Planning a Merger? Avoid Pitfalls Through Proper Due Diligence

After reaching an all-time high in 2013, the pace of U.S. law firm mergers and acquisitions is showing no signs of slowing down.

Last year saw 88 mergers — the most since legal consulting firm Altman Weil started tracking M&A deals in 2007. And with 22 mergers in the first quarter of 2014, this year is already on track to match or even surpass that number. With all of these deals in the news of late, you may be considering whether a merger or acquisition might be an appropriate growth strategy for your firm. Does an accelerated alternative to slow, organic growth seem attractive to you? Not so fast. Before you can make an informed decision, you will need to weigh many factors and perform proper due diligence to determine if a particular deal is a strategic move for your law firm. You don’t want to just get bigger, you want to get better. A successful merger should improve the firm’s competitive position and add value for your clients — due diligence is key to that success.

Why consider a merger?

Though the majority of deals so far this year involved acquisitions of small law firms, there have been a few notable mergers of large firms. The biggest deal announced in the first quarter of 2014 was the combination of Pittsburgh-based Buchanan Ingersoll & Rooney and Tampa-based Fowler White Boggs. With 450 lawyers and 90 lawyers, respectively, the two firms have combined to form one of the 100 largest law firms in the U.S.

The merger expanded the combined firm’s geographical reach and strengthened its expertise in targeted practice areas, including health care, cybersecurity and government relations. Jack Barbour, Buchanan’s CEO, told Accounting and Financial Planning for Law Firm’s ALM sibling The Legal Intelligencer that Fowler White looks in Florida a lot like Buchanan Ingersoll does in Pennsylvania when it comes to the number of offices in their respective states, the practice focus and lobbying components. Barbour said he was initially looking at growing the firm’s presence mainly in Tampa through the acquisition of a smaller group. But when the possibility of the Fowler White merger came along, it “accomplished some goals very well and gave us other challenges,” Barbour said.

If you are considering a merger or acquisition, it’s important that you spend some time thinking about the reasons your firm might want to pursue such a deal and what the impact would be. What are your firm’s short-and long-term goals and objectives? And how will combining with another firm help you achieve those goals?

There are many reasons a law firm might consider an M&A deal, including:

• Adding new practice areas;
•  Deepening existing expertise, particularly in areas of specialization;
•  Expanding geographic reach into targeted markets;
• Increasing (or decreasing) client base; and
• Strengthening client relationships.

Assessing the merger (due diligence)

There are also many reasons these deals can fail — from leadership and management issues to loss of key clients. Performing proper due diligence is a critical part of the merger assessment process and can mean the difference between failure and success. The following are a few of the key areas you may want to include in the due diligence process and some questions to ask as you consider whether a particular merger or acquisition is a good move for your law firm.

Corporate culture and governance

One third to one half of all mergers fail to meet expectations due to cultural misalignment and personnel issues, according to John W. Olmstead, MBA, PhD, CMC, president of Olmstead & Associates, Legal Management Consultants. A poor cultural fit can be a huge challenge to overcome and may be a sign that a particular deal is not the best fit for your firm. In considering whether your corporate culture and governance aligns with another firm, you can ask questions such as:

How do our partner compensation systems compare in terms of measurement criteria and parity? What’s open, what’s closed and how is compensation decided?

What is expected of shareholders at each firm? How much emphasis and value is placed on traditional responsibilities (e.g., business origination, billable hours, collections, firm management) versus non-traditional responsibilities (e.g., mentoring and internal training, presenting external seminars and webinars, organization involvement, marketing efforts, strategic abilities)?

• How do our management structures and styles compare?
• Do the partners like each other? Are there any major personality conflicts between partners?
• Do both firms share the same work ethic and values?
• Do any of our practice philosophies differ?
• How do our client acceptance and retention policies compare?
• Do our missions and visions align?
• What are each firm’s policies on retirement, voluntary withdrawal and expulsion? How would we merge these policies?
• What would the new, combined firm name be?

Financial analysis

In order to understand what a potential deal is really worth and whether it makes sense economically, you need to consider several factors and take an in-depth look at both current and historical financial data for both firms. Instead of going it alone, you may want to involve a team of trusted advisers. For example, a tax specialist can help you with the possible tax implications of an M&A transaction, and an accountant can help you evaluate financial trends and identify potential issues.

Questions to ask may include:

• What is each firm’s current financial situation, including off balance sheet liabilities (e.g., deferred compensation arrange-ments, leasing and other contractual obligations) and current and deferred income tax liabilities?
• What are the average monthly billings and collections for each firm?
• How much are each firm’s current annual expenses, including payroll, overhead, etc.?
• What are the average billing rates for attorneys at different levels at each firm?
• What is each firm’s realization rate (ratio of collected to billed)?
• What is each firm’s current work in process and accounts receivable balance in relation to its billings? How efficient is each firm at billing and collecting?
• What is the breakdown of each firm’s client base stratified by size, types of matters, geography, industry and service line?
• What is the potential financial impact of both unasserted and ongoing claims against either firm?
• Are there any significant client conflicts that could potentially arise from the merger?
• Do both firms set productivity goals (i.e., targeted billable hours)? If so, are the targets comparable?
• Who are the top rainmakers at each firm? How much revenue do they each generate? Are they all expected to stay on after the merger? How close to retirement are the most important partners?

