Dealing with Merger Financial Data

There are two primary reasons why census data may be incorrect. The first reason is that some firms simply do not track attorneys and staff on an FTE basis. Many firms do not track personnel movement in such detail and will choose to provide year-end headcounts as substitutes. Using such substitutes is not recommended. A better approach is for both firms to go through their personnel records to determine an accurate census. Variances in the results from using headcounts instead of proper FTEs can be substantial.

The second reason census figures are often inaccurate is due to manipulation. Many law firms, particularly those that participate in public financial surveys, maintain census data in more than one way. Typically, the different sets vary in the number of equity partners that are reported (as well as reported net income per equity partner). In merger financial analysis, it is important to ensure that the 'counting' methodology is applied consistently between firms and across the years.

Since most law firm financial metrics are considered on a per lawyer or a per partner basis, accurate census data is critical to the analysis. The most notable financial metric is of course profits per equity partner, which requires an accurate denominator (equity partner FTEs) for calculation. Considering this, it is easy to see how incorrect census data can throw off comparative results. Revenue per equity partner, revenue per lawyer, expenses per lawyer, and overhead per lawyer are all examples of common metrics that will be either overstated or understated by erroneous census data.

2) DON'T get caught up in minutia (at least initially).

Too often, merger discussions stagnate when the parties focus on insignificant financial discrepancies instead of overarching trends and themes. Joint meeting time during merger discussions is too valuable to spend on small-ticket questions such as whether storage costs are included in occupancy expenses or whether parking for partners is paid by the firm or the partners or whether such-and-such should be excluded. Discussion during these meetings should focus on the big picture. Does the other firm fit with our strategic goals? Are the financials compatible? What are the potential roadblocks? What are the potential synergies?

If a situation arises where too much time is spent on minor details, a good question to ask is whether the result (one way or the other) will impact the go/no-go decision. If the answer is 'yes,' then obviously further discussion is warranted. If the answer is 'no,' then move on and have someone revisit the issue and report back at a later meeting.

3) DO use simple 'sniff' tests.

Law firm economics is primarily a billable hours x rates model. The relative simplicity of the economic model allows quick 'sniff' tests on the exchanged financial data to garner insight and check for accuracy. Examples of these quick tests include checking to see if the billing rates x hours x timekeeper FTEs x realization equals the total firm revenue (rough ballpark) or checking to see if the reported average and median billable hours are similar. These types of tests can be done in a few minutes and can provide valuable insight. Information gleaned from quick checks can include whether or not the overall data are accurate, whether or not data are skewed by a large contingent fee, whether profits per equity partner are increasing due to de-equitization (rather than improved business), and whether outliers are skewing an average, etc.

These types of tests can also be extremely valuable when discussing expected future performance. When two firms decide to continue merger discussions they will eventually create a pro forma to model the financial performance of a merged firm. In this case, simple testing will allow the reviewers to quickly test whether or not the model is reasonable and to determine whether a discrepancy is revenue or expense related. These types of tests are not meant to replace in-depth analysis; rather, they are a quick and effective way to help determine where detailed analyses may be appropriate.

4) DON'T use aggressive assumptions in the pro forma.

Developing a pro forma requires each firm to independently project its future performance as a stand-alone entity and then jointly determine what type of additional activities the combined firm can expect to accomplish (i.e., additional hires, office consolidations, etc.). Oftentimes, firms start with relatively aggressive assumptions. In most cases, the reported assumptions are not necessarily unreasonable, but given the firms' past performance the results are unlikely. Examples of aggressive assumptions could include estimating average billable hours at 1,800 (when prior years were 1,750 at best), assuming a year-over year billing rate increase of 7% (when past increases were 4%-5%), or using a realization rate of 90% (when past years have always hovered around 86%-88%). Aggressive assumptions typically spawn from a mixture of pre-merger posturing as well as the desire to portray significant merger benefits to the partnership. However, excessively positive outlooks should be avoided, even in preliminary drafts.

A problem with using aggressive assumptions is that those assumptions can start the pro forma process off by setting too high a reference point. Obviously the pro forma will go through much iteration, and assumptions can always be adjusted downward. However, once people see a scenario they like (in this case, high profits), some will be reluctant to move away from the scenario and will defend the feasibility of the assumptions regardless of logic.

Starting with conservative assumptions for the first pass of the pro forma usually results in more reasonable final versions than starting with aggressive assumptions. By using conservative estimates a lower boundary is created, and it is an easier task to move up from the lower end than it is to work down from the upper boundary.

Aggressive assumptions are not just relegated to the revenue side. There are numerous one-time or short-term expenses associated with mergers that require fair consideration. Examples include technology expenses to achieve parity between the firms, marketing costs for new material for the combined firm, and merger-related travel and retreat expenses. These expenses can run anywhere from thousands of dollars to well over $1 million depending on the size of the firm.

