Merging balance sheets: The key financial issues in law firm mergers

Feature | 9 November 2012
merger-finances

Colin Ives explores the key financial issues to manage in law firm merger negotiations

A merger is not right for all firms. There is a market position for a wide variety and sizes of firms with different types of practice areas, but this comes with an acceptance, by the partner group, of a certain type of business existence, stability and lifestyle. Each of these three criteria are important; the culture of the firm will determine the balance between them.

Firms not considering a merger will need to have a vision and understanding of the external market pressures and how they will impact upon their clientele, profitability and hence partner lifestyle.


Market changes

In the UK, the changes associated with the Legal Services Act are causing firms to peer into the future and consider the impact of new entrants to the legal market, firms accessing external capital and the additional burden of increased regulation.

This has been exacerbated, in some firms, by generational issues, with fewer new partners being made up since 2008, but a continuing wave of partners reaching an age when they are seeking to wind down their activities.

The easiest mergers to bring to successful conclusion have been those where one or more of the parties concerned has accepted that part of their strategy is to be part of something bigger, including an acceptance that they would be the smaller party.

However, responses to our June 2012 UK survey on law firm attitudes to mergers showed that nearly 75 per cent of those firms seeking a merger within the next 12 months anticipate being the acquirer or larger party (see Figure 1).

What is very interesting to note is that, often, the management of the firm accepting the lesser role has quite often risen within the merged entity to become part of the management of the merged firm.

Accordingly, the managing partner or leadership team of a firm being ‘taken over’ in a merger scenario should not always be concerned about their future, as the successful delivery of a merger will invariably impact positively on those who had the foresight to see the opportunity that the combination of the firms could achieve.


Due diligence

Having advised law firms and their partners for over 30 years, I have been involved in more mergers and merger discussions in the past 12 months than I have in any year previously. I have also noted a very high level of merger completion in 2012 whereas, in the past, merger activity has met with only relatively modest success.

Historically, the major focus of our work has been upon the prior years’ due diligence of each of the merger parties and what the firm would have looked like if the figures had been combined for the past 12 to 36 months. This dynamic has changed. We are now receiving instructions based more upon what the merged firm will do in the next 12 to 36 months and what can be done to achieve this performance.

When merger talks are revealed in the press, the immediate focus tends to be on the diversity of the merger parties’ financial performance, such as PEP, turnover and profitability. Whilst interesting, this does not say anything about what a merger of the two parties might actually achieve – it is this that the partner groups will be buying into, not the financial performance of the past.

There is, however, considerable value to the financial due diligence review, which makes this an essential part of the process. It is important that each firm presents its figures such as profitability, liabilities and other commitments in a common format, so that the two firms can compare like with like. This process can reveal a number of items which may make the merger unattractive; early identification is important.

A focus of this work should be on long-term commitments, such as pension scheme deficits and property commitments. These items need to be considered in the context of what can be achieved through merging the firms. Sometimes, they just need to be factored in as a ‘cost of the deal’ rather than as deal breakers.

When entering into merger discussions, there must always be an expectation that there will be items for both parties for which the position may not be ideal. An open discussion about how these should be dealt with and the possibility of spreading these costs between the partner groups going forward should be considered.

The fixed accounting rules do not necessarily need to be followed for dealings between partners or years. It is therefore not unusual for such items to be spread over three to five years, or for a group of partners to be excluded from the burden of some costs and/or benefits.

Other items that often get overlooked in a merger can include the valuation of work in progress and debtors. It is common for parties to a merger to value these items differently. Each firm should have such items valued on the same basis, being the basis to be adopted by the merged firm.

It may be appropriate for additional profits or costs to be reflected in either of the pre-merger businesses or within the merged business, but apportioned to only a group of the partners who are affected.


Capital structuring

The capital structure required by the merged firm and how it is to be funded should be thought through prior to merger. It should be considered in the context of the financing of the merged business.

When looking at the capital funding of the firm, it is important to consider all aspects of the funding contained within members’ interests of the business and not just capital account balances. This can include capital provided by the partners, profits retained and paid out later in the year and taxation reserves.

Often, when initially approached by firms looking to merge, we are told that their capital funding structures are a significant issue. For example, one group of partners may have partner funding of £250,000, whereas the other firm has partner capital funding of £400,000. Whilst these are headline figures, the actual position may be much closer than first thought. One item that can particularly impact on this scenario can be tax reserves, particularly where there are different year ends.

The figures quoted above are similar to an actual case. Once adjusted for the funding of tax reserves and an amalgamation of accounting dates, the firm with partner funding of £250,000 actually had, on a like-for-like basis, partner capital funding of £410,000.


Taxation

A major factor that needs to be considered at the time of merger is the tax position of both firms and their partners. Where both firms have the same accounting dates, the merger can be relatively straightforward, as the tax rules allow for mergers of professional practices to be undertaken with limited impact on the partners and firm.

However, for the tax rules to apply, certain criteria will need to be met. These criteria primarily look to see whether the businesses that existed prior to the merger can be said to be in continuation in the new merged firm.

One aspect that may apply in the future is where the law firm joins an alternative business structure. It could be argued that the legal practice is a small part of the overall business and, thus, it may be possible for HMRC to contend that the legal practice has changed significantly from its pre-merger form and therefore ceased.

Where this is the case, all partners will be deemed to have ceased their self-employed business as at the merger date and then commenced a new business. This can have a significant cashflow impact for one or both of the merger parties and should be considered at an early stage.

It is also possible that it could be favourable for one or other of the merger parties to actually have a cessation for tax purposes. This will particularly apply where profits have been falling or, in the pre-merger year, there has been a significant loss.

Another tax aspect is the choice of accounting date that is to be used by the merged firm. Typically, where a firm with a 31 March year end merges with a firm with a 30 April year end, it would be normal for the merged firm to adopt a 30 April year end. This is because, assuming rising profits, a firm with a 30 April year end will have an inherent cashflow advantage which would unwind if a 31 March year end were to be adopted.

Assuming an alignment of accounting reference dates to, for example, 30 April, the firm with the alternative accounting reference date will have a change of accounting date for tax purposes. This position needs careful consideration, as the rules for a continuing business are different from those where one of the parties has ceased upon the merger.


The personal impact

One area that can be really essential when presenting a merger proposal to the partners of a firm is to demonstrate that the personal impact on the partners has been considered and evaluated. While this will be particularly important for the partners of a smaller firm being taken over by a larger firm, it can be equally valued in a merger of equals or where the larger firm is expecting a period of additional costs associated with the merger.

This analysis will show some small items which may be particularly valued by one or both partner groups, which can cause a disproportionate negative view of the merger proposal. These items, if addressed early, can normally be dealt with at minimal cost, but will produce a greater feeling of comfort with the overall merger proposal.

It is normal for a merger to result in a short-term depression of profits during the period when the merged firm deals with any cost savings and reduction in duplication. This is a normal cost of a merger and the real benefits are likely to take more than 12 months to materialise. Partners should be made aware of this cost, timeframe and the potential position when this period has expired.

Consideration should also be given to the position of partners who have a planned retirement during this period, as they will not be around to see the longer-term merger benefits.


A clear vision

There will likely be a continued focus on consolidation throughout the professions. For firms with a clear vision of what they and their partners want, the opportunities are great, but need to be planned. Those without a vision may find the marketplace moving ahead without them and are in danger of their visionary partners doing likewise.

Colin Ives is a partner and head of professional services tax at accountancy firm BDO (www.bdo.uk.com)

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