must be wound up due to the death or incapacity of the lawyer, application must be made by a personal representative, guardian or conservator. If there are cases or other matters not completely closed, the appropriate bar association can intervene, assume responsibility for action, and seek both reimbursement and compensation from the lawyer’s estate or assets.
Of course, facing up to the reality that they are not immortal is difficult for many lawyers. So too is the reality created by the Great Recession, as lawyers, like many others, have seen nest eggs shrink dramatically and fear they may outlive them if they don’t continue working – or if they don’t sell their practices for whatever they can get for them. Whatever the reason for failing to plan a practice succession, fear is the driver. To counteract this fear, make a rational assessment of the facts of one’s practice, life and anticipated or desired retirement. Assess the realities of financial resources and physical health. Consider whether there is an estate plan to estimate and minimize estate tax liability exposure, create trusts to conserve assets and minimize tax impact, and properly value the practice for estate tax purposes. As they say in the airline business, put your oxygen mask on first, before trying to do anything else.
As a starting point for assessing the financial implications of succession planning, remember that the value of a practice may be more or less than the amount of money the lawyer wants to have as a standard of living in retirement. The more urgent is the desire to sell, the lower will be the price; the less urgency, the greater will be the price. Not every law practice is salable. Some practices are so small and personal in nature that the purchaser might not succeed in keeping the clients. This, however, is a rarity. Even the smallest and most personal practices might be saleable for the right price and under the right terms.
Although every lawyer will have different income needs in retirement, valuation of a practice to support retirement is typically based on a “rule-of-thumb” method after valuing physical or identifiable assets. This method attempts to determine what the stream of income is worth to a prospective buyer, and although a standard has not yet been set for law firms, a general multiplier would be in the range of 50% to 300% of annual gross receipts, depending on the nature of the practice, the transferability of the clients and how much repeat business is expected.
Valuation and Goodwill
One of the thorniest issues in practice succession involves both ethical and business considerations: the issue of goodwill and how to value it. “Goodwill” in this sense is the reputation, client base and client loyalty that the selling lawyer has created over the life of the practice. Firms with bad publicity, malpractice and disciplinary matters hanging over them have little goodwill.
The issue of whether goodwill exists mainly has been limited to the selling negotiations. Typically, smaller firms understand the value of their client relationships and reputations and, when negotiating for the sale of a practice, discuss compensation for goodwill. However, larger firms argue that there is no goodwill and will walk away from a transaction if the "seller" wants to be compensated for their goodwill. The parties may not talk about goodwill; they may say there will be no deal if the seller insists on goodwill. Oftentimes, however, there is a "credit" for a factor that might be analogous to goodwill in terms of the cost of the capital buy-in. There has to be some adjustment for this factor, irrespective of what it is called.
There is no definitive way of calculating goodwill, but appraisers often use the “excess earnings” model in which goodwill is defined to be a differential advantage resulting from the individual lawyer’s skill, reputation and special talent. A rough calculation involves determining the average annual earnings of the firm over the previous five years, subtracting a fair return on the physical assets of the practice, and comparing the result to a researched typical compensation figure for a lawyer in the local market. This is the amount of excess earnings, and can serve as a proxy figure for goodwill. This is imprecise at best, however, emphasizing the need to get insurance in place to protect the value of the goodwill in the event that it cannot be realized in a practice sale because the lawyer has dissipated it through delay or lack of preparation.
Valuation and the Successor
If the practice is not sold, the best succession alternative is grooming a successor brought on board as an associate or a lateral partner. Ideally this succession plan can be structured to transition over a period of up to five years, as client responsibilities gradually transition to the new lawyer. During this period there can be ongoing conversations with key clients about the upcoming transition, an opportunity to forge new ties between the successor and both current and new contacts at the client, and sufficient planning to ensure that the new lawyer is completely up to speed on what the client needs and expects.
Preparing for this kind of smooth transition can ease problems over the issue of goodwill when the time comes to turn the practice over to a successor. If the new lawyer seeks to buy the firm outright and change the name from what clients have known, one might question whether the value of the firm's goodwill is decreased or even destroyed. However, goodwill infers that the reputation of the firm continues beyond the removal of any one individual. With that reputation come the client list, the phone number and the on-going nature of the practice (with staff and systems in place). Grooming and transitioning a successor from inside the firm can eliminate discord over this issue.
Our discussion of succession planning financial concerns has to this point emphasized human concerns, but there is another dimension to take into account: technology. Many small firm lawyers, facing financial pressure, resist buying or updating technology because they are overwhelmed by the high up-front expense. They may have software and hardware that is going on ten years old, or may not be using case management software or document assembly software at all, or may not be backing up and storing client electronic files at all. Lawyers who do not use adequate technology may be committing malpractice per se, by failing to provide competent representation when measured as the standard of care in the local community. And such malpractice directly and negatively impacts goodwill.
Cheating Your Heirs
Some lawyers at this point may say that succession planning is more bother than it is worth, and intend to stay in practice until they “die with their boots on.” If so, they are extremely short-sighted. In effect they are throwing away the value of their practices, cheating their heirs and making an unrecognized gift to strangers (existing clients have to go somewhere and the lawyers who pick them up will be the strangers and beneficiaries of the deceased lawyer’s stupidity).
Years ago when I was the chief operating officer of a midsized law firm, I had a conversation with the firm’s primary rainmaker. He maintained that, despite the size of the firm and revenue stream, and the quality of our client relations, our firm had no value. I considered asking him, “Would you please give me the million-dollar certificate of deposit that you maintain in the bank?” Obviously, the answer would have been “no.” That money was set aside to benefit his family and heirs; why would he give it to me? Similarly, why would lawyers ignore perhaps the largest asset in their estate, their practice? Why throw away so much value that would otherwise go to family and heirs? The value is there. After investing years of hard work and financial resources in growing the practice, effective succession planning allows any lawyer to reap the benefits of that value and the years-long investment of time and effort that created
©Edward Poll 2010
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