External investment is increasingly common in the legal sector, and for all sizes of firm. But is it for you?
Not that long ago, external investment in law firms was not even a possibility; the first alternative business structure (ABS) was licensed less than seven years ago. Even law firms which were ABSs were slow off the mark to seek external investment in the early days. In the last year or two, however, we are starting to see more and more firms looking to venture capitalists, family offices, private equity (PE) houses or even stock market flotation as a way to garner much more investment than might traditionally be possible.
Plenty of firms are already used to having to ‘keep the bank manager happy’
And this trend stretches beyond very large firms (DWF, for instance, which is set to be the largest law firm yet to float on the London Stock Exchange), through to firms such as Stowe Family Law LLP – which is under PE ownership – all the way to small start-ups.
So external investment is now possible for everyone – could it be right for you?
Status quo
Before we start looking at the ‘new’ options, it’s worth remembering that there has always been external investment in law firms. The lateral hire partner who comes from a rival practice down the road is external, and is likely to buy considerably capital upfront. A sensible incoming partner will take time to analyse the figures to make sure they are getting value for their investment, taking specialist accountancy advice as they do so. That is (or should be) no different to any other external investor.
We should also not forget that the bank overdraft, disbursement funder or office mortgage is a source of funding from an external provider. Clearly, the bank does not take direct ownership when it provides funds like these, but with charges, liens etc, you might take the view that it ‘owns’ as much of the assets as the partners in the firm do! Moreover, these institutions tend to have considerable due diligence exercises that they undertake, often asking for copious amounts of information before they release funds, and then request regular updates about the use of ‘their’ money. Plenty of firms are already used to having to ‘keep the bank manager happy’ – is that much different to having an external investor to keep appeased?
Why?
The answer most often given to this question is: the money. It is true to say that external funders are likely to have more resources than the existing partners. So you need to ask a follow-up question: what do you need the money for?
It’s no good getting the money and not having a plan about how you are going to use it
External funding is often used to create an exit route for the current owners of the firm. Transactions such as LegalZoom’s purchase of Beaumont Legal in 2015, for example, enabled former partners from that firm to retire.
Another common use of the funds is to support growth. Gordon Dadds has publicly declared that its funding round, following its stock market flotation, will be used to purchase multiple other firms.
The point is: it’s no good getting the money and not having a plan about how you are going to use it.
And don’t forget that the answer to ‘why?’ needn’t just be money. These funders come with other advantages too. Investors will often provide extra board-level resource, usually with considerable business expertise. Through this individual (or individuals), the funder will be able to give access to a wide variety of skills and knowledge around marketing / finance / HR etc – expertise that the firm might otherwise not have.
Who?
This is harder. Most external funders will claim that they are supportive and interested solely in the growth of the business. This will be true for some, but for others, possibly even the majority, profit and then a short-term exit route will be the prime driver. Therefore, in selecting a funder, care should be taken over how they operate and what their expectations are.
In general (though this is not an absolute rule), a results-driven PE funder would insist on monthly management information, and regular commentary and catch-ups in terms of forecasts and business plans. They would typically want to see considerable increases in profitability in a short time, and then sell on their stake within three to five years. Meeting these demands, changing the business model to accommodate the required results, only for the funder to hand over to someone else can be frustrating.
Other funders might be less demanding than this, but however ‘nice’ a funder is, you are ultimately handing over some amount of control – possibly 100 per cent! – to a profit-driven entity that may not share the same ethos as you.
So aim to ensure that, whomever you approach, it is clear from the outset how the relationship will work and that you are comfortable with that level of over-watch.
How much?
Law firms most commonly change hands in either a true merger or a distressed sale. In both cases, the value to the vendor is usually to be found in the creation of an exit route. In a true merger, the vendor will also be looking to enhance profitability, whereas in a distressed sale, the vendor will be looking to avoid closure liabilities. However, law firms do change hands for actual consideration in both situations, and they certainly do where external funders are concerned.
Stand your ground and make sure your numbers (and advisers) are solid
The actual value you achieve will depend on a whole host of variables that I do not have the space to cover here, but it is common to see between two and five times the adjusted maintainable profit. Adjusted maintainable profit is similar to the average statutory profit for the last three years, but with various adjustments made to allow for the nature of the business. Inevitably, the external funder will have considerable experience in negotiating acquisitions of various types of business, and may well attempt to ‘price chip’ the value – stand your ground and make sure your numbers (and advisers) are solid.
Recent flotations and acquisitions for actual consideration prove my point: Legal Zoom acquired Beaumont for £6.4m, Livingbridge acquired Stowe for approximately £10m, and Gordon Dadds raised in excess of £20m upon flotation.
How?
There are three stages to the process of actually securing external funding.
- Get ready internally
Do you have sufficient management information and reporting to answer the inevitable questions you will receive? Are all your partners on board with the plan? Do you have the robust business plans, forecasts etc to show how the funding will be used? If not, take the time now to get it right: nothing looks worse than having to re-do (or do in a hurry) something that should have been done well in advance.
- Market the offer
While some investors might be known to you, it is likely that you will want to access the network of an experienced corporate finance adviser, ideally with a specialism in or full-time outlook on the legal sector. This will not only help professionalise the information you are releasing to the market and give you access to many more potential offers, but also avoid too much information being released into the public domain. It is very important to be clear why you are different and worth the investment – however, I have found that successful investments are not necessarily revolutionary. The investor will want something they can ‘hang their hat on’, but that need not be a clever piece of practice management software, a niche bit of the law or a ‘disruptive’ business model – it could be (and has been!) something as simple as being based in a particular town with minimal competition but access to an enviable client list. In that example, the unique selling point (USP) was an accident of geography, but the point is that there was a USP.
- Negotiate the terms
As any Dragon’s Den fan will tell you, the investor inevitably wants to have more ownership for less money that the original proposal. Therefore experienced advice in this arena will help to ensure that you get a fair and sensible deal.
Is it right for you?
The answer is yes, if you:
- have a clear rationale for why you need the funds
- have a USP that you can articulate and can be proven
- can see how professional business directors could help you at a senior level
- don’t mind entering an information-hungry world that will expect swift results.
If most or all of these don’t apply to you, a more traditional funder / funding arrangement may well be more appropriate.
The author of this article is Tom Blandford of Armstrong Watson. Tom can be contacted at tom.blandford@armstrongwatson.co.uk or 07793 621 951. Other members of ALFMA can be contacted here.