The Value of Partnership

[Editor's Note: Ed Wesemann developed this article for A&FP based on my inquiry about a Montreal conference he recently conducted on law firm capitalization. I think readers will find Ed's unusual analysis intriguing and valuable.]

When someone becomes an equity partner in a law firm, he or she becomes an owner of an institution that has a substantial value ' certainly greater value than is demonstrated on a cash basis balance sheet. Yet the majority of U.S. law firms admit partners with little or no requirement that they make a purchase of the firm's capital assets.

Apparently, the theory is that associates labored in the vineyards for a period of years and have earned their right to participate in the fruits of their labors. That may have made sense when the current law firm model evolved in the 1970s and associates worked for comparatively low wages in exchange for a shot at the brass ring of partnership. But with New York starting salaries topping $145,000, and, by trickle-down, the salaries of associates all over the country now on the rise, one has to ask: Is it rational to give away something that the existing partners have invested so much in, for such a small price?

Certainly there are law firms that demand an up-front capital requirement from new partners, often helping finance that contribution with guaranteed bank loans. This is simply a cash contribution to bring new partners equal to the current cash capital account value for existing partners. The vast majority of firms, however, take pride in telling new partners, 'You enter naked and you leave naked' ' meaning you don't pay anything to become a partner, and you don't get anything when you leave the firm.

But let's rethink this whole process. What is the true value of the law firm that we are giving away so freely? If an appraiser were given the assignment of determining the value of a partnership in a law firm, the consultant would have to consider a whole variety of assets that make up the value of a law firm. These would include, at a minimum, the firm's know-how (Intellectual Capital), the fee earners that the firm assembled and maintains (Human Capital), the firm's contacts and influence (Relationship Capital), and the firm's reputation or brand (Reputational Capital). These are, of course, in addition to the standard Economic (monetary) Capital and Structural Capital that show up on a balance sheet.

The immediate reaction may be, 'Those things are too subjective to be valued' or, 'Even if they could be valued, that value would be de minimis.' But anyone who has been involved in evaluations and appraisals knows that a value can be assigned to anything ' and usually with surprising accuracy. Let's consider the value of each area of capital independently.

Intellectual Capital

Among the greatest values that a law firm brings to the client marketplace is its collective expertise and experience. Intellectual capital takes on different forms and appropriately greater value depending on the sophistication of the legal matter. The intellectual capital applied to a routine commoditized matter involves perfected documentation and procedures. With greater sophistication comes the ability to organize complex projects and drive results.

The firm's intellectual capital investment derives from the aggregate of non-billable training and development time, and has a value equal to creating that knowledge were it not available. New partners access the firm's intellectual capital both to enhance their skills and to make themselves more attractive and valuable to potential clients.

Presumably, all partners learn something all year that makes them a better lawyer or increases their knowledge of their practice or an industry, beyond the knowledge that lawyers routinely have. To keep the math simple, let's say that the time required to achieve this knowledge or skill is just 1 hour a month, and that the average member has been a partner for 15 years. Even at the most discounted billing rate, that makes the value of acquired knowledge something north of $50,000 per partner.

Human Capital

Law firms are assemblages of people who were trained and developed, or laterally recruited. The firm invested in the training and development of the attorney, or paid headhunter fees to acquire the individual. In a business where its greatest asset rides up and down the elevator every morning, having people and a sustainable culture is a hugely valuable asset. An average headhunter fee is 25% of compensation and, typically, hiring through law school recruiting and summer associate programs costs at least that much. Considering the value of partners alone, we're looking at an average investment of around $75,000 per partner.

Relationship Capital

Relationship Capital is the law firm's collective network. This involves both relationships that refer business to the firm (accounting firms, banks, smaller law firms, trade associations) and relationships that assist in serving clients (government officials, court clerks, money sources). The ability to tap into those relationships provides partners with a competitive advantage in attracting and serving clients. It has been my experience that, in most law firms, about 10% of their average revenues each year comes from new clients, and that at least 10% of their new business comes in as the result of a referral from someone outside the firm. So, given that the average revenue per equity partner among the AmLaw 200 last year was $1.8 million, the value of new client work in any given year that was the result of referrals is around $18,000 per partner per year. Our research seems to indicate that the average life of a client (balancing out long-term relationships with one-time litigation matters and transactions) averages 3.5 years. The average margin for the AmLaw 200 is 36%, which suggests a per-partner value of the current referral base of over $22,000 ($1.8 million x 10% x 10% x 3.5 x 36%).