Another commonly overstated expense assumption is cost savings firms expect post-merger. Significant economies of scale rarely exist in merged firms, at least in the short-term. In reality, the larger a firm becomes the more it costs, on a per lawyer basis, to operate. Even savings from a reduction in staff can be minimal due to typically generous termination packages and the fact that other individuals may demand increased compensation to stay with the new firm.

5) DO ask about off-balance-sheet items.

The most common off-balance-sheet item is an unfunded obligation to partners. The size of these obligations can range from a very modest sum to well into the tens of millions. Unfunded liabilities can be deal killers, so the size and scope of the obligations should be known relatively early in the discussions.

Surprisingly, we often find that firms with these commitments are themselves not fully aware of their exact size and scope. Upon asking about unfunded plans, firms provide detail ranging from gross numbers to decade-old estimates to recent-year's payments. Since these plans are not on the balance sheet, they are not necessarily audited or closely tracked. As part of the merger financial exchange, firms with off-balance-sheet items should provide documents detailing the individuals in the plan, anticipated retirement dates, and discounted payment schedules. Asking about such obligations early on will help avoid any unpleasant surprises late in the process.

6) DON'T distribute interim financial data to the general partnership.

While those involved in the merger discussions do not want to be accused of withholding information, they must take great care to not let incomplete analyses or unfiltered messages reach the general partnership. When partial information is released without proper understanding and context, the most likely result is a partnership with inappropriate expectations, confusion, or unwarranted concern.

The best way to broadly disseminate financial information is to include only the final version of relevant financial analyses within a merger prospectus. The merger prospectus includes other items such as firm profiles, merger terms, acknowledged practice synergies, and client conflict analyses. By including the financials in the prospectus, partners will be better able to understand how the financials fit in with the larger scope of the merger.

Conclusion

Even in the best-case scenario, merger discussions are challenging and time consuming. It is hoped that the suggestions listed above will help prevent the merger financial analysis from contributing to the difficulties of merger negotiations.

Jonathan S. Kuo is a consultant with Hildebrandt International, Inc., a management consulting firm that specializes in the legal profession. Kuo is based in Washington, DC, and can be reached at [email protected].

When two law firms undertake merger discussions, they eventually exchange financial information. Typically, this exchange is anticipated from both a curiosity standpoint as well as a practical standpoint. Ultimately no merger will occur if it does not make good economic sense; therefore, critical financial review is essential. In our experience at Hildebrandt International, Inc. certain missteps involving the financial review appear repeatedly. Here, we have compiled a short list of do's and don'ts to combat avoidable problems related to merger financials. This list is not meant to be all-inclusive; rather, these are some suggestions for those unaccustomed to financial merger analysis.

1) DO focus on accurate census data.

Census data tracks the number of individuals in each title category (e.g., equity partner, associate, secretary, etc.) and should be tracked on a full-time equivalent ('FTE') basis. This means that a full-time, full-year individual is counted as 1.0 and an individual that works part-time or is employed for only part of the year is counted as a partial FTE (e.g., 0.5, 0.7). Accurate FTE calculations form the foundation for most law firm financial analyses, yet the figures are often compiled incorrectly. As a quick test, if census figures received from the other firm do not contain decimals, then its data may have been compiled incorrectly.

There are two primary reasons why census data may be incorrect. The first reason is that some firms simply do not track attorneys and staff on an FTE basis. Many firms do not track personnel movement in such detail and will choose to provide year-end headcounts as substitutes. Using such substitutes is not recommended. A better approach is for both firms to go through their personnel records to determine an accurate census. Variances in the results from using headcounts instead of proper FTEs can be substantial.

The second reason census figures are often inaccurate is due to manipulation. Many law firms, particularly those that participate in public financial surveys, maintain census data in more than one way. Typically, the different sets vary in the number of equity partners that are reported (as well as reported net income per equity partner). In merger financial analysis, it is important to ensure that the 'counting' methodology is applied consistently between firms and across the years.

Since most law firm financial metrics are considered on a per lawyer or a per partner basis, accurate census data is critical to the analysis. The most notable financial metric is of course profits per equity partner, which requires an accurate denominator (equity partner FTEs) for calculation. Considering this, it is easy to see how incorrect census data can throw off comparative results. Revenue per equity partner, revenue per lawyer, expenses per lawyer, and overhead per lawyer are all examples of common metrics that will be either overstated or understated by erroneous census data.

2) DON'T get caught up in minutia (at least initially).

Too often, merger discussions stagnate when the parties focus on insignificant financial discrepancies instead of overarching trends and themes. Joint meeting time during merger discussions is too valuable to spend on small-ticket questions such as whether storage costs are included in occupancy expenses or whether parking for partners is paid by the firm or the partners or whether such-and-such should be excluded. Discussion during these meetings should focus on the big picture. Does the other firm fit with our strategic goals? Are the financials compatible? What are the potential roadblocks? What are the potential synergies?

If a situation arises where too much time is spent on minor details, a good question to ask is whether the result (one way or the other) will impact the go/no-go decision. If the answer is 'yes,' then obviously further discussion is warranted. If the answer is 'no,' then move on and have someone revisit the issue and report back at a later meeting.

