A law firm transition plan can span over several years, requiring substantial investments from the remaining partners. Quantifying the potential impact on the firm’s profits and, ultimately, the income of the partners, informs plan development.
Healthy firms that have the right information can expedite the process. Firms that lack profitability and/or have weak financial reporting may need remedial action before committing to a transition plan.
The elements of a transition-oriented financial plan are as follows:
- Cash flow, debt and equity over the transition period
- Effect of transition comp on earnings for the firm and for assuming partners
- Profitability of transitioned work
- Effect of multiple transitions occurring simultaneously
- Scenario planning at various levels of transitioned work
- Exit costs in the event of a failed implementation
1. Cash flow, debt and equity
The capital structure of many firms is reliant upon a combination of trade credit, bank and other interest bearing debt obligations, and members’ equity. Members’ equity consists of fixed or paid in capital plus any undistributed profits.
Depending upon the amount and duration of retiring partner payments, a firm may need to secure additional capital. Preparing partners for the eventuality of the firm incurring more debt, withholding current earnings, or requiring more paid in capital from partners ensures that sufficient cash is available to make retiring partner payments.
Firms that skip this step are asking for trouble and potentially inviting instability.
2. Effect of transition compensation
The effect of a retiring partner’s compensation is either borne by all partners or only those partners participating in the transition plan. In most situations, a hybrid is also possible that includes a share that all partners absorb and a share that the benefiting partners pay.
All remaining members typically underwrite retirement payments not tied to a transition plan. Firms that link retiring partner compensation to the transfer of client relationships can either allocate transition costs to all partners or only to the benefiting partners.
As an example, a firm that uses a profitability driven compensation approach or considers originations in compensation may allocate a retiring partner’s transition costs to the partners receiving post-transition origination credit.
A firm may also withhold assigning client credit to any partner until the transition period is complete. In these instances, the partners benefiting from the client transfer defer any compensation increase until after the transition period.
Regardless of the approach, calculating a pro forma effect on the remaining partners’ compensation adds to the transparency of the process.
3. Profitability of the transitioned work
Understanding the profitability of a client relationship before a transition is useful, but it is more important to project profit post-transition. Future profit models allow a firm to determine the amount of net income available for transition compensation.
Additionally, a firm must consider the impact of changes in the staffing mix. Assume that the retiring partner worked a high number of billable hours on a client account, but the replacement partner plans to use a more leveraged model. Client considerations aside, what is the impact of that decision?
What if the opposite were true and the replacement partner plans to work many of the hours that were performed by others in a leveraged model? What if the replacement partner is planning to staff the account differently altogether? If the transition plan calls for a retiring partner to receive compensation based on client profits over a period, these considerations are important.
4. Effect of multiple transitions happening simultaneously
Depending upon the size to the firm, simultaneous transitions can overtax the resources of the firm. Additional factors include the term of any payout or return of capital. Some firms cap combined transition costs or retiring partners’ costs at a percent of net income.
When transitions are essentially agreements between individual partners, they are easier to accommodate. In these instances, the firm has an interest in ensuring that transition arrangements are well understood by the parties and are feasible. A weak agreement will inevitably become a problem for the entire firm. We recommend partnership approval of all transition agreements.
5. Scenario planning at various levels of transitioned work
We recommend modeling a best and worst case scenario. Worst case planning prompts a firm to consider a process for managing a failing transition. Several considerations become relevant including:
- Who assumes the risk of a successful transition?
- Is there a role for the firm if the transition is not working?
- What monitoring tools are necessary to detect issues in a transitioning account?
Modeling or a best-case scenario is also important. Client relationships are fragile, and a firm may want to allocate additional short run resources to ensure that service levels remain high. A firm may also incur higher marketing and training costs. Recruiting fees may also apply.
In these instances, it is necessary to consider the costs of these additional resources in the transition plan.
6. Exit costs in the event of a failed implementation
Firms should also consider the possibility of failure. This is difficult to do with such a forward-looking action as transitioning a retiring partner’s successful practice.
While the retiring partner will likely want compensation in a failing transition, the firm will not have the underlying economic base to make these payments. Correspondingly, a firm or the assuming partner will not want to pay the retiring partner if the clients chose to hire another law firm. Basing compensation to the retiring partner on future receipts diminishes the cost of a failing transition.
Regardless of the approach, quantifying exit costs in the transition agreement is recommended.
A credible process
Transition plans can include several components and a substantial investment. Understanding these costs and adequately preparing for contingencies will add credibility to a firm’s practice transition process. A credible process that is repeatable is a competitive advantage.