Reputational Capital

This is the firm's brand, or what accountants call 'goodwill.' It is the value of the firm's name recognition and reputation that accrues to members of that firm. A partner with a well-regarded law firm never has to go through the rituals of proving quality, and recognition of the firm's name easily opens doors that would otherwise be impenetrable. The value, however, depends on the reputation of the firm. Certainly, the value to a new partner of the reputation of a Wall Street firm is vastly greater than that of joining a mid-sized firm in a small city. To make this easy, let's assume that the only ways a firm creates reputation and name recognition are advertising, public relations and sponsorships. Let's further assume that what the PR firms tell us is true, that branding requires a sustained effort over a period of time ' say, optimistically, 3 years. According to surveys, the average spent on reputation-building aspects of marketing is about 0.5% of revenues. Then, again using the $1.8 million revenue per partner figure, the value of investment in reputation is $27,000 per partner ($1.8 million x .005 x 3).

Monetary Capital

Perhaps the largest monetary asset of a law firm is the combination of its work in progress (work that has been performed but not billed) and accounts receivable (work billed but not collected). This is an asset that has literally been bought and paid for by the existing partners. Let's conservatively say that a firm has 45 days of work in progress and 45 days of accounts receivable. Again using the average of $1.8 million revenue per partner, the value of WIP and AR (knocking off 10% for write-downs and delinquent accounts) equals more than $400,000 average per partner.

Structural Capital

It used to be that the fixed assets of a law firm were limited to a bunch of old furniture, some typewriters and, perhaps, a law library. But law firms today require a heavy investment in technology. After accelerated depreciation, the value of hardware and custom software rarely reflects the investment made by existing partners. Operational leases and other forms of off balance sheet financing make the value of structural capital even more obscure.

But this pales in some firms to the value of under-market office leases and unamortized tenant improvements. During the late 1990s, many law firms found that they had overestimated their office space needs and renegotiated leases to dispose of excess space. In most cases, this meant an extended lease term ' sometimes as much as 15 or 20 years ' in exchange for giving back chunks of space. Today it is not uncommon to see firms with 5 or 10 years to go on a lease that may be 30% below market rates. Even if a firm doesn't cash in on the asset, the value translates to increased profits through lower operating costs for firms' second largest expenditure category after salaries.

By the same token, the tax code requires about a 40-year amortization of some tenant improvements. It is rare for a law firm to stay in the same offices for 40 years, which means that the unamortized value of office build-outs in excess of tenant improvement allowances is recoverable in a lump sum deduction when a law firm moves.

Clearly there is value in fixed assets in every law firm, but it is highly dependent upon where firms are in their depreciation cycles. So we'll ignore it.

The Value of Partnership

The sum of the values expressed above comes to more than $570,000. Of course, there may be debts that count against the value of partnership ' long-term debt, off balance sheet equipment leases, guarantees and unfunded, non-qualified partner pension plans. But the largest portion of debt is typically devoted to fixed assets, which (one hopes) are depreciating at a level approximately equal to debt service.

The point in all this is that there is substantial value in becoming a law firm partner. Beyond the status, virtual lifetime tenure and six-figure income the position provides, a new partner becomes an owner in a going concern. Whether the existing owners ask new partners to buy into the business or generously give a part of their business away is, of course, up to those owners. But at minimum, new partners ought to recognize the value of what they are receiving.

When I'm playing golf and a putt is meaningless, I can sink them backhanded all day long. But when you get to the end of a golf match and are standing over a 3-footer to keep from losing a $5 bet, the hole suddenly seems to get smaller. I've heard partners argue that making a new partner has no economic impact on the firm. If partners understand that they are collectively betting on a new equity partner and the amount of the bet exceeds $500,000, the partnership decision might justify a little more selectivity. Sometimes a smaller hole is a good thing.

