Peter Noyce, partner in accountants Menzies and author of Brighter Thinking for Law Firms, explains the vital importance of anticipating the merged firm’s financial position. (Updated 12 November 2020)
More than ever in these challenging times, any merger has its uncertainties. Ideally most aspects – cultural, geographic, service lines, name going forward, who is ‘in control’ going forward and planned communications – will be sorted out pre-merger rather than post-merger.
But the financial elements can be strangely overlooked, despite being most crucial. An early and surprising cash shortfall will not kick off any marriage in a positive vein. A law firm merger is no exception.
You need to go into any merger understanding your cashflow and the financial roadmap ahead.
The need to plan
Putting together one cash-strapped, inefficiently-run practice with another does not automatically make for a well-financed combined entity in the immediate aftermath – far from it. The financing will require in-depth analysis, sometimes by independent experts with a knowledge of robust financial modelling and the likely pitfalls that can (and will) arise.
The cost base and staff levels are sadly an emotive matter that needs sorting out well in advance of merger day – preferably in advance of Heads of Terms (deal structure) being agreed. Capacity and other issues need to be resolved early.
The experience of furlough has made many firms realise that they can run their businesses with fewer staff. So the model for the combined firm may be different than previously envisaged, with improved profitability and cashflow.
On the other hand firms may have deferred liabilities (especially tax) recently, or taken on other borrowings (such as a government guaranteed loan). This artificially inflates their cash positions.
Short term working capital requirements
Many mergers lead to initial working capital being a problem.
Typically, one party to the merger is the acquirer, while the firm merging in will bill out most work in progress (WIP) in advance. This absence of ‘pregnant’ WIP for billing at the date of merger becomes an issue in the short term.
At the same time, the joined-up practice will be incurring increased expenditure. The enlarged salary base coincides with the very important – but not fee-earning – task of joining teams and cultures together for the future benefit of everyone. Additional spend is also likely to be needed to merge or enhance existing IT and CRM systems, to be used as soon as possible by the combined entity.
Detailed cash flow forecasting is crucial to work out the effect of this initial period on the productivity of all staff and partners, billing patterns and cash collection.
Financing this initial shortfall often needs an extension to existing facilities. This funding should really only be over the timeline that it takes to build up WIP, reach billing points with clients and receive payment whilst meeting ongoing commitments to new staff and additional costs.
If the cash flow shortfall goes beyond, say, the first nine months, it suggests that the deal may not have been quite right in cash terms anyway.
A possible remedy to this is that the practice being acquired commits to retaining a certain amount of cash or near cash (debtors) – to cover that initial period whilst work in progress is being built up.
Combining different types of firm
A different scenario can apply when two very different firms are merging. For example, one firm might be largely based on conveyancing and private client work while the other has a large contingent fee base.
If so, more detailed modelling will be required. The combined entity will have cash requirements and pinch points that are different from the individual firms. All involved, whether equity partners or key management, need to fully understand the effects or there will be nasty surprises all round.
As with any aspects of a merger, these things need identifying and agreeing in the early days of evaluating the merger – not in the early days of the merger itself! Surprises are not appreciated by the partners, and even less by the funders.
It is fairly rare for law firms to be sold for a value – most are mergers of some kind. But when there is genuine value and the acquiring practice is paying a lump of cash for a law firm, the funding takes on further complications.
Partners in the firm being acquired may be becoming consultants, or departing on day one. Either way, payments due to them should be built into the forecasts. If these partners will be continuing in the business for a period of time, expectations of work and billings should be sorted out long before the merger date.
The financial team in the acquiring practice should be carrying out what-if/sensitivity analysis to see how increases and decreases in business activity might affect the combined entity going forward. Covid-19, lockdowns, Brexit and the economy in general add to the current uncertainty.
On the positive side, additional work may be generated, perhaps as the result of the merger and the PR around it. If so, the combined practice will need to ensure it has the capacity and expertise to deliver excellent client service.
On the flip side, despite all the early and excellent planning, workflows might mean that the practice ends up being overstaffed. Plans for redressing the balance should be in place and agreed by the management team, so that this can be dealt with appropriately and effectively without destroying the culture of the combined practice straightaway. Short-term funding may be required to deal with any redundancy payments.
A very useful focus for the acquiring practice is the payback period – how long it will take to ‘get your money back’. After this period, the ongoing increase in turnover, profitability and cash is that of the successor practice, with all commitments to the firm acquired and funding the acquisition having been met. Whether this is six months or two years, all financial planning should be structured to meet this planned return on investment.
Funders and funding
As with a merger, cash flow pinch points often reflect the timing of the deal with regard to the billing cycle of the acquired firm – and whether they have the normal billing frenzy just prior to the acquisition.
Where a target firm is being acquired, it is easier to build a cash or working capital clause into the agreement. This helps ensure that the acquiring practice does not immediately have a shortfall of funds to meet staff and fee-earners’ salaries until work in progress levels build into billing opportunities and ultimately cash receipts.
It is absolutely essential that the acquirer gets its partnership onside in respect of any personal funding that will be needed to ensure that the successor practice is appropriately capitalised. External funders may well want to see that the partners of the firm are sharing some of the pain in the funding of the acquisition.
Banks and other funders will be relying on the communication and accuracy of forecasts – no one likes surprises! The robustness and stress-testing of the forecast for profit is most important.
Financing a law firm merger top ten
- Understand the deal and its (unique) funding requirements.
- Align both parties to their commitment to the financing.
- Ensure external funding is in place well in advance.
- Prepare robust forecasts, stress-tested using external expertise if necessary.
- Take the effect of any seasonality or billing patterns into account in respect of the merger timing.
- Understand capacity and resource issues that may arise from under or over-activity post-merger.
- Maintain constant and planned dialogue with internal (ie partners) and external funders.
- Ensure tax effects (including any tax deferrals) are built into forecasts for both the firm and individuals.
- Ensure credit control is adequately resourced to maintain collections at or above the levels in the forecasts.
- Put reporting structures in place and empower management to react to changes in working practices post-merger, and to deal with financial issues before unexpected shortfalls arise.