The law firm market is undergoing a process of transformation and concentration on both sides of the Atlantic. The last few months have seen not only mergers and acquisitions or integrations of well-known firms, but also an acceleration in market concentration and inorganic growth processes. Every week, firms in Europe and Latin America are immersed in integration processes.
The integration of law firms is a complex operation and differs significantly from the usual mergers and acquisitions (M&A) that the same firms usually advise on. The success of these integrations depends not only on negotiable issues or market opportunities, but also on the integration process itself being relevant, careful and methodical. In this type of professional firms, where people and their reputation are the most important assets, the integration process takes on a particular relevance and becomes a crucial element for the future success of the merger or integration. This process requires an adequate methodology, as well as a precise management of timing and “opportunity criteria”, which often become critical. To avoid interruptions, misunderstandings and unexpected changes of pace, it is essential that both parties speak ‘the same language’.
In this type of integration, one of the elements that often generates friction is the comparison and extrapolation of future financial issues and economic projections. In many cases, the parties do not speak the same language in this regard, because not all firms measure their profitability, analyze their financial ratios or manage their profit drivers adequately, or at least in the same way.It is essential that at least the appropriate profit drivers, also known as financial KPIs, are calculated and managed in a similar way for the integration process to flow smoothly; especially to accurately address the most complicated points of the negotiation, which will undoubtedly revolve around the partner compensation system. To this end, having accurate and unambiguous information is essential to avoid dysfunctions in the comparison of firms and in the economic projection of the future integrated firm.
These ratios can be varied and different, but there are undoubtedly some essential ones that are not only useful for a supposed integration but are also necessary tools for the day-to-day management of the firm.
Good control of these ratios makes it possible to manage the firm’s finances and understand how close or far it is from the appropriate ratios to achieve the strategy. Let’s take a look at the essential profit drivers that not only serve to “pilot” the firm, but also to compare it with its peers, in what is known as the “law firm profitability formula”.
In a law firm, regardless of the formal accounting and asset and liability items and the control of long and short term debt, attention must be paid to other variables to measure true profitability. Although the concepts of profit, costs, P&L, balance sheet and EBITDA remain the same, the main criteria differ significantly. It is more important to analyze the average tariff and the average rate of a type of service such as commodity, before prioritizing aspects such as working capital or goodwill.
This becomes even more relevant when we understand that corporate profits are often diluted by distributions to partner lawyers, either as fringe benefits or directly as salaries.
The calculation of partner profit and its impact on the balance sheet and profit and loss account can distort the official accounting and the usual financial ratios. To obtain a more accurate perspective, it is necessary to analyze the concept of “profit per partner”, using a variable of the modified Dupont formula, especially with regard to the concept of leverage. In this context, leverage does not refer to financial leverage, but to leverage in terms of “people”. This is because the greatest asset of a law firm is precisely its professionals and, in turn, they are the greatest multiplier of the profit generated. The factors that determine the profit per partner in a law firm are threefold:
- The margin.
The formula is calculated as follows: profit per member = margin x productivity x leverage.
- Margin: the margin is obtained by the ratio between profit and sales (profit divided by sales).
- Productivity: the result of multiplying utilization by the firm’s average rate, once the time factor has been introduced into the equation.
- Leverage: the ratio between partners and non-partner lawyers. It is applied in this type of professional services firms as a sort of “leverage” in people, not leverage in financial capital.
The control of these three ratios, some strategic and others not, helps us to know if the model we are executing is aligned with the chosen positioning. This is important, since the profit drivers described above operate differently in each of the four classic positioning of law firms: commodity, process, experience and expertise. Once the ratios have been calculated and controlled, we will be able to clear up many doubts and approach complicated conversations in an integration process.
Thus, before approaching an integration, firms should have well defined and pristine each of the profit drivers mentioned above: profitability per partner and the different types of services provided according to each of the positions. By having these aspects well established, they will be able to face the new challenge of an integration process with all the cards on the table and, moreover, ensure that everyone is playing with the same deck of cards and the same cards.
Jose Luis Pérez Benitez