Law Firm Finance for Dummies

Episode Notes

Transcript

Conrad Saam (00:00)

Welcome

 

to Lunch Hour Legal Marketing. This is Conrad Saam I am running solo because Gyi is not here. I guess that is a strange tautology. Anyway, we have an amazing episode for you today. This is all about money and marketing. ⁓ and so I have sat down with two amazing guests, Leah Miller from Firmly Profits and Josh Porte Is it Porte or Porte? I’m gonna go with Porte from Holland Knight

 

⁓ and so we have had a conversations mostly around finance and growth and marketing. ⁓ Leah Miller, ⁓ we had a great conversation about kind of this two different law firm reality. One is the bumping along, struggling at about, you know, a ten may a a negative five to ten percent growth rate. and w with with the the the owner really serving as every function.

 

And then on the other end of that spectrum was the well-run, ⁓ heavily marketed aggressive growth law firm that had achieved operational efficiencies, et cetera. Leah actually believes, and I think this is interesting because we’ve talked about the puberty of businesses, that a lot of people get stuck and can’t make that cross, can’t go from one to the other. ⁓ so we’re gonna talk about that. We’re gonna talk about offshoring and staffing and labor cost changes. and then

 

We have an amazing interview with Josh Porte from Holland and Knight We actually recorded this back at Tim McKey’s seat at the table event around ⁓ MSOs. ⁓ and so we talked about a plain English breakdown of of of of what the MSO means, why rule five point four is the guardrail around how this is built out, how money flows in and out of law firms with an MSO. And and I think this is a really important thing.

 

How you should be thinking about running your law firm before you even think about acquisitions or MSOs, et cetera. There’s a man named David C. Baker who Gyi and I have both followed. I’ve been following his his advice for over a decade, and he works on buying and selling agencies. And I do this, and so and as does Gyi. We run David C. Baker metrics every single month at my firm. And I have done so again for more than a decade. ⁓ but this concept of

 

Using the guidelines of how people who buy and sell these businesses ⁓ as a direction for running a well-run law firm, right? Even if you have no intention of selling, which is a case for most both Gyi and my I shouldn’t speak for Gyi but certainly for myself. I’m running my business as if it is being positioned to sell all the time because a well-run business will have solid financials. And we’re gonna get into that with Joshua Porte

 

Conrad Saam (03:23)

All right, everyone, welcome to Lunch Hour Legal Marketing. We are here with Leah Miller, fractional CFO, Firmly Profits. We’re gonna ask a couple questions around the marketing side, the intersection of marketing and finance, starting with the most common question that we have. How much of my budget should I put towards marketing? And how do you help firms ascertain that?

 

Leah Miller (03:44)

Normally I say at least ten percent of revenue, up to fifteen, twenty percent. I have some PI firms doing twenty-five percent. ⁓ if you’re doing under ten percent, I try to get up to that. ⁓ but the caveat is we need to know what is working on marketing or what to actually spend the money on and make sure that our intake is fixed before we start increasing that.

 

Gyi Tsakalakis (04:12)

So we talk about this ⁓ marketing ⁓ budget as a function of revenue like all the time. And it’s funny because I would say in my experience, most firms we talk to are way under capitalized in marketing. ⁓ so first would you say is that similar to your experience?

 

Leah Miller (04:31)

Yes. Most of the time when I start working with them it’s way under.

 

Gyi Tsakalakis (04:34)

Okay.

 

And I would say that I Conrad and I were talking about this and I think it’s fair to say we were like in the ten to twenty percent range for firms at a variety of different growth stages.

 

But I gotta tell you, today I heard something that really took me aback. Yeah. And that is that there’s a very large firm on the East Coast that’s spending fifty-five percent of revenue on marketing. So and I’m not saying that’s a good thing or a bad thing, but when you’re looking when you’re you come in with a CFO hat on, what kind of signals might that be sending?

 

to you or we what would you be looking for to see if like is that fifty five percent a good investment and and and doesn’t that make everything else operationally at the firm like really thin?

 

Leah Miller (05:25)

What the fifty five percent would eat into probably is the profit going back to the firm owners. So if they want to grow this and there’s all the talk around, you know, selling firms and this and that and like things are changing, if their goal is to grow it very quickly, I’m assuming at fifty five percent, I’ve not seen any that high yet, that I’ve worked with, they are intentionally taking less money in their pocket to put into the marketing, and if that’s okay, if they don’t need to live

 

this you know increased lifestyle or depending on how big the firm is once you hit a certain number like you have enough personally you can put it back in. So I don’t think that’s a bad thing. ⁓ and there’s a lot of other factors that go into the operation side of what does your team look like. A lot of people are leveraging you know overseas ⁓ team members at a lower cost or they’re leveraging AI so like their wage costs are coming down. So there is

 

money being freed up for marketing.