3) DO use simple 'sniff' tests.

Law firm economics is primarily a billable hours x rates model. The relative simplicity of the economic model allows quick 'sniff' tests on the exchanged financial data to garner insight and check for accuracy. Examples of these quick tests include checking to see if the billing rates x hours x timekeeper FTEs x realization equals the total firm revenue (rough ballpark) or checking to see if the reported average and median billable hours are similar. These types of tests can be done in a few minutes and can provide valuable insight. Information gleaned from quick checks can include whether or not the overall data are accurate, whether or not data are skewed by a large contingent fee, whether profits per equity partner are increasing due to de-equitization (rather than improved business), and whether outliers are skewing an average, etc.

These types of tests can also be extremely valuable when discussing expected future performance. When two firms decide to continue merger discussions they will eventually create a pro forma to model the financial performance of a merged firm. In this case, simple testing will allow the reviewers to quickly test whether or not the model is reasonable and to determine whether a discrepancy is revenue or expense related. These types of tests are not meant to replace in-depth analysis; rather, they are a quick and effective way to help determine where detailed analyses may be appropriate.

4) DON'T use aggressive assumptions in the pro forma.

Developing a pro forma requires each firm to independently project its future performance as a stand-alone entity and then jointly determine what type of additional activities the combined firm can expect to accomplish (i.e., additional hires, office consolidations, etc.). Oftentimes, firms start with relatively aggressive assumptions. In most cases, the reported assumptions are not necessarily unreasonable, but given the firms' past performance the results are unlikely. Examples of aggressive assumptions could include estimating average billable hours at 1,800 (when prior years were 1,750 at best), assuming a year-over year billing rate increase of 7% (when past increases were 4%-5%), or using a realization rate of 90% (when past years have always hovered around 86%-88%). Aggressive assumptions typically spawn from a mixture of pre-merger posturing as well as the desire to portray significant merger benefits to the partnership. However, excessively positive outlooks should be avoided, even in preliminary drafts.

A problem with using aggressive assumptions is that those assumptions can start the pro forma process off by setting too high a reference point. Obviously the pro forma will go through much iteration, and assumptions can always be adjusted downward. However, once people see a scenario they like (in this case, high profits), some will be reluctant to move away from the scenario and will defend the feasibility of the assumptions regardless of logic.

Starting with conservative assumptions for the first pass of the pro forma usually results in more reasonable final versions than starting with aggressive assumptions. By using conservative estimates a lower boundary is created, and it is an easier task to move up from the lower end than it is to work down from the upper boundary.

Aggressive assumptions are not just relegated to the revenue side. There are numerous one-time or short-term expenses associated with mergers that require fair consideration. Examples include technology expenses to achieve parity between the firms, marketing costs for new material for the combined firm, and merger-related travel and retreat expenses. These expenses can run anywhere from thousands of dollars to well over $1 million depending on the size of the firm.

Another commonly overstated expense assumption is cost savings firms expect post-merger. Significant economies of scale rarely exist in merged firms, at least in the short-term. In reality, the larger a firm becomes the more it costs, on a per lawyer basis, to operate. Even savings from a reduction in staff can be minimal due to typically generous termination packages and the fact that other individuals may demand increased compensation to stay with the new firm.

5) DO ask about off-balance-sheet items.

The most common off-balance-sheet item is an unfunded obligation to partners. The size of these obligations can range from a very modest sum to well into the tens of millions. Unfunded liabilities can be deal killers, so the size and scope of the obligations should be known relatively early in the discussions.

Surprisingly, we often find that firms with these commitments are themselves not fully aware of their exact size and scope. Upon asking about unfunded plans, firms provide detail ranging from gross numbers to decade-old estimates to recent-year's payments. Since these plans are not on the balance sheet, they are not necessarily audited or closely tracked. As part of the merger financial exchange, firms with off-balance-sheet items should provide documents detailing the individuals in the plan, anticipated retirement dates, and discounted payment schedules. Asking about such obligations early on will help avoid any unpleasant surprises late in the process.

6) DON'T distribute interim financial data to the general partnership.

While those involved in the merger discussions do not want to be accused of withholding information, they must take great care to not let incomplete analyses or unfiltered messages reach the general partnership. When partial information is released without proper understanding and context, the most likely result is a partnership with inappropriate expectations, confusion, or unwarranted concern.

The best way to broadly disseminate financial information is to include only the final version of relevant financial analyses within a merger prospectus. The merger prospectus includes other items such as firm profiles, merger terms, acknowledged practice synergies, and client conflict analyses. By including the financials in the prospectus, partners will be better able to understand how the financials fit in with the larger scope of the merger.

Conclusion

Even in the best-case scenario, merger discussions are challenging and time consuming. It is hoped that the suggestions listed above will help prevent the merger financial analysis from contributing to the difficulties of merger negotiations.

Jonathan S. Kuo is a consultant with Hildebrandt International, Inc., a management consulting firm that specializes in the legal profession. Kuo is based in Washington, DC, and can be reached at [email protected].