Is an Internal Sale Right for My Law Firm?

If you are a solo practitioner or a small firm lawyer, a serious discussion about succession planning should be in your future at some point. But according to recent ABA demographic data, this discussion is coming quicker for an increasingly large portion of the lawyer population.

Data released in 2005 show that 34% of lawyers were aged 55+ (up from 20% in 1991) and that the overall median age for lawyers was 49 (up from 41 in 1991).

What this means is that there will be a large number of lawyers transitioning out of their law firms in the near future. You may be one of these lawyers, and you may be wondering what these transitions look like and when you should start planning.

If you’re a small firm owner or solo practitioner in your 50s or 60s, the time to plan your exit strategy is now. Your succession plan is one of the biggest choices you will have to make regarding one of your most valuable assets—don’t wait until the 11^th hour.

There are a limited number of profitable paths available to transition out of your firm. And what I find steers too many attorneys away from making profitable exits is a lack of planning and a lack of familiarity with the process.

In the rest of this article, I want to acquaint you with how you would develop and implement an internal sale of your firm. We’ve dealt with the external sale, the other profitable path, in a separate piece.

What Is an Internal Sale?

Generally, when I consult with attorneys about selling their law firms, the first topic we broach is an internal sale because, in many ways, it’s a process many lawyers are already familiar with.

In short, a junior attorney becomes a partner and eventually takes over the entire operation. Obviously, it’s more complicated in practice, but that’s it in a nutshell.

An internal sale brings with it many benefits:

• Keeps your other staff employed
• Makes sure your current clients are taken care of
• Protects the reputation of your firm
• Substantially increases the size of your retirement fund

But it also has some drawbacks. Chief among them is that it takes time to identify, qualify, train, and transition a potential successor. So, planning ahead is key. Moreover, you can devote substantial time and effort into one candidate, only to realize that he or she doesn’t have what it takes.

On the other hand, I urge lawyers I consult with to see both of these as positives. Because you’ll need to invest so much in your successor attorney, you can take the time to mentor the associate and ensure that your firm is in good hands.

How Does It Work?

The majority of lawyers will implement a multi-stage, multi-year succession plan. The number of stages will vary, but generally a two- or three-stage succession plan works best for most firms. The total number of years and the number of years per stage will also vary depending on how far in advance you’ve begun preparing.

Let’s look at a fairly typical internal sale for a small firm owner. In the example below (based loosely on an actual client we worked with), a three-stage succession plan is used, which plays out over the course of six years.

Saul Goodman and His Criminal Defense Firm: A Three-Stage, Six-Year Plan

Saul Goodman was a successful criminal defense attorney, but at age 59 he was looking forward to spending more time with his wife and grandkids. He decided he wanted to retire in six years, by the time he was 65, and transfer his practice to the two attorneys he employed at his firm.

Saul brought in the lion’s share of the billable work. Local news reporters knew him, and he was the face of the firm. In short, the firm was, like most solo and small firms, built around Saul and his capabilities and relationships.

This meant that two things had to be accomplished by the end of the succession plan. First, the buying attorneys had to have the capital needed to afford to buy the equity in the firm. Second, and just as important, Saul needed to have transferred as much of his personal goodwill to the buying attorneys as he could to enable them to successfully operate the practice after his retirement.

Stage One (Years 1–2): The Initial Buy in and Test Period

The first stage serves many purposes, but its most basic function is a “test period” where the owner determines whether the new partners have sufficient business, management, and legal capabilities to take over the law firm.

To initiate this stage, Saul’s two attorneys immediately became partners of the firm, each purchasing a small amount of equity (1%). The buy-in cost was fairly low for Saul’s junior attorneys, and, if they had not measured up, the buy-out cost for Saul would have been equally low.

The equity purchase can be handled in a number of ways (e.g. bonuses, seller financing, or even an SBA loan—although there are contingencies with an SBA loan to consider). The most important thing to remember is that your younger attorneys are probably not going to have large balances in their savings accounts, so keep the amount of equity small.

The specifics of the initial buy-in (pricing, terms, etc.) were included in a comprehensive shareholders agreement that was drafted and signed by all the parties. This was key to protecting both Saul and the value of the firm had the deal not worked out.

Saul gave each of the new partners additional management responsibilities in the firm and took a more active role in mentoring and training them to run a small law firm. He could also begin the process of transferring his personal goodwill to the partners through a “team approach” and introductions.

Stage Two (Years 3–5): Semi-retirement and Peaceful Transfer of Power

Since Saul was satisfied with his potential successors during Stage One, the succession plan moved into Stage Two where Saul Goodman further removed himself as the face of the firm and the new partners took an increasingly prominent role.

The new partners bought additional equity of the firm to bring them to a combined 49% interest, making the overall equity distribution 51-24 ½-24 ½. This purchase was funded via a promissory note made by the buyers to Saul and secured by a lien on the law firm’s equity. Because the amount of equity being purchase increased, the payments during Stage Two also increased, but they didn’t put too heavy a financial burden on the buying attorneys.

During this stage, Saul moved into a semi-retired role, working 2–3 days a week in a mostly supervisory capacity. The younger partners, on the other hand, brought in the majority of the business and ran day-to-day operations. Both Saul and the younger partners grew more comfortable with their new roles.

Vital to the success of this stage is that throughout Saul provided support to the younger attorneys and continued to transfer his personal relationships with referral sources and community members to them. Through his express confidence in his successors and his slow removal from the firm, he transferred his goodwill to the buyers.

Stage Three (Year 6): The Final Buyout

During year five, Saul had reduced his time in the firm to roughly one day a week, which meant it was time to initiate Stage Three, which is really more of a point than a stage.

In the sixth year, the buyer attorneys purchased the remaining 51% of Saul’s equity in the firm (i.e. the successor attorneys collectively own 100% of the equity in the firm). Although he no longer owned any percentage of the firm, Saul continued in an of counsel relationship with the firm for a few months before fully retiring.

During this final stage, the payments to Saul increased substantially. As with the other two stages, the purchase of Saul’s remaining equity was financed. Payments continued over the period of time as it had been negotiated and agreed to in the seller note, and Saul got to enjoy his retirement with an additional stream of income.

Planning to Plan Isn’t a Plan

I’ve said this hundreds of times to my family—so many times that I’m certain that my daughters make fun of me for it—but, planning to plan, isn’t a plan. In order to accomplish an internal sale of your law firm you have to plan ahead. The internal sale process works best when there is sufficient time for a smooth transition.

Finding, vetting, hiring, and integrating the potential successor attorney(s) will require a considerable amount of effort on your part. The new partner(s) will also need time to make the necessary capital investment in the firm. Above all, these steps take time.

You have to educate yourself about the process, find the right advisors, make plans, put those plans into action, and stay focused. If you don’t take the first steps now, you may find yourself in a difficult spot.

You’re burnt out and ready to retire, but you have no exit strategy in place and your sale options are limited. You don’t want to continue working long enough to bring on a partner to take over the firm, so you have to sell to an outside firm. But because you’re getting burnt out and you’ve been referring out cases, the overall value of your firm has declined.

In the end, (if you can sell at all) you sell for well below what your firm is worth.

You can avoid this situation, and we can help.

We Can Help You Plan

If you are one of the thousands of attorneys nearing retirement age, take an extra second to think about how you want to exit your law practice. There are only four ways that you can leave your firm, and I urge you to consider doing so in a way that lets you profit from your years of hard work.