 

Conrad Saam (06:27)

Let me ask this question. So you talked about making sure that it’s working. What are your you’re you’re the CFO brain. What do you want to see numbers wise, dashboards wise, KPIs, whatever you want to talk about? Are you looking at ROAS? Are you looking at ROI? What what are the numbers that you think about when you’re assessing how firms are doing with the market?

 

Leah Miller (06:43)

A lot of what we’re looking at is just simple like how many leads are coming in, and then also how many cases we’re signing. ⁓ other things I’m looking at is cost per case, obviously. and we want to see the trend of that over time. Because if you look at just the month, like it may not make that much sense. So we want to look at the trend of the cost. ⁓ obviously if the cost is a little higher, but we’re bringing in higher valued cases, then it’s okay. ⁓ so that’s the next part, and that’s something I’ve really been focusing on recently, is what are the value of the cases we’re bringing.

 

So you know, there’s some firms I work with and they’re like, hey, our intake has increased double, it’s doubled since last year. I’m like, okay, but what is your average case value? And obviously we can’t see that for twelve to eighteen months, like if there’s a you know lagging time there. But if our case value is going down and our intake is going up, like to me that is not

 

the direction we want to go and so there’s something with the marketing and I fully believe that you can target better valued cases in some ways. I don’t know how, but I I just believe that there’s ways.

 

Gyi Tsakalakis (07:46)

One

 

of the things I think is super valuable knowledge that you have that even if you have so first let’s start here. Out of a which make numbers up as anecdotes, in your experience, out of a hundred law firms, what percent have any kind of finance function at all? Whether it’s a full time CFO or they’re even like thinking CFO-ey things.

 

Conrad Saam (08:07)

You mean finance beyond Excel?

 

Leah Miller (08:10)

Well,

 

you know, most people have like QuickBooks and stuff, but ⁓ an actual functioning finance department, very, very low percentage.

 

Gyi Tsakalakis (08:19)

Okay. And

 

then of those that do, you know, there probably have s there’s people that they have CFOs, they’re thinking about it. But the my the thing that I think is so interesting that I’m so curious to hear your thoughts on is you work with many different law firms. So you’ve got this like benchmark data. What are some of the things what are some of the benchmarks that like you look for where you’re like this is a potentially a problem or this is healthy? Like is there is there a are

 

there financial vitals that you look at at firms?

 

Leah Miller (08:53)

Yeah. So ⁓ the biggest thing I break everything into three categories. We look at our wage expense, our operating expenses, and then our revenue driving expenses, marketing expenses. ⁓ there’s the big debate, do you include marketing staff and the marketing expense and all of that? I like including it. I think it’s an all in type of thing. I will do it both ways depending on like I just want to acknowledge. I want everybody to understand

 

Gyi Tsakalakis (09:08)

What do you think about that?

 

Leah Miller (09:23)

where that person is falling into these percentages. ⁓ so, you know, as far as benchmarks to talk marketing ten, fifteen, twenty percent, ⁓ up to twenty five percent.

 

wage expense twenty five to thirty five percent, operating expenses ten to fifteen percent. I’m seeing it below ten percent for some who are more hybrid and not paying, you know, huge rent costs and stuff. ⁓ and then I’ve got firms getting up to thirty, thirty-five percent in profit. So those are some of the benchmarks.

 

you know cost per case I’m seeing that everywhere from fifteen hundred per case to three thousand per case. ⁓ it really depends on the markets and stuff like that. And so obviously I don’t know all the details of that, but I just want to track the trend of that and make sure we have that data.

 

Conrad Saam (10:10)

Alright, you mentioned QuickBooks. On a scale of one to ten, how much do you hate QuickBooks?

 

Leah Miller (10:17)

Ten being the worst? Yes. Ten. Yes. Because they just changed it too. Again. And then they’re actually changing it for accountants as well. But it’s the best product out.

