Should you take equity in your law firm?

Becoming an equity partner has always been a significant step in the career of a solicitor — the stage at which a lawyer “graduates” to true ownership of the business in which they participate. With equity comes recognition, respect and importantly, in theory, increased remuneration. It also comes with additional responsibility and risk, so it’s not to be accepted lightly or without proper consideration and an appreciation of what might go wrong.

For those considering taking equity, here are four questions which you may wish to ask (and answer positively) before you consider taking on the mantle of equity partner. Although, in this article, I refer to becoming an equity “partner”, what I set out applies equally to partners, members in a Limited Liability Partnership (“LLP”) and owners in any corporate or alternatively structured vehicle through which a law firm is run.

1. How healthy is the business which you are (literally) buying into?

This is fundamental. As an equity partner, your income is your share of the profits of a business — not a fixed share, but a variable share which will be based on how the business performs. So, how healthy is that business? Do you understand that or, alternatively, do you need help to understand that? If so, you should get that help. Hardworking fee earners often find it difficult to transition from doing what they know best, (dispensing quality legal advice), to approaching matters commercially as a business owner. If you are contemplating taking equity you will need to be entirely confident that you are buying a share in a successful, healthy business. Some businesses which superficially seem healthy and prosperous are anything but. Law firms can, and do, implode so you will need to see proof that everything is in good shape.

If you are considering buying into the equity you may already, as a fixed share or salaried partner, have access to some information regarding the finances of the business. If not you will need at least to see the business’s accounts, (and perhaps its management accounts), together with any other relevant information regarding how the business is performing and what its projected performance looks like. Does the business have an overdraft? If so, how big is it, and how is it used?

If you have any concerns in this respect, then becoming an equity partner may not be the right course of action. You will also need confirmation that there is nothing of which you are unaware, (but which others in the business know about), which may negatively impact your willingness to take equity — for instance, a possible team departure, internal schism or off-book liability which may negatively impact on the business.

If any of that information is not readily made available, ask yourself why that is the case.

2. What’s in it for you, financially?

Don’t be afraid to ask this question. The lawyers who succeed in law firms are often firm-first, industrious and loyal, all features of the sort of person you would want to join you as a stakeholder in your business. That is as it should be — however, becoming an equity partner requires an additional, commercial, perspective. Are you clear that taking equity will make you better off, financially? If not, why would you want to invest your capital into that business? In particular:

• how much capital will you be required to invest into the business — and how will you get that back out if you eventually wish to leave the business? Can the business assist you in obtaining a loan to make your capital contribution? Often capital is repaid to outgoing equity partners over a period of years. That is obviously undesirable where capital has been borrowed from a bank charging interest, although there may be an arrangement in place to relieve an equity partner from the burden of that interest
• what is your predicted monthly and annual draw of profits — and what other benefits will you receive? How does that compare to your fixed share or salaried position?
• can you be provided with a worked example of your predicted earnings, before and after tax? Will your potential liability to tax change?
• will the business reserve a sum out of your profit share for tax and pay this on your behalf, or will you be responsible for this yourself?
• do any of the partners enjoy additional benefits or remuneration to that which you will enjoy as a new equity partner? Is the partnership already committed to pay sums out of profits ahead of any that will be available for distribution to you and others?
• are any personal guarantees required, whether in relation to the business’s premises or otherwise?
• is the way in which profits are shared fair, and what is the route to increasing your share of profits in the future? That often leads to the next question…

3. How will your relationship with your partners be regulated — and can you rely on your partners to treat you fairly?

The answer to the first part of this question is almost always contained in the partnership or LLP agreement or equivalent constitutional document. If you do not already have the relevant agreement or document you must obtain it and understand it, as it will set out your rights and obligations. Amongst other things, you may find that upon becoming an equity partner the provisions relating to your ability to leave and/or any post-departure restrictions become much tougher than would otherwise be the case. For instance, outgoing equity partners may be subject to longer restrictive covenants than those applicable to fixed shared or salaried partners or employees.

This document will also set out what you can and cannot be compelled to do within the business — and provide for who has the power to make the business’s decisions. Many modern legal business agreements are prepared on the basis that they give the business the upper hand over the individual equity members. That may include the right for the business/your partners to terminate your equity partnership in the business, alter your share of profits, place you on garden leave and otherwise control what you can or cannot do. If there is no such agreement or document, ask why that is the case. The Partnership Act 1890 and the LLP Regulations 2001 each set out (similar) default regimes which apply unless displaced by agreement, (typically, but not always, a written agreement). This may be a problem for fixed share partners too, but it certainly would not be one that you would want as an equity partner.

All of that leads to the next question — and it is also fundamental. Can you rely on your partners to treat you fairly? In smaller legal businesses, you may already know the personalities of those with whom you will jointly own the business if you take equity. In larger law firms, power is usually delegated and concentrated in the hands of just a few individuals. How you fare inside the business may come down to how others decide you should be treated. Ask yourself whether the culture of the business gives you any reason to question how things might work out for you. If you have any doubts in this respect, think long and hard about whether taking equity is for you. Bear in mind that the way that business owners treat each other, as they compete for their shares of the available profits, can differ significantly (and negatively) from how they treat employees and fixed share or salaried partners.

4. What are the risks to you?

Partners in “traditional” partnerships are all too familiar with the fact that they face potentially unlimited liability for the debts of the partnership and the acts of their partners. That liability is never to be assumed lightly. Becoming the owner of a legal business which is run as a partnership means that you are, potentially, putting everything on the line.

Part of the reason why LLPs were brought into existence was because they permit some of the liabilities of running a business to be limited — precisely as the name suggests. However, not all liabilities can be avoided by operating out of an LLP or a corporate vehicle. Perhaps the biggest risk that arises is where a firm performs badly and slides towards insolvency. In that instance, those responsible for running the LLP (and that may include some or all of the equity partners) can, in some circumstances, find themselves responsible for those liabilities which arise after they knew or ought to have known that there was no reasonable prospect that the insolvency of the business can be avoided — effectively for wrongfully trading the business.

I have mentioned above the fact that most law firms reserve from each partner’s profit share a sum in respect of tax. Where a firm is performing badly, that may also lead to issues. If the partners’ tax reserve is used to prop up the firm’s finances and is therefore no longer available to discharge the individual partners’ liability to tax, this can be disastrous. Partners can find themselves needing to source the sums needed to pay their tax elsewhere, whether out of savings or otherwise. The money they had saved for that purpose is already spent by the business. Not a happy prospect.

Conclusion

Asking all of these questions is the right thing to do, but don’t forget to feed into the equation the fact that most law firms are well-run, adopting conservative policies which mitigate the risks of being in business. Participation in a successful legal business as an equity partner is potentially very rewarding, but taking equity is a decision that should be taken from an informed position.

In well-run firms, any requests for information will usually be dealt with positively and promptly — after all, a properly run business has little to hide and ought to welcome a new equity partner who approaches matters pragmatically and commercially. If there is resistance to providing any information which has been reasonably requested, (perhaps it is suggested that the prospective partner ought to be able simply to “trust” the existing owners of the business), ask yourself what advice you would give a client who found themselves in that position. Don’t allow excessive caution to prevent you from signing up to what may be a very good thing, but make that decision with your eyes wide open.