[Editor's Note: Ed Wesemann developed this article for A&FP based on my inquiry about a Montreal conference he recently conducted on law firm capitalization. I think readers will find Ed's unusual analysis intriguing and valuable.]

When someone becomes an equity partner in a law firm, he or she becomes an owner of an institution that has a substantial value ' certainly greater value than is demonstrated on a cash basis balance sheet. Yet the majority of U.S. law firms admit partners with little or no requirement that they make a purchase of the firm's capital assets.

Apparently, the theory is that associates labored in the vineyards for a period of years and have earned their right to participate in the fruits of their labors. That may have made sense when the current law firm model evolved in the 1970s and associates worked for comparatively low wages in exchange for a shot at the brass ring of partnership. But with New York starting salaries topping $145,000, and, by trickle-down, the salaries of associates all over the country now on the rise, one has to ask: Is it rational to give away something that the existing partners have invested so much in, for such a small price?

Certainly there are law firms that demand an up-front capital requirement from new partners, often helping finance that contribution with guaranteed bank loans. This is simply a cash contribution to bring new partners equal to the current cash capital account value for existing partners. The vast majority of firms, however, take pride in telling new partners, 'You enter naked and you leave naked' ' meaning you don't pay anything to become a partner, and you don't get anything when you leave the firm.

But let's rethink this whole process. What is the true value of the law firm that we are giving away so freely? If an appraiser were given the assignment of determining the value of a partnership in a law firm, the consultant would have to consider a whole variety of assets that make up the value of a law firm. These would include, at a minimum, the firm's know-how (Intellectual Capital), the fee earners that the firm assembled and maintains (Human Capital), the firm's contacts and influence (Relationship Capital), and the firm's reputation or brand (Reputational Capital). These are, of course, in addition to the standard Economic (monetary) Capital and Structural Capital that show up on a balance sheet.

The immediate reaction may be, 'Those things are too subjective to be valued' or, 'Even if they could be valued, that value would be de minimis.' But anyone who has been involved in evaluations and appraisals knows that a value can be assigned to anything ' and usually with surprising accuracy. Let's consider the value of each area of capital independently.

Intellectual Capital

Among the greatest values that a law firm brings to the client marketplace is its collective expertise and experience. Intellectual capital takes on different forms and appropriately greater value depending on the sophistication of the legal matter. The intellectual capital applied to a routine commoditized matter involves perfected documentation and procedures. With greater sophistication comes the ability to organize complex projects and drive results.

The firm's intellectual capital investment derives from the aggregate of non-billable training and development time, and has a value equal to creating that knowledge were it not available. New partners access the firm's intellectual capital both to enhance their skills and to make themselves more attractive and valuable to potential clients.

Presumably, all partners learn something all year that makes them a better lawyer or increases their knowledge of their practice or an industry, beyond the knowledge that lawyers routinely have. To keep the math simple, let's say that the time required to achieve this knowledge or skill is just 1 hour a month, and that the average member has been a partner for 15 years. Even at the most discounted billing rate, that makes the value of acquired knowledge something north of $50,000 per partner.

Human Capital

Law firms are assemblages of people who were trained and developed, or laterally recruited. The firm invested in the training and development of the attorney, or paid headhunter fees to acquire the individual. In a business where its greatest asset rides up and down the elevator every morning, having people and a sustainable culture is a hugely valuable asset. An average headhunter fee is 25% of compensation and, typically, hiring through law school recruiting and summer associate programs costs at least that much. Considering the value of partners alone, we're looking at an average investment of around $75,000 per partner.

Relationship Capital

Relationship Capital is the law firm's collective network. This involves both relationships that refer business to the firm (accounting firms, banks, smaller law firms, trade associations) and relationships that assist in serving clients (government officials, court clerks, money sources). The ability to tap into those relationships provides partners with a competitive advantage in attracting and serving clients. It has been my experience that, in most law firms, about 10% of their average revenues each year comes from new clients, and that at least 10% of their new business comes in as the result of a referral from someone outside the firm. So, given that the average revenue per equity partner among the AmLaw 200 last year was $1.8 million, the value of new client work in any given year that was the result of referrals is around $18,000 per partner per year. Our research seems to indicate that the average life of a client (balancing out long-term relationships with one-time litigation matters and transactions) averages 3.5 years. The average margin for the AmLaw 200 is 36%, which suggests a per-partner value of the current referral base of over $22,000 ($1.8 million x 10% x 10% x 3.5 x 36%).