 

Conrad Saam (10:30)

Okay, that was my next question. ⁓ thi QuickBooks to me is like having a rash that will not go away. But there’s no alternative. There’s no good

 

Leah Miller (10:37)

Right. No and

 

no, and there’s a lot of case management systems that are now starting their own accounting platforms, which I get. I normally push people away from that only because if you decide to change case management systems down the s road

 

You then have to move all of your accounting data. And your accounting data really should be separate from your case data because it’s two separate things. It’s your business and it’s your clients. So I do set everybody up on QuickBooks. There are alternatives. They’re all equally terrible. ⁓ It’s just, you know, kind of what we have to deal with.

 

Gyi Tsakalakis (11:13)

This might be a question you’re saying, I don’t know, we don’t have that much granularity into it. But you have a sense of what the split is in marketing investment between brand investments and non brand investments?

 

Leah Miller (11:25)

I don’t get that granular. So I do I look big picture, like hey, I want you to spend this much money. I don’t know how. And I can tell when it’s not working because intakes down things like all those metrics we talked about are down. But that’s where I’m like, you go to people that know what they’re doing. ⁓ I will say talking to clients about what they’re doing, it is so regionally dependent. So some clients are doing LSAs, they’re working. Some are just doing SEOs, it it’s working, some are doing

 

this it like it’s so different for every firm on what’s working for them and that’s where I think you just have to continue to evolve in question and the marketing world is changing rapidly. Like I can’t keep up with it.

 

Conrad Saam (12:08)

Let me ask a different kind of growth question. I’ve had this question from a couple clients. Should I borrow a bunch of money to grow by acquisition? How would you help someone think through the elements to consider when thinking about borrowing for acquisition for growth?

 

Leah Miller (12:26)

I think that it goes back to what is your ultimate like personal goal for you in the firm. and then we can map it out and just see what the cost benefits are and what your time is gonna take and things like that. I’m not against it. I’m not against borrowing money for anything. It’s just being super intentional and making sure it aligns with where you want to go with your firm and it’s not just the current shiny thing that everybody’s doing.

 

Gyi Tsakalakis (12:53)

So let’s assume a firm is investing 10 to 20% and r or some healthy percent. What do you look for as a healthy output from that? Like what sh how should they be growing year over year or different time frames? Or or do you even think about it that way? Like I you know, so we’re we’re always saying like, okay, we’re gonna put 10 to 15%, 10 to 20% in. What should come out of that?

 

Leah Miller (13:20)

obviously ⁓ increased number of cases. Like so that’s one. Like what does intake look like? Is that increasing? what I always tell people for sustained growth and what we look for is we need to be bringing in more cases than we’re settling. So, you know, if we’re settling this many cases you know, we’re settling ten cases a month.

 

To grow next year we need to be settling fifteen cases a month. So we need to be bringing in fifteen cases this year. And so it’s like that stepping stone there ⁓ is part of what we look for for growth and obvious because the ultimate goal is to increase revenue and then keep those percentages the same, which then increases profit, right? So it’s like a kind of a stepping stone that we look at there.

 

Gyi Tsakalakis (14:04)

I was curious if there’s like a bench I was curious if there was like a benchmark or range of expected growth based on the ten to twenty percent investment. Like does that correlate to ten to twenty percent top line growth or

 

Leah Miller (14:19)

I have not run that data. I don’t have that answer.

 

Conrad Saam (14:22)

So

 

in in in the world that the like the tech growth world there’s often this multiple under the rule of forty where it’s like you should be by looking at your profitability and your growth, you should be over forty. A really healthy company is over forty. I don’t know if that that translates into the

 

Leah Miller (14:39)

I don’t know, it’s so it’s so up and down also. And it’s like I have firms that are doing very similar things and like it’s just everything’s clicking and working for one in this part of the country and then like it’s just not over here and so it’s so like it’s so different for every firm.

 

Gyi Tsakalakis (14:58)

No, that’s

 

totally fair. One more thing that keeps coming up in a lot of the context that we talk about and there’s a lot of talk about you mentioned it yourself, is service delivery with technology and the I you know the the promise of AI is is that you’re gonna drive the costs down, you’re gonna be able to do wage replacements, so you should do you have you seen that impacting the benchmark on labor costs and is that are you changing your number or what do you think about that?

 

Leah Miller (15:27)

For people who are leveraging that, I am seeing it. It’s coming down. ⁓ and that’s how we’re increasing profit to thirty, thirty-five percent profit. if it makes sense, we can then invest that profit back into marketing, like the firm that’s doing fifty percent. So that’s when, you know, we hit a certain profit and like number and the firm owner is getting what they need out of the business, then we can start having the fun conversations of like how do we invest back into it and all of that.

