September 21, 2022
I was asked this question earlier in the week by an investor looking to enter the legal market – do law firms constitute a ‘good’ investment?
This question comes up usually from external investors and the person asking the question will usually be expecting to be purchasing a law firm with fully functioning departments, staff in place and plenty of steady streams of work. They will often want to know what sort of return they will get on their investment and the typical profit margins. Law firms do not usually have the benefit of gross recurring fees to provide a consistent income, unlike accountants and tend to be dependent on a continuing stream of new business coming through the door.
The reality of investing in a law firm is somewhat different from expectations, for the following reasons:
Law firm value is almost completely dependent on the staff team
I am never sure if owners of law firms always appreciate this, but the value of your firm is almost completely dependent on the team of staff who run it for you. If you take away the staff and are left with files and a structure, then your law firm has a very reduced value. Files do not make money on their own and neither does the structure of a law firm. If you are looking to invest into a law firm, then essentially you are looking to take over a team of staff in order to continue to generate income for the law firm and yourself. Without the staff, you have no income.
Recruiting into law firms at the moment is notoriously difficult due to the huge gap in expectations between employees and employers in relation to conditions and also salary levels. The risk with investing into a law firm at the smaller sized end is that you will not be able to retain the existing staff and subsequently will need to enter the recruitment market to keep the business going.
Profit margins can be very tight
Quite a lot of law firm purchases at the lower end of the market are done with the expectation of being able to trim the costs, merge into a larger operation to reduce overall administration and to use the new acquisition as a branch of the larger organisation. This is fine, but if the owner is retiring and virtually all the work has been undertaken by them as the fee earner, the new owner will need to quickly source a replacement lawyer which can prove difficult and also reduce profit margins quite drastically. If someone is recruited at a senior level to run the firm and the caseload, it will reduce the profit margins somewhat.
ABS structure
It is difficult for a non-lawyer to own an interest in an SRA regulated solicitors’ firm that does not have ABS status. If an external investor seeks to acquire a standard law firm, they will need to change the structure in order to take a share. This will involve converting the practice to ABS status (alternative business structure). This involves quite a bit of regulatory work, and costs somewhere in the region of about £4-£8k on the complexity and whether or not you get consultants in to do it. It seems to take a minimum of six to nine months on average to get this through. This of course is perfectly possible to do, and is quite often something undertaken by larger investors acquiring larger size law firms, but it is a bit restrictive for somebody looking to take over a smaller practice, because it does ramp up the costs somewhat.
Summary
Are law firms a good investment? Yes in the right circumstances and definitely not in other circumstances. Purchasing a law firm as an external investor is something that is possible to do, but it is not as straightforward as purchasing other businesses, because there are quite a lot of different hoops to jump through. For most people the regulatory steps can make a purchase somewhat prohibitive unless you are looking at a good sized investment.
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