Addressing Balance Sheet Issues In a Law Firm Merger

Total Liabilities …

 Capital:

Contributed capital
Undistributed earnings
Economic capital

Total Capital …

 TOTAL LIABILITIES & CAPITAL …

 Key Ratios:

Assets per equity partner
Debt per equity partner
Liabilities per equity partner
Contributed capital per equity partner
Capital per equity partner

The EBS should not be viewed as a basic mechanical, accounting exercise. Instead, it should be viewed as a critical component of the merger financial analysis, which requires a rigorous assessment of on- and off-balance sheet assets and liabilities. The primary goal is to determine whether or not the net value that each firm is contributing to the new firm is consistent with that of the other firm, based on per partner averages, relative share of profits and relative share of contributed capital.

When To Do an EBS

Merging firms typically prepare a draft EBS well in advance of the merger effective date in order to spot any glaring balance sheet inconsistencies. Most often, the firms will prepare this draft using data dated as of the prior year end or sometimes as of the date one year before the anticipated effective date. The reason firms choose these dates is that they typically serve as the best proxy for what the firms' asset and liability positions will be like as of the effective date. Of course, the actual results will undoubtedly be different as of the effective date. Consequently, it is important that a final EBS be done as of the effective date.

Once the final numbers have been agreed upon by the new firm's Management Committee, the value of each legacy firm's contribution of economic capital to the new firm will be fixed and any required balancing adjustments will be made.

Assessment of Assets

One of the trickier and sometimes more contentious aspects of the EBS is the valuation of fee inventory. When calculating the realizable value, it is important that a consistent valuation method be used for each firm. Oftentimes, it is helpful to have an objective outsider perform the analysis, since it does require asking difficult questions about the collectibility of inventory.

Most often, inventory is valued one of three ways ' by applying one realization rate to all inventory (using historical averages), by applying separate realization rates to inventory based on specific inventory aging categories, or by performing a detailed analysis of each inventory item and applying individual realization rates to each. The method where separate rates are applied to each aging bucket is the system most commonly used in practice. Frequently, firms will follow this method, but delete certain matters that are absolutely known to be unrecoverable or need to be separately valued outside an aging analysis (eg, contingent matters that may have a high realizable value, but where work-in-process is in very old aging buckets because the matter has not been billed).

There are also a number of non-inventory items that may impact the ultimate outcome of the EBS and require discussion or significant analysis. Examples include:

• Are the firms using consistent depreciation methods?
• Should the appreciated/market value of one firm's artwork or other unique assets be included?
• What impact will technology integration have on the useful life of both firms' equipment and software? Do some of the fixed assets on the balance sheet actually have no value post-merger?

Analysis of the Results

As with the financial profile, it is helpful to prepare the EBS in a side-by-side format that allows for quick comparison the firms' results. While the bottom-line, gross results of the EBS are important, firms also need to look at the relative, per equity partner value of the individual components as well. It is also important, particularly for firms whose income per partner may be different, to look at the relative balances overall. Ideally, the percentage of one firm's capital compared to the sum of both firms' capital should be similar to the percentage of that firm's net income compared to combined income. But, as in any analysis, there is no one number that tells the whole story; so it is important to look at the whole picture and really understand factors behind the numbers as well.

In addition to basic comparison tests such as assets per equity partner and liabilities per equity partner, it is useful to compare the following:

Contributed Capital. This should be analyzed on both a per partner basis and relative to profit allocation. Significant differences in contributed capital per partner may indicate potentially troublesome cultural differences regarding the willingness of partners to make a cash investment in their firm. The comparison of contributed capital versus profit allocation is useful to assess each firm's expected “return” (in terms of compensation) given the firm's total capital contributed.

Debt Load. Here, comparisons are commonly made between debt load and net fixed assets and between debt load and contributed capital. At a minimum, the debt load to fixed asset comparison can reveal whether a firm is borrowing to fund operations (if debt exceeds fixed assets), including partner compensation. The debt load to contributed capital comparison can identify whether partners are willing to contribute capital to the firm or prefer to have the bank finance the firm's operations.

Unfunded Obligations to Retiring or Former Partners. Fortunately, many firms have taken steps to limit their exposure to unfunded obligations. In firms that still have unfunded obligations, it is important to include the present value of the obligation on the EBS, since the present value can have a significant impact on the relative economic contribution of the two firms. Including the present value can also help the firm that is not bringing the obligation to the deal get a better feel for the level of obligation that it may be taking on. At times, seeing the magnitude of the liability can help the firm with the obligation understand that something needs to be done to limit the firm's exposure, regardless of merger. The present value should be determined based on reasonable and consistent assumptions, particularly if both firms have unfunded obligations that are being valued.