 

Conrad Saam (15:55)

One of things that makes doing kind of modeling from a financial perspective really difficult for law firms is those big outlier cases, right? you know, most of our cases we make 30 grand and every now and then you get the you know eight hundred thousand dollar. How do you take that into account when you’re thinking about modeling financials?

 

Leah Miller (16:15)

So I always start with what do we need to make every month and like that’s the goal of like we want to break even and do like hit the profit we want to hit and we don’t take into account those cases necessarily. So then when we hit on those cases, we get if we’ve been

 

in the black every month and we’re covering our expenses and doing all the things we need to do when we hit that eight hundred thousand dollar case instead of catching up on all the bills we can then say okay does the owner get a you know chunk of money do we have a cool marketing campaign we want to do in addition to what we’re already spending so like we get to have those conversations if and that’s what’s so cool about keeping the finances going like we are so then you can spend that money in a different way.

 

Conrad Saam (16:58)

So you heard it here first, everyone. Take all of that money and send it to your marketing agency.

 

Leah Miller (17:04)

Yeah.

 

Gyi Tsakalakis (17:06)

Speaking of spending money, you know, we we we asked this question of some of the fractional CMOs, and we’ll ask it of you as well. And you know, maybe you might consider this self-serving and a softball, but what should law firms look for in a fractional CFO? Like what are the when you’re out in the marketplace and you’re like, these are red flags, these are good indicators that the CFO knows what they’re talking about, what should folks be looking for?

 

Leah Miller (17:31)

One, you want somebody that’s familiar with law firms because it is such a different industry, especially personal injury law firms. ⁓ and I’m definitely like that’s my my niche is personal injury. ⁓ and then also you don’t want somebody that’s going to put you into a box. So we’re talking benchmarks. I can give you benchmarks all day long, but when I’m talking to a firm that, you know, does things a certain way and they’re not gonna hit those benchmarks, we’re not gonna push to hit those benchmarks if it’s not working for the firm.

 

And so you don’t want your fractional CFO to say, you’re in this box that all my clients go into. You want somebody that’s going to collaborate with you and you want them to educate you so that you understand why they’re telling you what they’re telling you to do. And that’s how I work with clients is like, let’s collaborate. I want you to understand the financials. You don’t have to do it, but understand it so you know why I’m telling you the things I’m telling you.

 

Conrad Saam (18:25)

And that was the fabulous Leah Miller. Thank you. Thank you so much for joining us. How can people get a hold of you?

 

Gyi Tsakalakis (18:30)

people get a hold of you.

 

Leah Miller (18:34)

I

 

am on LinkedIn. I post almost every day. I try to give tactical advice, things that you can do, or you can go to my website, firmlyprofits.com and book a consultation and we can talk about how we can help you.

 

Gyi Tsakalakis (18:45)

Is that actually you on LinkedIn or is it an AI or a ghostwriter? Okay. It’s actually Leah, so you know you can engage with Leah. Thanks, Leah.

 

Conrad Saam (18:48)

It’s AI Leo.

 

Leah Miller (18:56)

Thank you.

 

Conrad (19:00)

This is Josh from Holland & Knight out of Nashville. And we may have just been able to get him to agree to join us at the summit and do a five minute Ignite Talk on, ultimately, the ethical side of these MSO deals. Can you give us a quick primer, as if I was British, a quick prima on the ethical side of these deals?

 

Josh Porte (19:23)

I can, nice to be with you guys today. ⁓ The key rule that we have to operate under is rule 5.4.

 

This has two components that we need to be mindful of. The first is the prohibition on non-lawyer ownership or control of law firms. And the second is the prohibition on splitting of fees between attorneys and non-attorneys. So when you structure a transaction involving an MSO, which is where private equity fund comes in, right, they form an MSO, it’s going to acquire the non-legal assets of the targets, which we mean kind of almost everything except for those handful of assets that need to remain

 

owned by the law firm, which is attorney workforce.

