Best Practice Tips: Law Firm Capitalization – Should There Be a Buy-In?
Asked and Answered
By John W. Olmstead, MBA, Ph.D, CMC
Q. I am a partner in a firm in Los Angeles. We have nine attorneys: four partners and five associates. We are a young firm in that we have only been in business for four years. The four partners started the firm together, and we are equal partners who split the profits equally. When we started the firm, we each made equal capital contributions. We do not have a partnership agreement. We are thinking about bringing in two associates as equity partners and are trying to think through the mechanics. One of our questions is whether there should be a buy-in and, if so, how should we determine it. We would appreciate your thoughts.
A. Law firms have different viewpoints on this subject. I have worked with some larger firms that are in second generation or later that do not require a capital contribution at all. They use end of the year distribution hold backs and credit lines to fund their working capital requirements. Other firms do require capital contributions upon being admitted as a partner and additional contributions over time when additional capital is needed or when partners acquire additional capital interests.
Smaller firms tend to require new partners/shareholders to pay for their interest in the firm. The buy-in can provide additional capital for the firm or can be used to compensate the existing partners/shareholders for their investment and sweat equity in creating the law firm or in growing it to its present size. One approach that some firms use it to include in the partnership/shareholder agreement the formula for determining the value of the firm, to which the new partner’s/shareholder’s percentage interest can be applied. This could include non-cash-based assets such as accounts receivable, unbilled work in process, and goodwill. Another approach is to base the buy-in or capital contribution upon the cash-based capital based upon the number of ownership shares a partner receives. Most firms allow for a buy-in over several years. Firms that do have a buy-in provision also typically provide for a payment to partners/shareholders upon departure for the value of their capital account. In recent years, an increasing number of large firms have adopted a free buy-in. Under that approach, there are no payments to departing partners/shareholders.
I believe that you should require at least a capital buy-in based upon the cash-based capital on the books and the number of ownership offered. This assumes that the partners still have capital accounts on the books. I also think you might consider them buying into the accounts receivable and unbilled work in process as well or be excluded from participating in compensation from those receipts. You should also get a partnership agreement in place as well.
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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 and author of The Lawyers Guide to Succession Planning published by the ABA. 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.