The shape of money

Constellation of options

As Chris Bull, a consultant at Edge International, says, there is ‘a constellation of options’ regarding a law firm’s structure and ownership. Firms regulated by the Solicitors Regulation Authority range from sole practitioners to huge global firms. As of January this year, there were 9,339 such firms in England and Wales, of which 56% were incorporated companies, 17% sole practitioners, 16% limited liability partnerships (LLPs), and 12% traditional partnerships.

The number of firms is slowly falling, but the percentage that are limited companies is trending upwards and the number of traditional partnerships is falling. While there is no direct correlation between a firm’s structure and its profitability, this shift is likely related to the legal sector becoming more commercial and entrepreneurial, partly in response to competition, including alternative legal service providers (ALSPs) – law firms owned and run by non-lawyers.

Law firms are also increasingly recognising the value of investing in technology, business support staff and professional management teams. This has prompted conversion to alternative business structure (ABS) status, in order to attract external investment.

ABSs and external investment

An ABS is any regulated legal business with at least one owner who is not a solicitor. ‘ABS status is not a legal entity,’ Bull explains, and a partnership, an LLP or an incorporated company can convert. Most commonly, firms convert to enable a corporate officer who is not a lawyer to become a partner, but Bull says many have deployed the vehicle to pull in outside capital.

‘A significant reason for firms converting to limited companies is that ABS-regulated law firms are becoming more common,’ says Jonathan Lea, founder and principal of law firm Jonathan Lea Network. ‘If a law firm wants to accept [external] investment, then it will almost certainly first need to become a limited company so it can offer shares to its new owners.

‘We are currently solely owned by myself as the founder, but as well as offering employee equity incentives in future, we may also consider investors who can add value to the business and help us scale profitably,’ Lea explains.

While ABS status opens up new opportunities, it does not guarantee profitability. There have been spectacular implosions among firms that relied on external investment to fund acquisitions, such as Metamorph, Kingly, and (in notoriously and admittedly unique circumstances) Axiom Ince.

Paul Bennett, a partner at law firm Bennett Briegal, a business adviser to law firms, says the financial and business risks of raising investment to fund expansion are particularly acute when it is done at a significant scale.

‘Law is dominated by owner-managed businesses,’ he says. ‘When you’re an owner-managed business with close control over your costs, the chances of financial overreach are much reduced. The SRA’s preference for ABS models and external investment creates a tension in the market, and importantly, when this goes wrong, it does so in a more high-profile and expensive way. I’m not sure that the balance is right between opening up the market and creating stability.’

Structure matters

Richard Burcher, founder of Validatum, which advises firms on pricing and profitability, does not see a link between a firm’s profits and structure.

‘The drivers of profitability are more influenced by commerciality, entrepreneurialism and pricing capability, and the good news is that a firm is capable of being successful and profitable irrespective of size and structure,’ he says.

But Burcher adds: ‘Structure matters. In order to be successful [profitable] you have to have the right pool of investors, whether they are partners or external investors, and whether you are a traditional partnership, an LLP or a limited company.

‘Personally, I don’t understand why anyone would set up a traditional partnership in 2024 because of the personal liability involved,’ he says. ‘It is a risk to your future that can be limited by setting up as an LLP.’

Burcher notes that all of the magic circle firms are LLPs, except for Slaughter and May, which uses a pure lockstep structure under which partner pay is based on seniority.

As the legal sector has become more entrepreneurial, the realisation that commercial awareness is a stronger driver of profitability than ownership or structure has grown. This was reflected in PwC’s survey, which found that while none of the top-100 firms are actively pursuing alternative funding or ownership structures in the next three to five years, a few are considering minority investment from private capital investors. Also, 73% are actively pursuing commercial training for partners and fee-earners, while the remainder are considering doing so.

Financial management, focusing on market differentiation and return on investment, is de rigueur now too. ‘Historically, firms have been good at managing costs, but typically they have a realisation rate [the percentage of billable time recorded less whatever is written off] of between 70% and 95%. So more profitable firms tend to have higher realisation rates,’ explains Burcher.

The introduction of ALSPs, which Bull describes as ‘market capitalism and entrepreneurial drive applied to law’, has attracted entrepreneurs into the sector. This structure has become a significant driver of commercial focus; it enables law firms to quickly scale up because profits do not have to be distributed among partners every year.

‘Firms don’t want to be ALSPs, but they can learn from their diversification, use of tech and profitability,’ says Bull. ‘For example, [stockmarket-listed firm] Knights is growing very fast, driven by high profit margins.’

The choice of structure also presents a challenge in terms of measuring profitability.

‘Firms measure profitability in different ways,’ says Bull. ‘A limited company has to measure EBITDA [earnings before interest, tax, depreciation and amortisation]. Traditional law firms file accounts and LLPs have to publish their turnover and profitability, but how they calculate profitability is up to them. The directories and the press report PEP [profit per equity partner]. But more firms are becoming limited companies, which don’t have equity partners, so it is hard to make comparisons.’

Management and profitability

How a company is managed, rather than how it is owned, underpins profitability.