 

client engagement letters, client funds, files, records, trust accounts and the like. Everything else gets owned by the MSO, which can be sold to an investor. It enters into a long-term management services agreement with the law firm at the closing. And you have a two-company structure where the investors can control the MSO, the law firm remains owned by the lawyers, and there needs to be a clean line of delineation between the two. So you should not see the investors telling the lawyers what cases they can or cannot

 

accept, how to litigate or handle a particular matter, hiring or firing of attorney workforce, all of those are exercises of legal judgment that need to be handled on the law firm side, whereas the investors can handle the non-legal aspects of the business, right? Non-attorney workforce, facilities. ⁓

 

Marketing, HR, finance, IT, right? All of that is the portfolio of the MSO to take off of the law firm’s plate, thesis being that if the law firms are able to focus more completely on the practice of law, energized and more capitalized with the resources of the fund and the MSO behind them, that they can take the firm to the next level.

 

Gyi (21:12)

And talk to us a little bit about your role in some of these deals. Where do you sit in all this?

 

Josh Porte (21:17)

Yeah, so I co-lead Holland and Knight’s legal services transactions team. I am a corporate and M&A lawyer by background, and I co-lead the team with my colleague Trish Rich, who is a legal ethicist. We work together very closely to structure and execute on these deals. ⁓ And so I represent either buyers or sellers in these transactions. we are involved in all aspects of the deal, from negotiating the letter of intent to helping to design the tax ⁓ structure of the transaction to negotiating the definitive agreements

 

to everything else that’s involved, and we’re working with the legal ethics team in tandem to make sure that at the end of the day, the transaction documents comply with applicable rules of professional conduct.

 

Conrad (21:58)

Okay, so you see both sides of these transactions. What makes for a great transaction? Like, this is gonna be positive for everyone involved, we’re setting this up the right way, what does that look like?

 

Josh Porte (22:00)

We do.

 

Yeah,

 

it’s gonna start with honesty and alignment between buyers and sellers from day one, right, of when they meet each other and start those ⁓ discussions even prior to the letter of intent. The seller has gotta know why they wanna do a deal, right? What is their motivation? ⁓ And they’ve gotta be candid with the buyer about that. If the seller really is looking to, ⁓ you know, retire in the near term, that can be fine, but.

 

In that case, they need to be honest with the buyer and they need to be able to demonstrate to the buyer that there is a succession plan in place to transfer the business to the next generation of leadership and ownership. There’s risk associated with ⁓ that. And if the systems are dependent on that founder, then the buyer is going to be taking on it. So you need to have good alignment from the seller should also be asking the buyer about their approach to these transactions generally.

 

that they’re not going to come in and violate rule 5.4 by telling the lawyers how to practice, right? Ask those questions, have those conversations on the front end to align expectations and make sure that there’s a good cultural and personality fit as well as a business plan fit between both sides of the deal.

 

Gyi (23:24)

These are the hard, the hard for me, and I think the hard for a lot of our listeners where we get into like the ethics things. Everybody’s very apprehensive about this. You know, some things are obvious in practice of law. I think you named a couple of those things, you know. And let’s face it, like the money people in the MSOs, like they don’t want to get into the practice of law. They don’t want anything to do with it. However, there’s some stuff where it does seem a little bit murkier, right? And you know, we’re…

 

We both own marketing agencies. We get that you can outsource marketing. You can outsource HR. ⁓ Intake and that kind of stuff. But there’s some things where you think about the ⁓ prospective client calling the firm. They call the firm. talk about their… Imagine Intake sits in the MSO. ⁓ They’re starting to have conversations. And imagine the MSO with the ⁓ guidance of the law firm.

 

is like, are the types of potential clients, qualified clients that we’re looking for. ⁓ But isn’t the decision even to take the case on? Doesn’t that kind of overlap with practice of law? Or how do you separate?

 

Josh Porte (24:23)

it does,

 

yeah. And so there is a rule of professional conduct 5.3, which is one that doesn’t give very much play out there, but it’s actually fundamental to the structure. I learned early on when working on these deals that every legal ethicist has a favorite rule of professional conduct. Trish’s is 1.6 and I have adopted 5.3 as mine. So what it says is that ⁓ a law firm is permitted to outsource non-legal business services to third parties.

 

provided that they’re not fee sharing, and provided that the third party service provider is acting under the direction and the purview of the lawyer and its law firms, and the ethical duties of the lawyers are imputed to that third party service provider. Right, so.

 

Payments gotta be fair market value for services rendered, cannot be a fee split, and it’s gotta be kind of ethically compliant in its structure. That is the foundation for the MSO model, right? That is the model. So when you think about something like intake, those intake personnel, are working under the auspices of, and at the direction under the purview of the lawyers in the law firms. So for sure, I would not want to see the MSO making unilateral decisions about

 

which clients to accept or not accept. Rather, it’s their duty to kind of pass on the leads and the lawyers will determine whether it makes sense to engage.

