Accepting shares in a client’s business for professional services rendered was unthinkable until recently, but it has now become an attractive option for law firms.
Theorists believe both the client and the law firm benefit from these arrangements. Struggling start-ups can defer fee payments and reallocate funds to IT, marketing or business development – and instil confidence in their bankers by having a law firm on board. Law firms gain a stake in a successful growing business, while demonstrating long-term faith in a new client’s commercial prospects.
But equity in lieu of fees (ELF) is not suitable for all firms. Key success factors include the partnership’s underlying financial strength and attitude toward risk, sector specialisation and the nature of its client base. Conflicts of interest will quash any ELF deal. A professional who holds shares in a client organisation must be aware of the implications if they advise on price-sensitive matters such as the timing of a new issue, strategy for high profile litigation or property asset valuation.
The law firms most likely to make a success of ELFs are those that combine vision for the big picture with careful scrutiny of the procedural aspects of ELFs that initially appear irrelevant. While the lead partner generally has the best client knowledge and relationship, they may lack the required detachment for a balanced investment decision: who makes partnership investment decisions; what proportion of fees might be settled via shares; what is the investment ceiling for any one client; is there a maximum exposure level for this type of equity investment; and what profit level should be reflected in fees?
Establishing an investment committee that includes an external investment specialist is an effective way to resolve the internal issues associated with ELFs. Questions that should be asked include: for whose benefit are these investments held; who participates in the scheme; are new partners allowed to join; should new partners make payments in advance of future returns; what is the expected period for holding a typical ELF investment; and is the strategy to minimise exposure or hold long-term equities?
In a practice comprised of equity partners and assistants, partner participation can be restricted to the year in which shares are acquired. The issues become more complex in larger firms with tiered partnership and remuneration structures where one or two departments might generate all the firm’s ELF arrangements. Under these circumstances, fixed-share partners and senior employees might be demotivated if they are excluded from any gain on the shares. Similarly, tensions might arise between equity partners if some believe they must share ELF windfalls with partners who have no realistic prospect of repeating these potentially lucrative deals.
In rapidly expanding firms, it might be necessary to create a method for distributing profit that is locked up in shares as bonuses to fixed-share partners and employees. Alternatively, all shares acquired in one accounting year may be siphoned off to a separate vehicle created specifically for the benefit of that year’s partners – a move that presents significant funding and
tax implications.
Although these vary with the nature of the holding and the terms of the options, a partnership should be aware that when it receives shares or share options, it will be generally taxed on the value at which they were accepted; at that stage, the shares will often not be realisable for cash so tax payments must be met from other sources. Similarly, the value of the fee represented by shares or share options are subject to VAT, so partners will be taxed individually on gains arising when they cash in shares.
UK law firms can learn from the successes – and mistakes – of their US counterparts; but prevention is the best strategy. While many firms appear to have triumphantly jumped on the ELF bandwagon, none have publicised losses. It is tempting to accept ELFs uncritically in a bull market, but it is essential to remember that the value of any investment fluctuates over time. The ill-prepared firm exposes itself to financial risk and a war among partners if a favourite ‘www’ investment transforms into ‘what went wrong’.
Cash-rich partnerships with thoughtful investment strategies are well placed to take advantage of ELFs. Funding the partnership and satisfying immediate and future financial needs is of paramount importance. Relying on traditional client work and methods of payment are no longer enough – industry and the professions are in the throes of change, and partnership finances must reflect this. ELFs offer an innovative and refreshing approach to client relationships and payment.
ELFs were launched via the booming dotcom sector. Now that the bubble has burst, law firms should look towards clients in other sectors for future ELF deals. Start-ups in perennially strong sectors such as biotechnology, traditional media and the service sector are touting for financial support and can offer excellent returns. Opportunities abound for professional practices that are prepared to meet the needs of today’s, and tomorrow’s clients.
George Bull is a tax partner at Baker Tilly Chartered Accountants.
