Welcome to a complementary edition of The Law Firm Disrupted, where I try to make sense of the biggest challenges and opportunities facing law firms today. In this week’s column, we finally answer the question we’ve been mulling over the past few weeks: How can law firms incentivize long-term thinking? I’m Roy Strom, the author of this weekly briefing, and I can be reached at email@example.com.
It was three weeks ago when we first entertained this important question: How can law firms change their governance or financial structures to incentivize more long-term thinking?
Last week, we looked at how law firms are “pathologically present-focused,” as Yale Law professor John Morley put it. The main culprit is the extinguishing nature of law firm equity. You can’t take it with you into retirement. That creates an incentive to make as much as you can while you can, causing a struggle to turn over client relationships; to bill clients in ways other than by-the-hour; or to invest in technologies or people that would benefit their firm after their retirement.
All that being said, it’s probably easy to see what I’ll suggest could be the solution: a corporate-like permanent equity structure. Don’t stop reading. This is not a professional-rules-need-to-change article. There is a way for law firms to do this today. We’ll get to it shortly.
Perhaps the most complete proposal for a permanent equity structure comes from Jonathan Molot, a professor at the Georgetown University Law Center and a co-founder of litigation finance giant Burford Capital Ltd.
In 2014, Molot wrote a 43-page article arguing that permanent equity would be a “corporate finance solution to law firm short-termism.”
Molot claims that by allowing partners to retain equity in their firms after they retire, they would be incentivized to build long-term value in their firms. They would look to build long-term client relationships and they would invest in the junior lawyers who would be needed to service those clients after they are done working on matters.
To illustrate how a practice may be valued in the long term, Molot uses an example of a practice that generates $10 million in annual revenue and $5 million in profit. Using a 10x multiple, the practice would be worth $50 million to a prospective buyer. That depends, of course, on the practice’s ability to generate revenue and profits after a key partner retires.
For example, if the $10 million practice declines 25 percent, but its costs stay the same, the future earnings would decrease to $2.5 million. Using the same 10x multiple, the value of the business would then decline 50 percent, to $25 million. That drop illustrates just how strong a financial incentive a partner would have to ensure that the practice would be just as healthy—if not healthier—when the partner is done working.
Under the permanent equity model, Molot points out that compensation would be determined by whether a partner “is cultivating long-term client loyalty likely to generate future billings, and whether he or she is training junior lawyers to service those clients’ needs in the future.”
Molot wrote in his paper that the equity would be more valuable if law firms were allowed to be owned by non-lawyers. A larger pool of potential investors makes any investment more valuable.
But, like I said, the model here doesn’t require that regulations be changed.
Molot has figured out a sort of backdoor to provide today’s partners with permanent equity. And that is by spinning off a firm’s back-office operations and granting partners long-term equity in what may be called a “service co.” Molot said Burford is actively discussing financing this structure with major firms today. He expects a deal will eventually close—it’s not just a hypothetical.
“I think liberalizing the ethics rules is a good idea,” Molot told me. “Because you’re not looking to move the entire profit center of a law firm into a permanent structure, only a slice of it, I think that can all be done now without any change.”
Molot said he couldn’t go into all the specifics of how the structure would work, but he said there would be enough value in a potential spin-off entity to create the types of long-term incentives he wrote about years ago.
“The reason I think there is enough value in that non-legal services company is because you don’t need to get a majority of the profits to that entity,” he added. “You still want a majority of the profits to flow to the partners who are generating them. A minority [of profits in the spin-off] is plenty. I’m not looking to revolutionize the way lawyers practice law. I’m just looking for an adjustment at the margins that rewards partners who build long-term value with a nest egg when they retire and that incentivizes ongoing performance and long-term thinking.”
In an article this week for a Burford publication, Molot wrote that beyond the long-term incentives, there are tax advantages to this spin-off structure. Partners’ equity ownership, when sold, would be taxed as capital gains rather than personal income. And for ongoing operations, the back-office operations could be structured as a pass-through entity, which receives tax preferences in the 2017 tax law.
Much has been written about the varying desires of differing constituencies inside a law firm. That often inhibits change. But one reason I think this structure may actually work—or why it would at least be intriguing to a managing partner tasked with coalescing a firms’ constituencies—is that it benefits almost all groups.
I’ve written already about the benefits to senior partners. Equity into retirement can be a much-needed nest egg. Junior partners would benefit from knowing that the senior partners at their firm are invested in their long-term future. The same can be said for associates. And wouldn’t clients like to know that the partners they trust today are invested in training the partner they can trust next year?
If law firms want to truly think long term, this is how they should do it.
Thank you for reading this abbreviated edition of The Law Firm Disrupted. Please feel free to reach out to me at firstname.lastname@example.org. And sign up here to receive The Law Firm Disrupted in its entirety as a weekly email. Or subscribe to our brand new RSS feed.