 

Gyi (25:50)

And this is the second part of your favorite rule, which is the fee sharing. again, I’m not this new-ish for us. Most of the outsourced services that we see, some of them are hourly, some of them might be flat fee retainer, but none of them are tied to profitability of the law firm. They’re not pegs.

 

to case results in any way. Talk to us about how these deals are structured from how the money flows from the law firm to the MS.

 

Josh Porte (26:20)

Yeah, this is one of the most important questions. It’s generally the first question I get when I hop on the line with investors who are looking at this investment thesis.

 

The answer is that ⁓ the economics are going to flow through this management services agreement, which is entered into at the closing and connects the MSO with the law firm. It provides that the MSO is going to provide this ⁓ laundry list of administrative services to the law firm in exchange for payment of a monthly service fee. ⁓ Again, the MSO might also ⁓ own the intellectual property and the branding, even up to and including the name, image, and likeness rights associated with the founders, and then license those

 

IP assets back to the law firm by operation of these management agreements. however structured, you really have two choices when it comes to the fee that is going to be paid by the law firm. You can do a fixed monthly fee, or you can do a cost plus fee. What you cannot do, what violates law, is a fee that is a percentage of law firm profits or revenues that is going to directly violate 5.4.

 

Conrad (27:26)

percentages of law from revenue or

 

Josh Porte (27:29)

Correct. Yep,

 

so those are off limits. Instead, you’re looking at a fixed monthly fee or a cost plus fee. And we add a further gloss on this, which there’s a Texas ethics opinion from last year that gets into this in some detail. ⁓ The overall fees, the aggregate fees, however structured and payable by the law firm, need to be commensurate with fair market value.

 

Gyi (27:52)

Okay.

 

Conrad (27:53)

I was exactly

 

my next question.

 

Gyi (27:56)

So I’m using AI software, one of these law practice AI softwares. Is that license living in the MSO, or is it living in the law?

 

Josh Porte (28:07)

We’ll generally want to put as many of the assets into the MSO as possible. ⁓ The theory being that the more value and the more assets we can concentrate at the MSO, the more we can substantiate a higher service fee to extract as much value as possible. So the general rule of thumb is if it can be in the MSO, we generally want it to be there. We acknowledge that, take a software license agreement for like Harvey or something like that. ⁓ It might be difficult to interface with a third party vendor to get that assigned over

 

or have the right to then sub-license that software to the law firm itself. So we’re practical about it. But yeah, as a general matter, you’d like to see anything that can be over there, would be over there.

 

Gyi (28:48)

And maybe

 

I’m getting this wrong, it’s naive about this stuff. But if the software, some of that software seems very close to law practice, right? Like some of it’s writing demand letters, of it’s doing that kind of stuff. you’re able to navigate that because it’s still got the lawyers got ultimate say over time.

 

Josh Porte (29:09)

Yes,

 

exactly right. the view of the ethics bar on this is that AI cannot practice law. It’s not a person, right? And only people can practice law. But yes, any work product that’s actually kind of being delivered to a client, you would want to make very sure that it is reviewed and approved by a lawyer.

 

Gyi (29:33)

That would be true of any kind pleading.

 

Josh Porte (29:38)

Correct. Yep.

 

Gyi (29:41)

Very interesting. ⁓ I think the other thing, do have another?

 

Conrad (29:44)

I was going to shift a little, maybe given your experience. We’ve asked a couple people this question. sorry. ⁓ no, we’re good. Growth through acquisition. Like outside of the whole MSO conversation, which we’ve been really focused on here, but ⁓ law firms thinking about growth through acquisition. What’s a great opportunity for that? And where is it like the red flags, this is something you should stay away from?

 

Josh Porte (30:12)

So.