‘Firms owned by private equity are generally profitable because they are owned by sophisticated investors who demand commerciality and financial rigour. They come in to make money and then get out. When firms are run by lawyers there is a very different dynamic,’ says Burcher.

The big corporate firms are highly profitable because, while the equity partners still own the business, they install a corporate structure – usually a full C-suite – to manage the business and make strategic decisions.

‘For those firms to be profitable, the partners have to let go of some of the day-to-day control of the business,’ says Burcher. ‘Those who do will generally make more money because the firm is run like a business, not a club. When firms reach a certain size, they cannot have 300 or 400 partners involved in every decision, so they end up with a tier of senior partners, and above them a management board and/or a governance board. As a broad generalisation, those firms will outperform firms that are not professionally managed.’

Other variables that affect profitability include work profile, as some practice areas are inherently more profitable than others, and the clients that firms work for.

‘Clients that spend a lot of money have more ability to negotiate rates down,’ says Burcher. ‘[Firms] need to be careful about how many of those clients they have, otherwise they can end up with a disproportionate number of trophy clients that pay poorly, leading to a comparatively high turnover, but a poor profit margin. Again, it’s a trade-off that firms have to make – a smaller percentage of a higher figure or a higher percentage of a smaller figure.’

As law firms have become bigger and more commercial, it is of course true that the title of ‘partner’ no longer necessarily denotes ownership.

‘Salaried partners are presented to clients as partners,’ Bull says. ‘But they don’t have a stake in the firm and they are treated as employees for tax purposes.’

Some large national firms have many salaried partners, he notes.

Employee-owned firms

Other firms are extending ownership structures further. The number of employee-owned firms is increasing. Around 20 UK law firms are wholly or majority-owned by an employee ownership trust. This offers an alternative to succession issues instead of seeking new partners via lateral hires or inviting associates to invest in a partnership.

‘But distributing profits beyond the partnership does not require changing the firm’s structure or ownership,’ Bull stresses. ‘Some more progressive firms have introduced all-employee profit-sharing schemes, which can be contractual or discretionary. There is usually a formula, related to revenue targets or a percentage of salary.’

Triple bottom line

While sound financial management supports profitability, the business of law also depends on client relationships, and staff recruitment and retention. As environment, social and governance (ESG) matters have become more prominent, more firms are seeking B Corp certification. This shows a commitment to balancing profit and purpose, without changing the company’s legal structure.

Bates Wells became the UK’s first B Corp-certified law firm in 2015, followed by Radiant Law in 2020. There are now 22 B Corp legal services businesses in the UK, the most recent addition being top-50 firm Freeths.

'We all work hard to create a positive impact on our people, our clients, suppliers, wider communities and the environment'

Sally Procopis, Bates Wells

Sally Procopis, chief operating officer of Bates Wells, says that her firm, like other B Corps, ‘rather than simply focusing on improving our financial results each year’ has a ‘triple bottom line’ of people and planet, as well as profit.

‘Our partners are not just motivated by money,’ Procopis says. ‘Rather, we all work hard to create a positive impact on our people, our clients, suppliers, wider communities and the environment.

‘We don’t have a culture of large bonus payments, but the partners put 5% of their profit into an employee bonus pot and more than half of that is used for an annual profit share payment of the same value for each employee, which benefits our lower-paid people.

‘We encourage people to volunteer… [for example] to act as charity trustees, and to help drive our [equality, diversity and inclusion] agenda. Our supply chain is something in which we invest carefully. We don’t buy the cheapest, rather we choose to work with fellow B Corps or ethical businesses wherever we can. We expect our suppliers to meet high standards of environmental and social governance.’

Bates Wells recently started working with Obelisk Support, a B Corp-certified ALSP that supplies specialist legal consultants. Obelisk’s chief executive, Dana Denis-Smith, says having a sense of purpose contributes to her company’s profitability.

‘Aligning to a set of values makes us lean and focused, which means that we have a lower operating cost. More transparency in decision-making means more accountability across all team members, which means less wasted costs. Most of the profitability is linked to productivity, an engaged and focused team and alignment with client values, which means more repeat business [and] good “sticky” clients. Therefore, the cost of client acquisition is lower… and the conversion is faster. It all helps with the bottom line.’

B Corps also measure success differently. ‘One has to consider all stakeholders, not just the shareholders,’ says Denis-Smith. ‘In a traditional partnership, profits per equity partner and profits per partner are the metrics of success, whereas we look at net profit in a wider sense.

‘The B Corp [criteria] require us to consider, for example, the difference between the lowest- and highest-paid in the company and, in our case, we don’t want to have a ratio that is bigger than five. Profit sharing before distribution is also important, and I have always set aside 20% of net profit for the team. In a law firm, the bulk of the profit becomes partner money.’

In summary, the profitability of a law firm is not determined by its ownership structure, size or profile, but by the same drivers of any other commercial sector: effective strategic and financial management, and high realisation rates; investment in talent, technology and culture; alignment with clients’ legal and business requirements; and, increasingly, values and purposes.

 

The first article on law firm profitability can be read here.