A few years ago, my firm got a phone call. A larger firm, based in the Midwest, wanted to buy us. We were told that they had noticed what we were doing and thought it was cool and wanted to talk about what opportunities there may be.
Our firm had a new equity partner.* She was really excited – since she had just come to have equity in the firm, visions of selling her equity stake and living on the beach danced in her head.
Sadly, that’s not really how it works. If you build a tech company and you sell it, you get money to buy a beach house or live the dream of financial independence. If you build a law firm and a larger law firm takes it over, you get a job as a partner in the larger firm.
Like so much of a lawyer’s money life, if you build a law firm, you aren’t building wealth, you’re building income. Income is great if you want to stay on the treadmill; wealth is better if you want to have money that lasts. Lawyers tend to choose income. Which is another reason to think that lawyers tend to be not very bright.
That said, most lawyers in private practice want to be equity partners some day.
There are bad reasons for that and good reasons. The bad reasons are that people unthinkingly want things that are shinier and equity partnership looks shiny and would be new. You can call your mom and tell her that you’re an equity partner now. Your tax returns just got more complicated, so you must be important. And, if you’re important, then you’re winning!
Basically, there are six things that go into what it means to be an equity partner and ought to get worked out in a partnership agreement: naming, decision-making, percentage of ownership, compensation, departure conditions, and taxes. The amount and terms of a buy-in also matter, but I tend to think of that as a separate deal.
I’ll talk about each of those in a later post, but, for now, let’s think about what equity is and whether it matters.
Most law firms – not all, but most – have very few assets. They’ll have some computers, some office furniture (which has a ridiculously low resale value), and some web domains that may be worth something. But, really, these hard assets have little value.
Many law firms have a stream of receivables from clients; monies that are owed but haven’t been paid. Generally, if the receivable has less than 90 days on it, there’s some real value there. But a bill that’s been outstanding for more than 90 days is not going to get paid, or it’s not going to get paid full value.
Some firms with a contingency practice may have a case out there that’s going to hit in the future, which may or may not be worth quite a lot. If a firm knows there’s going to be a massive payday in two years, that’s worth talking about as an asset. Though, again, you’ve got to discount a fair bit to get to an accurate present value.
If you just look at those kinds of assets, a law firm has little real equity. We’re not like a doctor’s office that has a bunch of fancy medical equipment. This is really the downside to a law firm having very few start up costs. It’s cheap to get in, but worth very little when you get out.
But, what matters most at a law firm is how it gets clients, because that’s how it gets money. Client flow is generally the biggest thing that should determine whether equity in that particular firm has any real meaning.
Most law firms get their work because the partners at the firm have a relationship with people who are able to refer them work, or because the partner has a reputation for a certain kind of work. If your revenue comes from an individual partner’s relationships or reputations, and that partner leaves, then you don’t have that revenue stream any more.
Which is to say that this is less equity of your firm, than it is equity of any individual partner. And, of course, if that partner stops practicing, his or her value disappears. Which is why lawyers in private practice almost never fully retire – they’d lose whatever reputation they’ve built up.
In that sense, becoming an equity in a law firm is illusory. The real value there is in each lawyer’s ability to bring in work.
When thought of that way, it’s kind of crazy to want equity in a law firm. If you can get decision making power and contractual guarantees that give you the functional equivalent, the additional kick of ownership (and hassle at tax time) is kind of silly to want.
That said, lawyers want silly things all the time.
* Strictly speaking this is false. We’re an LLC, so we don’t have partners we have members. There are a few differences between LLCs and partnerships, but for most of what I’m talking about here they don’t matter. That said, I’m not a corporate lawyer and you should really do your own investigation.