Making a move from one firm to another is a major career transition and due diligence is necessary.
When considering a lateral move to another firm, it is important for an attorney to make the appropriate inquiries into each potential firm. A thorough investigation into any potential new firm is necessary, now, more than ever as the COVID-19 pandemic has changed the practice of law. Remote work is very common and will continue to exist. A prudent potential lateral will examine the new firm’s financial documents and meet with firm leaders to gauge the firm’s overall health. A lateral candidate does not want to join a firm that is not financially sound or has not adapted to the current environment. By doing so, attorneys risk losing their clients, who are more likely to seek new counsel with a more stable firm, if they feel their current attorney has not performed proper due diligence when moving the practice.
Check Financial Information
Because law firms are privately owned, it may be a bit more difficult to obtain independent financial information than it would be from a publicly traded company. One cannot easily run a Dun & Bradstreet inquiry to determine financial health for most practices. Asking for two years of financials (balance sheet and profit & loss) is, therefore, a reasonable request. These reports should be easy to understand with key entries clearly visible. For instance, on a balance sheet, how much liability does the firm have? On a profit & loss, how much net profit did the firm earn? How much did the firm spend on certain expenditures? Generally, employee expenses should be at or around 40% of revenue, facilities should be approximately 5% of revenue, marketing should not be over 8% and technology should be about 10%. Be sure to read the comments because that is where accountants reveal possible issues of concern. Many attorneys may not totally understand all the line items and the financial statement comments, so it might make sense for them to hire a law firm consultant or an independent accounting firm to review the financials with them. Requesting two years of tax returns is also a good idea.
A lateral may want to ask for any routine monthly and annual reports that partners receive. Asking to review aged accounts payable and accounts receivable reports is also advisable. If essential expenses, such as rent, are not paid promptly, that’s a red flag. With respect to accounts receivables, if a large percentage of what is “on the street” is older than 180 days, that may be a problem as well.
Be Aware of Reported Profits
Many firms publish profits per partner (PPP), but this metric is easily manipulated. Before reporting PPP, a law firm can de-equitize partners to increase this ratio. Remember that this metric is an average. One or two partners may be earning multiples of what other partners are earning. Asking for a spreadsheet showing what each equity partner earned in the prior two years, therefore, makes more sense. There is no need to obtain names—the annual compensation for each partner from lowest to highest will suffice.
A better metric which is widely published is revenue per lawyer (RPL). Again, this is an average and lawyers can be terminated before publishing this metric, but it is less easily manipulated. Requesting a spreadsheet of cash receipts by originating attorney would also be beneficial. Again, attorney identities don’t need to be disclosed, but the range of cash received per attorney is a helpful statistic. For instance, if one attorney represents a large percentage of originations, that may cause some concern. If that attorney leaves the firm, will the firm survive?
A lateral should inquire if the firm’s profit-sharing plan is funded on an annual basis. A few other questions to be asked:
- What obligations does the firm have to retired or terminated partners?
- Do any of the partners have individually guaranteed loans?
- How much is the firm’s line of credit? Has that line of credit ever been used for partner compensation?
In recent years, there have been law firms that filed bankruptcy due to these issues. These liabilities can have long term effects on the firm’s overall profitability.
A prudent potential lateral will examine the new firm’s financial documents and meet with firm leaders to gauge the firm’s overall health.
Comb Through Clients
A list of clients and the percentage of income derived from each client is telling, too. Asking for a list of the top clients is advisable since it’s important to ensure that there are no existing conflicts with clients that will be moving with the lateral. It is also prudent to ask for two annual reports on income per client. If one client represents more than 20 percent of the firm’s total revenue, this may indicate a problem for the firm should they leave. The more diverse the client mix is, the better. This report will also indicate if one client was significant in one year and not so much in another year. This should be taken into consideration when judging the diversity of the client mix.
Meet with Leadership (and ask the right questions)
Other than addressing financial issues, a potential lateral may want to consider other factors. For example, the lateral should meet with the Director of Technology. Before joining a firm, a candidate should know that the firm employs best practices in data security. Widely used software applications should all be current. The candidate should ask the IT Director what major initiatives the firm has taken in the recent past, as well as whether the firm has a disaster recovery plan and when was it last updated.
Next, the candidate should meet with the Executive Director of the firm and inquire into the following issues:
- What are the firm’s limits and deductibles on its professional liability insurance policy?
- Does the firm’s policy offer Prior Acts? It probably does not. If a lateral is leaving a firm that may be going out of business, that lateral must purchase tail insurance. Professional liability claims are on a “claims made” basis. If a previous client sues a firm that is no longer in existence, that client will sue lawyers individually.
- The number and severity of active claims against the firm.
- What was last year’s turnover rate for the associates and partners? If there is a lot of turnover (more than 20%), that is concerning. There are many factors that can be attributed to turnover.
In summary, there are a lot of issues that a potential lateral must consider. Making a move from one firm to another is a major career transition and due diligence is necessary. Attorneys contemplating a change should be sure that they do not leave one firm to join another with similar or other issues that would prevent them and their clients from thriving. In recent years, studies have indicated that almost 50% of lateral attorneys leave a firm within five years of joining it. Performing due diligence before making the move should help to ensure an appropriate fit.
Written by CARET Legal partner, Gail Ruopp. Gail Ruopp has acquired more than 25 years of professional experience in senior law firm management, initiating best practices in administrative operations, including: financials, accounting, lateral recruiting, personnel, day-to-day operations, systems management, and firm marketing.