Then there is the issue of how a firm's owners — its equity partners — are compensated. The way that most partnerships are structured means that they are effectively unable to retain any earnings at the end of each fiscal year. Except for any planned investments, all remaining profit — what the Am Law 200 and Global 100 surveys refer to as "net income" — is distributed among the equity partners in full. Compared to companies in other industries, this gives law firms an artificially high profit margin, since from an accounting perspective, equity partners receive no above-the-line salary and therefore represent no cost to the business. This arrangement precludes the calculation of almost any recognized valuation metric, such as EBITDA (earnings before interest, taxes, depreciation, and amortization), which is the favored tool for private equity investors.
"Partner remuneration is reported as one figure, but really it's two things — it's a payment for a day job and payment for putting capital into the business as a proprietor," says legal consultant and former Clifford Chance managing partner Tony Williams. "Firms have never really looked at it that way before, but that's exactly what [external investors] would do."
Before a traditionally structured firm could attract outside investment, then, it would need to fundamentally change the way it compensates its equity partners. The firm would need to determine how much of an equity partner's total compensation is essentially a salary paid to an employee and how much is profit returned to a shareholder. One of the first hurdles we faced in our analysis — and the first of many assumptions we had to make — involved this issue.
The simplest solution would have been to look at how much partners in other professional services businesses are typically paid and assign a comparable notional salary to all equity partners, irrespective of firm. This salary cost would then be deducted from net income to leave a pro forma cash flow that could be used to create a valuation. It seemed unlikely, though, that a rainmaker at Wachtell, Lipton, Rosen & Katz, for example, would receive the same base pay as a partner at labor law specialist Littler Mendelson.
We instead opted to divide net income into separate pots for compensation and profit. This may sound straightforward, but in an actual acquisition, this would be the subject of intense negotiation. For any deal to proceed, a balance must be struck that both gives investors a return on their investment and allows partners — many of whom may be skeptical about the need for external investment — to maintain their lifestyles.
"It's critical for an investor to remain dispassionate when weighing an investment, but you also have to be sensitive of the fact that owners have an emotional stake in their business," says John Llewellyn-Lloyd, head of M&A at Espirito Santo Investment Bank. "The challenge for investors is to pay the lowest fee possible while still keeping the management happy."
Investors would likely demand that a sizable portion of a firm's net income make it through to the revised bottom line. The exact distribution would vary with each deal, but on the basis of conversations with a wide range of private equity and other midmarket investors, we settled on an even 50-50 split. Half of each firm's net income would be used to pay its equity partners in the form of a salary and bonus (the exact composition of which would be at the firm's discretion), and half would be its pro forma cash flow.
That would not be an easy pill for equity partners to swallow. Although the current partners would benefit from seeing a portion of their equity monetized through the sale, and would continue to collectively receive 50 percent of net income as a salary, they would have to accept that at least in the short term, they would, on average, be making less money.
Once we created our formula for equity partner compensation and came up with a workable cash flow figure, we needed to apply a multiple in order to generate our valuation. This was the crux of the entire process, and the stage that had the greatest bearing on each firm's result, relative to its peers.
Put simply, the multiple that investors are willing to pay depends on how attractive they believe the business to be. Much of this would come down to the perceived "quality of earnings" of each firm. This would encompass a wide range of factors and would vary depending on both the law firm and investor, but would commonly take into account such things as overall size and potential for further growth, the diversity of practice areas and geographic coverage, the strength of the firm's client base and of its relationships with those clients, and whether it is considered a market leader.
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