One reason is that law firms traditionally ascribed a nil value to goodwill and consequently failed to credit partners with any rights over the goodwill of the business. Instead, the model was – and, in many firms, still is – for partners to contribute a capital sum on joining a partnership and to be repaid the same sum when they leave. In effect, their return on investment is limited to the profit shares (and, possibly, interest on capital) they earn while partners. Under this model, if the business is sold a day after a partner leaves, any proceeds will be paid to those lucky enough to be partners on the day, who may not be those primarily responsible for having built up a large part of the goodwill over the years.

This state of affairs was unimportant when law firms, being people businesses distributing their entire profits annually, were perceived as having little capital value. But this has not been true for a considerable time. Factors such as restrictive covenants, client panels and better branding have helped firms to institutionalise clients, giving them a value independent of their individual partners.

The current pool of potential investors in UK law firms has immeasurably increased their prospects for external investment or an outright sale. However, partnership/shareholder agreements have yet to catch up with this changed business context. In principle, it seems unfair to exclude former partners from sharing in a capital gain to which their efforts have contributed. However, few firms currently have a legal obligation to share any gains with former partners. Partners at the time of a sale may argue that they are the ones who have secured the opportunity for a capital gain and who must, by their continuing efforts, assure any earn-out and give up a proportion of future income to an outside investor. That is all true, yet in the corporate context, former shareholders not infrequently share in a gain in these
circumstances.

It would be surprising if more law firms did not now actively consider including an ‘anti- embarrassment’ clause in their partnership/shareholder agreements. But how should such a provision work?

Some guidance can be found in anti-embarrassment provisions in share sales, where a seller of a company may secure the right to share in the proceeds of the sale if the buyer sells the company for a higher price within a year or two of the purchase. Often, this is structured as a contractual right, rather than a continuing equity stake and may be subject to various conditions, such as excluding any increase in the company’s value due to the buyer’s investment.

Alternatively (or additionally), the approach adopted by private equity houses towards their partners may find favour, in which partners’ interests in the capital value of the firm vested over a period of years are subject to ‘good leaver/bad leaver’ provisions, with partners potentially losing their interest if they compete with their former firm. Some adaptations would be necessary since, unlike private equity funds, which have a limited life span, law firms would need to incorporate provisions to taper former partners’ contractual rights over time to make room for other retiring partners and to ensure that the ongoing partners’ capital interests are not diluted to an unacceptable extent. The sale value in which former partners might retain an interest would typically also exclude any interest in the value of an earn-out.

Designing a fair system is a task that lies somewhere between very difficult and impossible. But designing a system that is fairer than the current norm should be relatively simple. Even though an anti-embarrassment clause may prove time-consuming to negotiate, it could help a firm to prevent tensions from arising. At its worst, the absence of such a provision might result in partners who are nearing retirement lobbying for a sale earlier than the ideal time or deferring their retirement as partners in the hope of still being in place to share in the proceeds of a sale that appears not too distant. Even if a firm has no present intention of seeking external investment or putting itself up for sale, airing the topic may prove beneficial. Moreover, it will be far easier to reach a consensus when a sale is not in prospect than when that pot of gold is in view.