Keep in mind that the metrics mentioned above represent only some of the information that you should gather and assess in the financial due diligence process. This list can help you get started, but there may be other data that you will want to review before agreeing to a deal. Also, just as important as gathering the information, is verifying the data you are collecting. Don’t rely solely on verbal conversations when you are dealing with key metrics; request the documentation.

Consolidation of resources and operations

Mergers often come with an overlap of resources, particularly when it comes to administrative staffing; and integrating IT systems can be a whole other challenge. In addition to assessing the number of lawyers and their skill levels and specializations, you will want to take stock of each firm’s administrative staffing levels and anticipated post-merger staffing needs in areas such as re-ception, bookkeeping/internal accounting, billing and collections, office services and legal research. It is important to understand each firm’s attorney-to-support-personnel ratio.

You should also plan for the ways in which a merger would change your facility needs. Consider any existing lease obligations as well as post-merger office space requirements and assignments.

In addition, you may want to inventory all hardware and software for each firm and ask the following questions to assess what would be involved in merging your IT resources:

• What IT systems and tools (e.g., Microsoft Office, case and practice management software) do we use for each of our business functions? Are there any redundancies with the other firm’s systems?
• How difficult or easy would it be to integrate our IT systems with theirs? How will we assess which systems we would use going forward to best suit the new, post-merger business model?
• Do both firms agree on insourcing or outsourcing IT functions?
• What does each firm’s current IT staffing look like?
• What are each firm’s policies on document management and retention?
• Do both firms have a proper data backup system? What are the paper and paperless procedures and policies at each firm? Does either firm use a cloud service provider?
• Are there any existing service contracts (e.g., phone lines and systems, hardware leases, internet service), and if so, what are the termination options?
• What about internal communications and tools? What collaboration and project management tools does each firm use? Does either firm have an intranet that employees rely on? How will these tools be integrated?

Managing the transaction and the transition

Now that you have a better idea of what is involved in conducting due diligence for an M&A transaction, you might be wondering where to start. Once you’ve determined a merger or acquisition is a growth strategy your firm would like to pursue, you’ve agreed on your goals for the transaction, and you have identified a firm that you are interested in negotiating with, there are a few next steps to take.

At the beginning of the process, you should consider forming a merger planning committee. This committee, composed of several partners from each law firm, can spearhead the negotiations and due diligence process. The committee’s functions may include gathering and reviewing relevant data from each firm, discussing and prioritizing issues, and communicating regular status updates to the partners. This is especially valuable at a large firm where it may be impractical to include all partners at the negotiat-ing table.

Next, make sure you understand who does the work and where. Clients want continuity in service. They have developed a relationship with the attorneys and staff who manage their engagement and they don’t want to have to train new people on their business priorities and operations. They have also built trust in their attorney and the firm’s ability to handle their legal needs. A successor firm can help to minimize disruption for clients by knowing who serves which clients and where. If changes need to be made to the manner in which a client is serviced, they should be made gradually with an eye on client retention.

Once the transaction has been finalized, you will need to announce the deal and manage the transition. How and when you make the announcement to employees, clients and the general public is an important consideration. Don’t let your employees — or clients — hear about the deal through the rumor mill.

Being open to change and managing change with employees, partners and clients will help make the transition smoother for all parties involved. Employees worry about their jobs, pay and benefits, as well as, changes in reporting relationships, responsibilities and policies. Maintaining good communication with staff throughout the transaction can alleviate their fears and provide some degree of transparency. Communicate the benefits of the merger so everyone can see the positive effects of the change. Share some information to help your employees “get to know the other firm.”

Above all, remember that there are many factors that you need to consider before finalizing a merger or acquisition with another firm. Performing comprehensive due diligence is a critical step in determining if a particular deal is a strategic move for your law firm. Mergers can be costly, disruptive and risky; but they can also improve your firm’s competitive position, accelerate growth and add value for your clients. A successful merger aimed at effective, strategic growth can help your firm achieve better economic performance, and due diligence is key to that success.

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Marc Feigelson, CPA, is an assurance and advisory services principal and real estate industry practice leader in Kaufman Rossin’s Miami office. Marc can be reached at mfeigelson@kaufmanrossin.com.

Steven A. Davis, CPA, is an entrepreneurial services principal in Kaufman Rossin’s Miami office. Steve can be reached at sdavis@kaufmanrossin.com.