 

The buy and build model is what is being pursued by private equity in this market at the moment. The playbook is first, private equity wants the fund, wants to identify some sort of what we call a platform, something with a little bit of size and scale and heft to it. ⁓ And then ⁓ that’s the first transaction. Once that platform is in place, they now have the operations, the systems, the people to begin ⁓ making add-on acquisitions. ⁓

 

So, yeah, for those types of targets, ⁓ you know, you’ll want to ideally have a firm that has done its kind of pre-sale prep work. This can be quite important to enhancing the likelihood of a successful transaction. ⁓

 

getting your own financial house in order is probably the single most important thing that a founder can do in order to facilitate a successful deal. ⁓ That means ⁓ actually spending time and money on advisors on their side pre-closing to ⁓ evaluate their last, call it three years of financial statements, make sure that ⁓ they can prove out and substantiate the information and the data contained in those financials, ⁓ some sort of pre-transaction

 

Legal diligence can also be advisable, like have ⁓ your counsel come in there and just look under the hood, if you will, make sure that ⁓ from an ethics standpoint, are your engagement letters properly drafted, are there any disclosures that you should have been making but haven’t been to your clients? Or ⁓ what is the, like understanding if there are issues, right, there’s some malpractice case that’s been asserted against the firm, or there’s other risk factors out there, at least identifying what those are and getting out ahead of

 

that can be helpful. There might also be instances where you think you’re complying with the law and you’re just not, like any business in the US, right? And so the better you can identify potential deficiencies and mitigate those pre-sale process, the better the likelihood that you’ll have either an increased valuation because you have a clean business or at the very least, more successful outcome for your transaction.

 

Gyi (32:29)

And then I’m really interested in like kind of the nuts and bolts and the weeds of this stuff. the Is that what is there an operating agreement at the MSO or?

 

Josh Porte (32:39)

Yes, there will be. when these deals are structured, one unique aspect of this industry that’s driven by our rules is that lawyers generally cannot be bound by non-competes, even in the context of a sale of a business, which is quite unique.

 

in scary frankly for ⁓ for private equity investors it’s one reason why you saw health care and accounting and other professional services verticals engineering you know this experience private equity investment long before legal services because it’s just more difficult to get comfortable in structure a deal in this in this sector ⁓ so one way that to to mitigate that lack of non-compete risk from the funds perspective

 

is to ensure that the sellers take some of their purchase price in the form of what we call rollover equity. This is basically continued skin in the game. Just by way of example, let’s say you’ve got a target law firm. It’s got an enterprise value of a million dollars. Maybe 70 % of that would be paid in cash at closing, and the remaining 30 % would be paid in equity in the buyer entity itself, right? So this is just like, you know, if the buyer were Apple Corp, it would be paying you in shares of Apple stock. And you’d have to put a price on that,

 

to get 300,000 bucks worth of buyer MSO stock. ⁓ You as a seller should expect to be bound by the terms and conditions of the governing documents of the MSO. It’s gonna have its own governance, probably a board. It will have typically repurchase triggers tied to your equity. So if you engage in misconduct, then they might be able to yank back your equity. ⁓ It might have other restrictive covenants, not a non-

 

compete, but other types of restrictive covenants that you would least want to be aware of. So it’s important from the seller’s perspective to do what’s called reverse diligence and actually request information about the buyer entity, right? Because you want to know, I would like to see buyer your financial statements so I can understand are you appropriately pricing your, you know, stock that I’m receiving as part of my purchase price? ⁓ Or what, send me copies of your governing documents so I can understand from a legal standpoint what I’m going to be asked to sign up for.

 

Gyi (34:50)

And I imagine this varies from deal to deal, in your sense, do a lot of the lawyers end up sitting on board positions at the MSO or do they kind of stay out of the MSO from a more leadership standpoint?

 

Josh Porte (35:02)

⁓ It will depend on transaction size and the kind of…

 

role, the go-forward role that’s envisioned for the founder there. So this would be an example of an important conversation that seller and buyer should have as they are getting into the transaction process, like at the LOI stage. Seller should be asking, what is my continued role in the business? Or if a buyer has identified a lawyer who says, that person’s a leader. I want them to be involved at the highest echelons of our organization to help us look at the strategic map of the US and help us figure out how to build this thing together, because I value

 

their perspective based on their experience. And that kind of alignment is very important. But yeah, and then for a small add-on deal, once the platform is established, then I probably wouldn’t have those expectations for a seller in that situation. It could be, sure, but it would be unusual.

 

Gyi (35:58)

The other

 

question I’m so interested about is the managed services agreement between the firm and the MSO. What kind of, and it obviously negotiated and varies all over the map, but what kind of length of terms do you have? Because I imagine the MSO wants to lock in the law firm to this deal for a long period of time.

