New money

External investment in law firms will mean different things to different lawyers. Some will view it as a threat to their independence and others will see it as an opportunity to grow in the future; some will see it as a pay-off for past performance and others will see it as a way to be rewarded more fairly for their future efforts; some will see it as providing financial stability and others will see it as an opportunity to invest.

With such contrasting views, what can, and, perhaps more importantly, what should firms expect from an external investor? To some extent that will depend upon the size of the firm and the size of the investment, but, on the basis the investor is likely to be taking a bigger stake in the firm's business than any of its partners, the firm needs to recognise that the investor will no more want to be a dormant partner than any of the existing working partners.

Assuming therefore that the law firm is able to persuade its doubting partners that external investment is good for the business (or persuade enough partners not to veto a decision to have external investment), what changes will come with the presence of an external investor? One of the first things a firm can expect is the need for the firm to have a clear and concise strategy about its future and how it proposes to achieve it. Although in carrying out its due diligence the investor will look at the firm's past performance, they will see its investment as one for the future and it will therefore need to have sufficient comfort and confidence that the investment it is making will be invested in a way that will provide it with the return it is seeking. It will therefore need to know how the firm sees its future, where it thinks it is going and how it is going to get there, and will need to be satisfied that the firm has a forward-looking business model which is realistic.

With the external investor wanting a minimum rate of return on its investment, the partners will see the diversion of what would otherwise be a part of the firm's profits to the external investor '“ the first tranche of profit will be paid to the investor. The partners may see this as reducing the profits of the firm or at least the profits to be distributed to them; this however should not be the case if, as is intended, the investment made by the external investor is invested in a way that will generate more profit than is payable to the investor.

Reworking rewards

On the subject of profits, will the investor want to have a say in how profits are divided among partners and, if so, to what extent? That of course will depend upon the existing profit-sharing arrangements but firms should not expect investors to warm to the concept of lockstep. Although there may be many good reasons why some law firms stay with lockstep profit-sharing, there are equally as many reasons why it is not right for a number of firms and you can expect investors to question a model that rewards partners on the basis of time served rather than on the basis of performance and contribution. External investors will want to motivate the stars in the firm they are investing in, and will see the best way to achieve this will be by having a remuneration package that rewards, at least in part, performance. They will not want their investment to be in a firm that rewards an under-performing partner equally as well as a star performer; they will not want to see those most likely to generate a return on their investment heading off to another firm because they are not properly rewarded, leaving the firm they have invested in with a bunch of overpaid under performers. Many firms have already moved to a modified form of lockstep which rewards in part performance but those that haven't can expect a change so that profit-sharing arrangements fairly reward partners according to their contribution.

I have mentioned above that, for the external investor, its investment is one for the future, but, for some partners, particularly those nearing retirement, they will see any such investment as reward for the past, a past they will see themselves as having built up more than the more junior partners, to a level that allows their firm to have the future the investor is investing in. The investor will see it differently '“ the past is the past, to which the older partners will no doubt say that there would not be a future to invest in but for them. External investors will undoubtedly have had these same sorts of issues to deal with when investing in companies and often enough have found the solution; they perhaps though will not have come across a situation where they are investing in a business with so many owner-managers as law firms have and where too often partners concern themselves not so much with what they earn but how it compares to what others earn. Law firms, or at least the partners in law firms, should therefore not see external investment as a means to reward past performance or as a pension for those closest to retirement, although all parties concerned may come to the view that part of the investment would be wisely spent in paying off a partner who is no longer pulling his or her weight.

As well as wanting to see partners rewarded according to their contribution, investors will want to ensure that what they are offering partners is not something that makes them feel so financially secure that they lose the hunger to continue to make their firm a success. Many blame the Halliwells experience on the fact that too many partners will have felt sufficiently secure financially following the sale of their premises, so as not to have to worry about their firm's profitability in the future, with disastrous consequences. Investors will be looking for dependable income flow and for a law firm that can deliver it.

Agreeing with an investor how partners are rewarded is far from straightforward but, if partners want the benefit of what is potentially on offer, they need to understand why an investor is willing to invest in their law firm and compare it with where it leaves them if there is no external investment.

Firm first

Once an external investor is on board, it will want to know that the law firm is being well managed, and, to the extent it can improve matters, it will want to do so. However, the firm and the investor may have different views as to whether or not the firm is being well managed. Running the firm as a partners' club may suit the partners, but, to the extent this is seen to be in too much the interests of individual partners rather than the interests of the business of the firm as a whole, this will not be what the investor wants. Investors will want a say in how their investment is spent to ensure that it is spent in a way that is in the interests of the firm as a whole.

As well as wanting to ensure its investment is spent wisely, it will also want to ensure that other costs and expenses are spent wisely. Although every firm will have some costs that are fixed, such as rental and PI premiums, most other costs are not, including salaries, which are usually the largest single item of cost. An investor may therefore question why solicitors tend to be paid by reference to their years of qualification rather than according to the value of the work they are doing, particularly when the solicitor may be more qualified than he or she need be to do the job they are doing. Investors will also look to see the extent to which the use of IT can improve productivity, particularly those firms with more commoditised practice areas.

What firms can therefore expect from investors is a mindset that puts the interests of the firm first and not the interests of the individual partners. External investment may therefore lead to firms having to be less protective and more willing to tackle issues that might otherwise get brushed under the carpet, to avoid upsetting one or two of the more precious partners.

Firms need to recognise that the UK legal sector, in line with the economy as a whole, is not as buoyant as it was over three years ago and therefore less appealing to external investors as an investment opportunity than it was then. Therefore, if the firm is looking for money, it is unlikely to be as available as it was once thought it would be. Investors will also wonder whether those law firms that are actively seeking external investment are seeking it from a position of weakness and therefore likely to be the least attractive to investors.

Assuming it can find an investor willing to invest, firms can expect them to monitor closely how the firm is managed to ensure that it is managed as a business with a view to achieving the return the investor is expecting on its investment. For the larger law firms, which are often run by an executive committee, this is likely to be an easier transition than for the smaller firms where individual partners may feel they want a bigger say in partnership matters than their interest in their practice warrants.