Reputational Capital

This is the firm's brand, or what accountants call 'goodwill.' It is the value of the firm's name recognition and reputation that accrues to members of that firm. A partner with a well-regarded law firm never has to go through the rituals of proving quality, and recognition of the firm's name easily opens doors that would otherwise be impenetrable. The value, however, depends on the reputation of the firm. Certainly, the value to a new partner of the reputation of a Wall Street firm is vastly greater than that of joining a mid-sized firm in a small city. To make this easy, let's assume that the only ways a firm creates reputation and name recognition are advertising, public relations and sponsorships. Let's further assume that what the PR firms tell us is true, that branding requires a sustained effort over a period of time ' say, optimistically, 3 years. According to surveys, the average spent on reputation-building aspects of marketing is about 0.5% of revenues. Then, again using the $1.8 million revenue per partner figure, the value of investment in reputation is $27,000 per partner ($1.8 million x .005 x 3).

Monetary Capital

Perhaps the largest monetary asset of a law firm is the combination of its work in progress (work that has been performed but not billed) and accounts receivable (work billed but not collected). This is an asset that has literally been bought and paid for by the existing partners. Let's conservatively say that a firm has 45 days of work in progress and 45 days of accounts receivable. Again using the average of $1.8 million revenue per partner, the value of WIP and AR (knocking off 10% for write-downs and delinquent accounts) equals more than $400,000 average per partner.

Structural Capital

It used to be that the fixed assets of a law firm were limited to a bunch of old furniture, some typewriters and, perhaps, a law library. But law firms today require a heavy investment in technology. After accelerated depreciation, the value of hardware and custom software rarely reflects the investment made by existing partners. Operational leases and other forms of off balance sheet financing make the value of structural capital even more obscure.

But this pales in some firms to the value of under-market office leases and unamortized tenant improvements. During the late 1990s, many law firms found that they had overestimated their office space needs and renegotiated leases to dispose of excess space. In most cases, this meant an extended lease term ' sometimes as much as 15 or 20 years ' in exchange for giving back chunks of space. Today it is not uncommon to see firms with 5 or 10 years to go on a lease that may be 30% below market rates. Even if a firm doesn't cash in on the asset, the value translates to increased profits through lower operating costs for firms' second largest expenditure category after salaries.

By the same token, the tax code requires about a 40-year amortization of some tenant improvements. It is rare for a law firm to stay in the same offices for 40 years, which means that the unamortized value of office build-outs in excess of tenant improvement allowances is recoverable in a lump sum deduction when a law firm moves.

Clearly there is value in fixed assets in every law firm, but it is highly dependent upon where firms are in their depreciation cycles. So we'll ignore it.

The Value of Partnership

The sum of the values expressed above comes to more than $570,000. Of course, there may be debts that count against the value of partnership ' long-term debt, off balance sheet equipment leases, guarantees and unfunded, non-qualified partner pension plans. But the largest portion of debt is typically devoted to fixed assets, which (one hopes) are depreciating at a level approximately equal to debt service.

The point in all this is that there is substantial value in becoming a law firm partner. Beyond the status, virtual lifetime tenure and six-figure income the position provides, a new partner becomes an owner in a going concern. Whether the existing owners ask new partners to buy into the business or generously give a part of their business away is, of course, up to those owners. But at minimum, new partners ought to recognize the value of what they are receiving.

When I'm playing golf and a putt is meaningless, I can sink them backhanded all day long. But when you get to the end of a golf match and are standing over a 3-footer to keep from losing a $5 bet, the hole suddenly seems to get smaller. I've heard partners argue that making a new partner has no economic impact on the firm. If partners understand that they are collectively betting on a new equity partner and the amount of the bet exceeds $500,000, the partnership decision might justify a little more selectivity. Sometimes a smaller hole is a good thing.