 

Josh Porte (36:15)

Yeah, functionally speaking, so ⁓ it’s often gonna be 20, 25 years. I had a client ask me if we could do 100 years. We actually looked at some Delaware law. We were not able to find an outer bound, but I said, at a certain point, the court’s probably gonna say that’s not enforceable. But functionally speaking, once a law firm enters into that management agreement, it’s probably never gonna get out of it, right? Because think about, at the time,

 

know, the platform changes hands and private equity funds number one sells to private equity funds number two. Well, private equity fund number two is gonna look at all of the MSO documents and say, okay, we’re six years into a 20 year term. As a condition to closing, I would like to refresh this please. So I’ve got a fresh 20 year clock. And so that is how it has happened in healthcare and it is what will happen here.

 

Gyi (37:05)

are largely aligned

 

right. lot of firm people they want to stick with the MSO

 

Josh Porte (37:10)

whole thesis of

 

this ⁓ model is around creation of equity value in the MSO. This is a concept that is foreign to a lot of lawyers because law firm equity is not real equity in very meaningful ways. Every year, law firms are liquidating almost in their entirety. They’re making distributions of all available profits to the shareholders based on their performance in the past year or two.

 

that is an inefficient way to run a business. If you want to actually grow a business, then you need to be reinvesting, and then with a view towards selling the business. That over time, again, it’s not my job, it’s the burden of the private equity funds to have these conversations with lawyers, show them the spreadsheet math. If you were to continue taking your distributions for the rest of your career, it looks like this. If you were to join us and then have some MSO equity and have a successful exit, it looks like that.

 

That’s a hearts and minds campaign, right? But yeah, think that from an empirical standpoint, that’s going to create a better outcome. And so there should be alignment

 

Conrad (38:13)

Imagine that value is

 

created through for early players in that deal, just through the nature of the increased scale, right? My early equity is worth a more.

 

Josh Porte (38:21)

Yeah.

 

It should be compared.

 

Conrad (38:27)

to

 

the 30th firm that we’ve acquired. So how much of that for the early players is it tied up in that value creation, versus we’re now running a much more efficient organization. there’s efficiencies of that scale, but it is not necessarily based on when I participate.

 

Josh Porte (38:45)

Yeah, so these transactions are typically priced as a multiple of EBITDA. Like that’s how you see transactions priced on just the normal M&A markets and that’s what you see here too. EBITDA for the listeners is really, just think about it as like the earnings of your firm. Exactly, yeah, in law firms. In the law firm space in particular, EBITDA is usually very, very close to actual like net income as reported on the tax return.

 

Gyi (39:02)

Usually what they’re taking home.

 

Conrad (39:06)

Different things, people.

 

Josh Porte (39:14)

And so for a smaller firm, you might see it trade at ⁓ two or three times EBITDA thereabouts. a more substantial platform, the current market is somewhere around 5 to 8x EBITDA.

 

And the entire goal here is to kind of grow and expand. And as the business grows and expands and adds EBITDA, it becomes more valuable, not just from like a total amount of EBITDA standpoint, but actually the multiple attached to that. This is called multiple arbitrage. And it should tick up over time, hopefully. So the idea here would be if you were an early mover and you transact with an MSO at a time when the MSO is pricing itself at

 

eight times earnings, and then several years later it sells at a 12 times, right, then that ⁓ represents a substantial appreciation in the value of your equity investment.

 

Gyi (40:17)

that was my question in your experience, like, I get that it varies a lot, but how long is that several years typically? And did the PE firm, do the funds talk about that at beginning? Like, are they talking about like, hey, we’re planning to do this over the next x year?

 

Josh Porte (40:25)

you

 

Yes, in fact a lot of these funds are raised for fixed life cycles of five to seven years and so Yes, and so they are Actively looking to try to transact You know on that time horizon to execute their business plan deploy the capital and deliver a return to their investors That is one reason why you see a lot of private equity funds when they they’re working on a deal They’re they’re sprinting and they’re trying to get it done because they are under their own Set of time constraints, right? There’s this time value of money aspect

 

where the faster they can get the capital deployed and get a return to their investors, the better the overall performance of their portfolio. So yeah, five-ish years, three to five years would be a fairly typical expected hold period. It could be longer.

 

Gyi (41:18)

was amazing. I don’t even know if you want people to reach out to you. If you want to learn more about this, where would you direct them?

 

Conrad (41:18)

you so much.

 

Josh Porte (41:28)

Yeah, you can find me on LinkedIn, Josh Port, Holland and Knight. You can look me up on Google on our website. And my email address is there. Thanks so much, guys.

 

Gyi (41:36)

Thank you so much.

 

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