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Becoming a Partner in a Law Firm: All About Finances

I was interviewed recently by LawFirmAmbition about the most common questions surrounding the topic of becoming a partner in a law firm. The questions below focus on the financial aspects of becoming a partner, including remuneration, risks and working out financial return. You can also read my answers to the first five questions here

6. What personal financial risks am I taking if I join the partnership?

The personal risks depend on the particular circumstances and the structure of the firm.

If joining a traditional partnership, the extreme position is that all of your personal assets may be at risk, including your family home. This could be the case if, for example, the partnership becomes insolvent as a result of poor performance or a negligence claim that exceeds the professional indemnity insurance cover.

If there are insufficient funds in the partnership to cover the liabilities, creditors could pursue the individual partners in a traditional unlimited liability partnership, typically on a joint and several basis. That means that a creditor could choose to pursue one partner rather than another on the basis that one partner may have more personal assets than another, even if the partnership agreement contains mutual indemnity clauses.

For a limited liability partnership or a limited company, the exposure levels are reduced, typically to the level of investment you have made in the business. This investment could be capital or current accounts, directors’ loan accounts or undrawn profits. Your personal assets should be protected, though there are clawback provisions which could reduce that personal protection – particularly if you have taken funds from the business whilst knowing it was in trading difficulty.

Even in a company or LLP, there could be personal liabilities if you sign up to a personal guarantee. Personal guarantees are sometimes required for bank overdrafts, loans, rent or professional indemnity insurance.

In addition to these financial risks, you may take on reputational risk. Should the firm cease practising, or a fellow partner or employee undertake activities that they should not, you may be tainted by association or potentially sanctioned for poor supervision.

There are also regulatory risks to consider. If a law firm becomes insolvent, it is possible under the code of conduct for the SRA to place restrictions on practising certificates. That could prevent future employment and more likely future law firm ownership possibilities.

7. How can I work out the likely financial returns of becoming a partner?

The offer letter should be reviewed. This often includes projections of likely personal profit share allocations and what that means for your drawings. The drawings are likely to be lower than the profit, as poor cash flow may mean that not all profits are distributed. Retentions are often made to cover tax payments and as a buffer against underperformance.

The projections in the offer letter should be reviewed for accuracy against the financial forecasts of the firm and past performance. This should then be compared to current net take home pay.

In the early days of partnership, many new partners do find that their net take home pay has reduced when compared to their previous positions. For many, this is a short-term investment that may result in far larger financial returns in the future.

8. How am I likely to be remunerated as a partner?

As a partner in a traditional partnership or a limited liability partnership, you are likely to either have a fixed profit share allocation or a percentage of the profits. Variations may include lock-step increases to the percentage of profits, or profit allocations based on individual or team performance.

Cash drawings will be paid on account of those profits as the year progresses. These drawings may be lower than the profit allocations, with periodic cash distributions to catch up, depending on the cash flow of the firm.

If the practice is a limited company, the idea of the profit share and drawings noted above still apply. However, the actual legal position may be a mix of salary, bonus, pension contributions, benefits in kind and dividends.

9. Will I be required to pay to acquire a share of the partnership?

This depends on the particular partnership.

In many law firms, in order to aid succession, partnerships do not charge new partners for ‘acquiring’ a share of the partnership so goodwill is not paid on entry. In those circumstances, it usually follows that goodwill is not paid on exit either.

This is not always the case, particularly in firms that operate effectively with a relatively low number of equity partners compared to the size and profitability of the practice. That smaller band of partners may indeed ask for a goodwill payment in order to join them (and it may then follow that goodwill would also be paid on exit).

10. How would I value my share in the partnership?

Obtaining professional advice is particularly important if you are asked to pay to acquire a share of the firm – as opposed to making a capital contribution that is classed as a loan to the partnership.

Valuing professional firms is often cited as an art rather than science. There are a number of specialists that have built up a great deal of experience in this art – through involvement in law firm transactions, valuing firms for tax purposes and acting as expert witnesses in law firm disputes.

If you have any unanswered questions about becoming a partner in a law firm, contact Andy

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