Happy Meals: Growth Through Small Mergers

A major objective of many law firms’ strategic plans is to grow specific practice areas or office locations through small mergers.  Unfortunately such small “acquisitions” often include practices that the larger firm doesn’t want.  But partners in the targeted practice frequently don’t want to be “cherry picked” and demand that the merger include everyone.  An answer may be the creation of a wholly owned subsidiary.

The Nature of Growth

Growing a practice is a classic Make or Buy decision.  Clearly the best way is to increase the size of a practice organically by getting more work from new and existing clients and internally developing lawyers to do the increased work. Unfortunately, internal growth is a bit like creating shade from the sun by planting an acorn.  The eventual result is excellent, but it takes a generation to occur.

The alternative is to, in some way, buy a practice.  For most firms this means laterally hiring.  But there are a bunch of negatives attached to laterals starting with the process of finding and hiring them.  Legal headhunters working on a contingent fee are in the business of making the easiest placement they can as quickly as possible.  So, when they find a good candidate, they attempt to place the lawyer with the firm that the candidate will be most eager to join, and where hiring will occur most quickly.  For firms that have a mediocre reputation, below average profitability, or a history of taking a long time to decide to make an offer, a rational recruiter will be taking the best candidates elsewhere.

In addition, laterals are expensive.  The recruiter’s fee runs 25 to 35% of first year compensation and laterals take up valuable cash.  A lateral who starts in mid year will work the month of July and bill his or her time in August (hopefully).  If the client pays somewhat promptly the cash will come in the door by the end of September.  So there is no revenue for first three months the partner is with the firm, even though draws and support expenses are being paid.  Typically breakeven on a cash basis for laterals occurs six to seven months after they start.  That means that laterals starting in the second half of a fiscal year will probably represent a hit against distributable income at year end.  If there are a large number of laterals, the profit impact can be significant.

Finally, there is the problem of sustained growth.  Many firms that depend on lateral hiring to implement their growth strategy find that they are merely churning business; their number of departing laterals is as high as their incoming laterals.  The result is turmoil, expense without long term growth.

Happy Meals

For these reasons, many firms are finding mergers as a preferable means of growth, especially if the merger enables them to acquire smaller firms that have a couple of marquee lawyers with a good reputations and reasonably large books of business.  Unfortunately, such firms frequently come with non-targeted practices that the acquiring firm may not want, e.g., workers’ compensation, domestic relations, residential real estate, insurance defense or plaintiffs’ litigation.  The obvious answer is for the acquiring firm to cherry pick the practices and partners it wants from its acquisition target.   But, more often than not, the targeted partners you want won’t move without a guaranteed soft landing for the partners you don’t want.  We call such firms “Happy Meals.”   Children love McDonald’s Happy Meals, but could care less about the food.  For them it’s all about the toy that comes with the meal.  So parents buy a Happy Meal give the child the toy and then have to figure out what to do with a tasteless hamburger and cold french fries.  You see the analogy…

So what are the tactical options for a firm that wants to grow but is being thwarted by a “Happy Meal.”  It seems to me acquiring firms have three choices:

1.  Push the deal through.  Often the targeted lawyers feel a moral obligation to at least try to find a safe home for their partners.  Unfortunately, acquiring firms frequently take such altruistic concern as the final word when it may effectively be a token gesture.  This is especially true when the non-targeted partners take an intractable position.  A well thought out negotiating strategy by the acquiring firm that is based on solid business logic but demonstrates some flexibility almost always prevails.

2.  Offer a Dream Act.  Provide non-targeted partners with a path to equity partnership.  Do this by offering to make them true contract partnership, that is, becoming non-equity partners with a contact that provides them with realistically improved tiered performance criteria over two or three years.  If they meet the criteria, they become equity partners.  If they don’t, they receive a specified severance.

3.  Create a wholly owned subsidiary.  Often practices that are unprofitable in a large firm environment perform well without all the overhead.  We have seen a number of firms create boutique firms for practices that would never survive in the larger firm.  The keys to this strategy are: (1) that the partners moved to the subsidiary become employees who are compensated at the market level for the practice; and (2) that the practice is reengineered to maximize the use of technology, non-traditional work styles (hourly associates, telecommuters, etc.) and non-lawyer workers.  If the subsidiary is not wildly successful after a couple of years, the firm can probably spin it off to the subsidiary’s senior lawyers or close it down.  In all likelihood, any accumulated loss will be less than what the severance would have been had the partners been terminated at the merger.

The point of all this is that if a firm is determined to grow by adding targeted lawyers through mergers, there are a variety of options to get around political and logistical road blocks.  But like so many other things in running a law firm, it takes creativity and perseverance.