DUE DILIGENCE FOR LAW FIRM MERGERS

Law firm merger activity dropped sharply in the wake of the COVID-19 outbreak but some struggling firms are reassessing the strategy as a possible life preserver. The pandemic economy makes comprehensive due diligence more important than ever when evaluating potential arrangements. Before signing on the dotted line, both sides need assurance that the numbers add up and no problems are bubbling below sight.

FINANCIAL ISSUES

Not surprisingly, the primary emphasis of due diligence is on financial issues. To flush out risks, work with merger and acquisition advisors to hone in on the following:

  • Financial Statements
    Start by reviewing the other firm's financial statements for at least the prior two years. While reviewing, give extra care and attention to its general ledgers, accounts receivables and payables, work-in-progress, notes payable, fixed assets, depreciation schedules and nonrecurring income and expenses. Gathering this information will help you estimate the value of the other firm's net assets. You can use this information to determine the price and terms of a transaction.
  • Projections
    The other firm should provide projections on partner buyout costs, impending retirement expenses over the next five to ten years, client retention and billing rates. If not included, request additional information on the assumptions used to form the basis for those projections so that you can determine whether they are reasonable.
  • Tax History
    Review several years of federal and state income tax returns. Sales and use taxes and commercial rent tax also warrant examination.
  • Liabilities
    Consider both on- and off-balance sheet items — including outstanding liens, unfunded retirement obligations, unpaid tax liabilities, deferred compensation, pending litigation and other contingent liabilities. Look beyond the facts and figures for potential underlying problems.
  • Malpractice Claims
    Any malpractice history should trigger further research. Defense, damage and settlement costs and their effect on insurance premiums are important, but you also want to know about attorneys with a trail of claims.
  • Billing Practices
    What payment methods does the firm accept? What are its collections policies and realization rates? Determine if the firm routinely writes down and/or off unpaid invoices, thus rewarding clients for late payments.  
  • Client Reliance
    How much of the other firm's revenues are attributable to its top 10-15 clients? Determine if there is any risk of losing clients that represent a significant portion of its revenues and the effects of losing those clients.

ENTITY STRUCTURE

The structures of the current firm(s) and the merging firm could lead to unpleasant surprises in partners' tax bills post-merger. The merger agreement will need to address this issue. For example, if both firms are partnerships, some or all of the partners might see accelerated taxable income on their individual tax returns due to the pass-through nature of a partnership.

If a partnership merges with a firm that is at the entity level, taxed as a corporation, the old corporation would liquidate. If this is your situation, consult with your financial advisor to determine the tax implications of a corporate liquidation. Be sure to include all such potential effects in the financial modeling performed to estimate the new firm's profitability.

Related Read: Merger Fever: Should Your Firm Get Hitched?

ATTORNEYS AND STAFF

The acquisition of reputable, quality attorneys generally is one of the goals of law firm mergers, so you need to know what the firm's partners and associates bring to the table — the good and bad. Who are the rainmakers and who might leave soon? Are incentives advisable to retain attorneys and, in turn, their clients? Which practice areas are the strongest and weakest? How does compensation break down?

Too often, firms pay attention only to a few key people in the other firm. The better approach is to look at everyone, including non-attorney staff. For the latter, determine their titles, responsibilities and salary histories. For both attorneys and non-attorneys, it is a good idea to run background checks.

CULTURE MATTERS

Finally, do not let the focus on numbers and similar data distract you from assessing cultural compatibility. Without alignment in values, overall goals and a sense of social responsibility, a deal that looks like a no-brainer on paper can end in failure.

SIDEBAR: WHEN YOU DECIDE TO MOVE AHEAD

Even if merging law firms are satisfied with their due diligence results, much planning still remains to facilitate a successful merger. Topics to consider and questions to ask include:

Management and governance
What will be the management structure of the new firm? How will you structure and integrate practice groups?

Premises
Which office locations will be closed and/or combined? How and when?

Technology
How will you align your systems for areas such as accounting and finance, document management, practice management, customer relationship management and legal research? How will you combine your databases?

Human resources
How will you reconcile different policies for issues such as training, performance management and annual compensation adjustments? Will overlapping positions created by the merger force you to lay off workers and, if so, what kind of severance package will you offer? Will you include restrictions such as non-compete and non-solicitation agreements?

Related Read: Law Firm Mergers: Once the Deal Closes, the Hard Work Begins

To make the transition smooth, tackle these areas as far in advance as possible.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.