Five ways to improve your law firm's buy-sell agreement

As the economic downturn lingers, lawyers continue to change firms at unprecedented rates. Firms seem to hire laterals and lose partners almost daily.

Many managing partners find a big surprise when they look at their firm’s buy-sell agreement. Management usually ignores employment and buy-sell agreements until someone leaves. They rarely focus on the impact of a mass, or even a semi-mass, exit.

Spending a few minutes with a buy-sell agreement prior to those departures may prove invaluable. Departing partner payouts can place an unexpected and unneeded burden on the remaining partners. The payments may put so much pressure on cashflow that they force the remaining partners to seek a more profitable situation.

Make sure your buy-sell agreement contains the following five critical provisions.

1. Valuation

Generally, valuation methodology falls into one of three categories:

a. going concern value;

b. AWIP value (accounts receivable plus work-in-progress); or

c. return of capital.

The first two have no place in a law firm buy-sell agreement. The going concern value of a law firm reflects its lawyers and clients. It is axiomatic that a reduction in lawyers will create a reduction in clients. Valuations based on historical performance do not take new conditions into account. Likewise, valuing the AWIP of clients that often leave with the departing lawyer creates an unrealistic value for that partner.

Return of capital, or some variation of it, would appear to be the preferred valuation method. In fact, many firms feel that returning capital eliminates the valuation issue. That may very well be the case, but two circumstances may preclude even returning capital.

A capital contribution based on a valuation of the firm at the time of the contribution may have little relevance to the firm’s current value. Likewise, returning capital may be unwarranted if the firm has used capital to maintain compensation or to pay unrealistic values to departing partners.

The capital account in many cases reflects the financial position of the firm over the past few years. The temptation to maintain compensation levels sometimes leads to de facto distributions of capital.

To be on the safe side, firms should pay the departing partner the lesser of:

x = his capital account; or

y = a modified version of book value.

Time constraints preclude a recitation of the additions and subtractions that need to be made to book value, but a fair value can be achieved using that type of formula.

Finally, in jurisdictions where the Bar allows it, a bifurcated valuation may be appropriate. Paying more when partners die, retire or become disabled than when they depart reflects business reality.

2. Payout terms

Firms should stretch the payments to partners over as long a time as possible. Many firms provide for a payout at the end of the departure year or within 60 days of a departure. These provisions may create a cashflow burden on the firm. A six to ten year payout of capital for a departing partner gives the firm the most flexibility.

The departing partner’s note should bear interest at the lowest acceptable rate. In the United States, that rate would be the applicable federal long-term rate. In today’s world, that is probably about one per cent.

3. Subordination

The departing partner’s note should include a provision subordinating the debt to all existing and future third-party borrowings. A bank renewing a line of credit or lending on capital assets will not welcome a position behind former partners. A proper subordination provision will allow the firm to maintain and add to its borrowings.

4. Arbitration

Disputes arising under the buy-sell agreement should be resolved by arbitration.

Members of the panel should consist of lawyers with at least ten years’ experience, one of whom has been a managing partner. The lawyer members of the panel should be from firms of the same size as the firm involved in the arbitration. Culture differs with the size of the firm, so the panel should include lawyers who understand the culture of the firm in the dispute.

5. Suspension of payments

Notwithstanding the inclusion of the above provisions, the firm may find itself unable to pay its bank, current partners and departing partners. In that case, the ability to stop payments to the departed partners for a period of time may very well save the firm. This hiatus in payments can be tied to an objective standard such as a percentage decrease in gross revenues or partner profits.

All of the suggested changes benefit the firm – that’s as it should be. The firm’s prosperity guarantees the payout of the departing partners and an income stream for the remaining partners. In short, a happy ending.

So, pull out that buy-sell agreement, check off items one through five above and start talking to your partners about making any necessary changes.