A law firm merger is an investment and should be accretive to a law firm's net income per partner. The costs of a merger or acquisition come in these areas: transaction, integration and revenue impact. This article deals with the first two areas.
The transactional costs of a merger can and do cause a dilutive situation short- and possibly long-term. Experienced merger and acquisition professionals know that transaction costs, in the business community, can range between 6 and 8 per cent of the gross revenues of the organizations. Few law firms are experienced enough to closely estimate these costs and most often underestimate them resulting in a dilution of partner profits.
Preparation of Pro Forma Financial Statements
I have consulted on hundreds of law firm mergers (and acquisitions) and reviewed an equal number of pro formas over the years. Ultimately, they were all wrong, as pro formas always are. But they must be prepared in order to answer the question, "How much will this deal cost?"
Unfortunately, too many pro formas are simply a "slapped together" set of budgets prepared by two law firms. Little quality thought is given to the key variables and the assumptions that will impact changes in the key variables. Key variables are those costs that will (just depends on the degree) make up the overwhelming bulk of the cost of a merger. There are a few simple keys to development of a good pro forma income statement, including:
- comments on the variability of the forces that impact each item;
- a clear explanation (the assumptions) of the expected impact of the merger for expense item;
- a separate section that outlines the total expected costs of the deal; and
- use professionals experienced in dealing with mergers to help develop the pro formas.
If the pro formas are prepared by the law firm, they will almost always have significant errors and you will experience nasty surprises. Qualified experts in some of the key areas, such as technology and marketing, must be consulted in order to gain a better picture of expected costs.
If the critical Go/No Go phase is conducted properly, then the initial cost assessment should occur before (or concurrent with) any further evaluation/due diligence/negotiations. Getting a preliminary assessment is beneficial to the entire merger process because the two organizations learn an enormous amount about one another's operations, policies, culture and the like. In addition, the early assessment facilitates the process by identifying issues and problems earlier. The sooner you have an idea of potential costs, the better decisions you will make.
Larger Firm, Larger Overhead
An analysis of the statistics contained in the Altman Weil Survey of Law Firm Economics for the past 10 years demonstrates that the larger the law firm, the more the overhead per lawyer. Other surveys confirm this fact. There are no economies of scale in law firm mergers of significance. Yes, accounting staff may be reduced, or a receptionist or librarian let go, but the larger IT staff and marketing staffs will offset those savings. But those savings are long term. In the short run, you are more likely to need the full complement, if not extra hands, to merge.
Banks and other service industries routinely justify mergers because of expected "efficiencies in operations." This means massive layoffs and consolidation of operations. Law firms do not enjoy such rationalization of assets to any great degree. Accordingly, economies of scale play no great role in mergers. If the merger is said to be one that will cost you very little because of economies of scale, be very skeptical.
The following, based on my experience, represents those costs which most impact merger transactional costs. You can be reasonably certain that costs in each of these areas will probably exceed the current costs borne by the two firms independently.
Largest Cost Salaries and Benefits
Salaries and benefits of staff and associate lawyers make up the overwhelming costs in law firms. Because law firms are labour intensive, fully loaded labour costs are substantial in mergers.
When firms merge, equalizing salary and benefit levels is the typical procedure. When a "benefits-rich" firm merges with a firm offering marginal benefits, the costs to equalize can be enormous. In addition, staff are sensitive and protective of perquisites. I saw major morale problems when one firm tried to do away with $50 per month parking allowances, creating a terrible situation from which the firm ultimately had to retreat.
Determine Technology Costs
The fastest-growing costs in law firms are technology related. These are typically the costs that are most underestimated by law firms and result in unwanted surprises. You must assume that the combined firm will operate with the same technology platform immediately. Not to do so will adversely impact activity integration and acculturation and that is unacceptable.
It is essential that the firms retain professional help to determine what the technology costs of hardware, software, migration/conversion and training will be. Firms that rely only on internal staff and vendors to determine these costs will almost always be disappointed. Law firms spend $8,000 to $12,000 (U.S.) per lawyer, per year, in technology costs. It is easy to see how a significant technology investment will be required to ensure everyone is on the same platform and is trained.
Office Space Costs
I was recently involved with a large merger where one firm had just committed to a lease for to-be-built space. The decision to abandon the new space in favour of moving in with the merger partner cost in excess of $2 million.
Space costs are exploding. Firms spend $15,000 to $20,000 (U.S.) per lawyer (even more in California) on occupancy costs. The variables in calculating costs are numerous because of the different types of merger, i.e., same-city mergers, a need to move offices, etc., and expert assistance is required to properly determine costs. The statistics show that larger firms almost always have higher per-lawyer occupancy costs than smaller firms.
Marketing and Public Relations Costs
Marketing and public relations is the cost (investment) that can most support the objectives of the combination. Yet many firms underinvest in this area in an attempt "to save money."
I was asked a few years ago to evaluate the rationale for a merger in which the parties were most excited about the opportunity to cross-sell one another's clients (something almost all merger partners hope for). I asked two questions:
- Will the compensation system encourage the necessary collaboration (behavioral change) to ensure cross-marketing?
- Do you have a solid process in place to manage a client cross-marketing initiative?
The firms were not even able to comment on the second question. I explained that effective infrastructure to support cross-marketing would include staff, databases, research facilities and the like. The firms had not considered their organizational, structural and support needs in this area and needed to budget for expenditures. At the end of this process, we discovered that staffing, technology needs, space and the like would exceed $1 million per year, a cost that had not been considered, but was critical to supporting the major reason for the merger.
Activity integration, getting people to do things with one another, and acculturation, melding of cultures, are two of the most important needs of a combined organization. Other than a few mixers and signing dinners, few firms actually budget for these critical functions.
We know from experience that if organizations are, in fact, to operate as one, people will have to get together and talk a lot. Practice groups need to meet and leadership needs to be seen in all the offices.
Integration and acculturation will occur more successfully when people see one another frequently. In separate city mergers, securing commitments of lawyers to move and work out of new locations is extremely valuable.
Most firms will pay the costs of relocation, essentially "making people whole." However, if you truly want to entice people to move for the benefit of the organization, you should consider paying moving bonuses. I recently recommended that a firm pay up to $250,000 to a key partner to entice him to move to the city in which the firm was acquiring an office. I reasoned that this was a little enough investment to help ensure that this major strategic move was successful.
Use professionals to help ascertain costs, especially where the professionals' experience outweigh yours. Legal, accounting, benefits, real estate, technology and public relations experts can all play a role. These costs need to be budgeted.
There are a myriad of other costs that will occur. Only through diligent line item by line item assessment will you be able to determine what those might be. In addition, it is always rational to have a contingency or fudge factor.
I am often asked for a rule of thumb pertaining to the costs of merger, i.e., an amount per lawyer or a percentage of revenues. Unfortunately, the numerous variables affecting costs make calculation of a useful rule of thumb impossible. However, I can state with certainty that not following the advice herein will result in very nasty surprises.
Making a merger or acquisition successful is always difficult. Don't hamstring the combination by underinvesting, either intentionally or because costs weren't estimated properly. A merger is an investment opportunity. Like any good investment, you need to know the costs to make sound financial judgments, both pre- and post-merger.