Equalizing the EBS and Resolving Potential Issues

Once the EBS has been prepared, the firms may need to look for opportunities to balance out any significant differences. In most cases, expect to see some difference in average per-partner economic capital, and in some cases these differences will be material. Perhaps the best way to evaluate capital is on a per-compensation-point basis, if compensation has been resolved and integrated pre-merger. The threshold question is at what point some level of equalization is needed. In some mergers per-partner differences of $50,000 or more go unadjusted. In others, equalizing adjustments are made for differences well below $50,000. When adjustments are made they can include the following:

Allocation of a capital credit to one firm, usually the smaller firm, to reflect the economic value that the firm is bringing beyond its paid-in capital. Normally this happens when the smaller firm's paid-in capital is significantly lower than the larger firm's position, and is in lieu of asking the partners to come up with additional capital on the merger date. However, some firms are wary of giving capital credits like this because it can be viewed as unfair by the partners of the larger firm.

Leaving assets out of the transaction to lower one firm's economic value to a more comparable level (such as particular contingency matters, or possibly a hard asset like artwork).

Dedicating certain assets to certain liabilities. For example, a firm may choose to hold out of the deal inventory that has uncertain value, and use the collections from that inventory, if any, to offset a liability that is not being brought into the merger (eg, an unfunded retirement plan).

Reducing unfunded obligations. Firms tend to focus more on reducing or eliminating unfunded obligations when they see that liability as a major stumbling block for an otherwise beneficial merger.

Contributing additional capital. In some instances, the primary discrepancy on the EBS is a difference in contributed capital between the two firms. Before deciding how to deal with an imbalance in capital accounts, it is important to determine the capital policy for the new firm. For example, while returning excess capital to partners in one firm may make sense in the context of the balance sheet, it may not be logical to do that if the combined firm's capital policy will require all partners to add capital to the new firm going forward.

Paying off the excess value contributed by one firm. One method of equalization is through actual cash payments from one partner group to the other. If large, the payments are often spread over several years. Most often, the firms isolate certain accounts receivable and work-in-process as of the effective date of the merger and allocate the cash collected from this inventory to the partners of the firm with excess economic capital. Over time, the excess capital payments to the one group of partners help re-equalize economic capital throughout the combined firm.

It is rare occurrence when the side-by-side EBS lines up perfectly between the constituent firms. More often, the EBS identifies equalization needed to adjust the interests in the contributed assets, both net cash basis and net accrual basis, of the two groups of partners in the ongoing firm. By identifying the drivers of the differences and then reaching compromise regarding their resolution, the EBS can usually be completed and serve as one more tool that supports the law firm merger. However, it is important in a merger discussion that the partners not lose sight of the ultimate objective, which is to do a merger that makes the combined firm more competitive in the marketplace. The upside on the income side should more than make up for minor differences on the balance sheet side if the merger is a good one.

Excerpted from the Law Practice Management publication, Anatomy of a Law Firm Merger, 3rd Edition, by Lisa R. Smith and William G. Johnston. (c) 2004 by the American Bar Association. Reprinted by Permission. All rights reserved.

[Editor's Note: A&FP is pleased to share with readers this newly covered topic in the forthcoming ABA-published book, Anatomy of a Law Firm Merger, 3rd Edition.]

Introduction [abridged]

Due to unrecorded assets and liabilities, modified cash basis accounting provides insufficient balance sheet information for planning a law firm merger. To understand the true economic value each firm brings to the table, it is necessary to capture off-balance sheet items, as well as to ensure consistency of approach. Without this big picture, firms tend to focus on differences in one balance sheet component (eg, debt) without understanding how other factors might offset that difference.

The Economic Balance Sheet

The exhibit, below, describes a simplified example of an Economic Balance Sheet (EBS), which expands on the cash-basis balance sheet by quantifying the relative economic position of each firm and comparing the on- and off-balance sheet assets and liabilities that each of the constituent firms contributes to the merged firm. Most often, the adjustments include the addition of assets equal to the projected realizable value of fee inventory (work-in-process and accounts receivable), the elimination of undistributed earnings that will be paid out to equity partners in short order, and the addition of liabilities for the present value of unfunded retirement plans, other commitments to retired and retiring partners, significant differences in lease obligations, outstanding claims against the firm and, at times, significant differences in deferred expenses/payables. Clearly, it is important to have realistic valuations of each asset and liability. On the Exhibit, each firm's “economic capital” represents assets less liabilities less paid-in capital and undistributed earnings.
[A full-sized PDF of an example balance sheet can be found here.]

Economic Balance Sheet

See the book for an Excel illustration of this spreadsheet design.

Columns: Define three sets of columns with these titles, one set for Firm A, one for Firm B, and one for the Merged firm:

• Cash Basis Balance Sheet
• Accrual and Other Adjustments
• Economic Balance Sheet

Rows: Define rows similar to these:

 Assets:

Cash & cash equivalents
Marketable securities
Client trust funds
Client disbursement receivables A/R ' partners & employees
Prepaid expenses
Other current assets
Fixed assets net of depreciation Other non-current assets
Work-in-process (less reserves)
Accounts receivable (less reserves)

 TOTAL ASSETS …

 Liabilities:

Line of credit
Current portion of long-term debt Pension/profit sharing payable
Payroll withholdings
Client trust funds
Interest payable
Other current liabilities
Long-term debt
Other non-current liabilities
Unfunded retirement plans