Best Practice: What to consider when buying out a law firm owner

Asked and Answered

By John W. Olmstead, MBA, Ph.D, CMC

Q. I am a senior associate in an eight-attorney elder law firm in Miami. There is one owner (founder) and seven associates including myself. The owner has approached me with a proposal to over time buy out his interests. I am the only senior associate in the firm and the only associate that he has approached concerning selling his interests. Specifically his proposal is as follows:

1. Pay him $825,000 for the practice over five years.
2. After five years I will own 100% of the shares.
3. My compensation arrangement will remain the same (salary plus formula percentage incentive bonus based upon my responsible attorney collections) until I have acquired 100 percent interest of the firm.
4. The owner wants to work in the firm indefinitely after his interest are acquired as an employee or Of Counsel.

I don't know how to respond to this proposal and would appreciate your thoughts? Is it fair? Does it make sense?

A. It makes sense for him. Seriously, you are going to need much more information than this proposal.To get started you need to ask for and review the following:

1. Profit and Loss statements and Balance Sheets for the past five years.
2. Tax returns or Schedule C for the past five years.
3. A report showing the current accrual based assets - mainly unbilled work in process and accounts receivable. There are often the largest assets that a firm has and it is not on a typical cash-based profit and loss statement.
4. A list showing any off-balance sheet liabilities.
5. Copies of the office lease and other leases to determine lease liabilities.

From these documents you can get a feel for the cash-based net equity, the accrual-based net equity after considering work in process and accounts receivable and unrecorded liabilities.

Two numbers that may be even more important is the average fee revenue generated over the past five years and the average compensation (net profit plus compensation - W2 and K1 earnings) that the owner has been earning over the past five years.

Here are a few thoughts:

1. One to one and a half times the owner's average earnings for the past five years is typical. So from this guideline you can evaluate the appropriateness of the $825,000.
2. What assets are included? Will he exclude any assets?
3. Will you be able to acquire minority interests over the five years as you pay towards the payout? I would insist on such.
4. If you do acquire minority interests as you go will there be a profit pie for you to share in or will the owner increase his compensation, personal perks he passes through the firm, cut down on his working time, etc.? You should get a handle on compensation as well.
5. I would not have the owner's employment open ended after you acquire 100% interest. Have some protection in case he fails to produce or has physical or mental problems that affects his performance. Suggest an Of Counsel agreement that gets reviewed and renewed annually.
6. Consider whether there is a transition that insures that the clients and referral sources stay with you after he retires. If he has not groomed you, involved you in relationships with clients and referral sources, had you giving seminars and plugged you into referral sources, future business could drop off dramatically. This should be factored into the value.
7. Weigh the cost-benefit of starting your practice vs. purchasing his practice. 

Good luck!

Click here for our blog on succession

Click here for out articles on various management topics

John W. Olmstead, MBA, Ph.D, CMC, (www.olmsteadassoc.com) is a past chair and member of the ISBA Standing Committee on Law Office Management and Economics. For more information on law office management please direct questions to the ISBA listserver, which John and other committee members review, or view archived copies of The Bottom Line Newsletters. Contact John at jolmstead@olmsteadassoc.com.