Thoughts on ways to improve the management of professional services firms

Thursday, May 24, 2007

Corporatisation, Corporate Structures and the Law - The Case For

I mentioned in my short previous post on the Slater and Gordon float that I had lost a much longer post looking at the issues raised by this post.

Since then, the float itself has been much discussed, and I see little point in replicating that discussion. Instead, I though that I should focus on one issue, some of the commercial reasons why corporate forms and indeed public listings can make sense in law. I do so because there seems to be a degree of confusion on the matter.

The core of the confusion can be simply stated: what is there about a corporate structure that makes commercial sense? How can this change add value to an already well managed practice?

The answer can also be simply stated. There are structural inefficiencies built into the current partnership system, inefficiencies that can be resolved by adoption of a corporate form.

A list of key inefficiencies follows. In writing, I am not trying to be absolutely rigorous, simply pointing to issues to be considered.

Professionals vs Managers

In many practices, the senior partners are also the key managers. As exemplified in the two case studies I used in my depression series (Free at Last, Jan's Story) many of them are very bad managers. I looked at some of the reasons for this in a post last July, People management in professional services - professionals vs managers.

Firms can address this one by introducing professional management as many have done, but the story does not end there.

Role Confusion within Partnerships

In many partnerships, the different roles played by partners (managers, owners, professionals) are all mixed together.

In my post On role clarification within partnerships I argued strongly that role clarification was essential if the partnership form was to survive.

My key point was the need to separate equity returns from payment for work. Once this was done, the definition of roles and the remuneration to be attached to those roles could then be dealt with using conventional job analysis and remuneration principles.

My experience has been that partnerships are often unwilling to address the issue of role clarification because the current role confusion benefits individual partners. This builds another weakness into the partnership approach.

Abolition of Goodwill

"It is something of a misrepresentation to suggest that there is goodwill at all", said one senior Perth barrister. "Who in the legal profession recognises goodwill? The big firms do not recognise goodwill." Quoted in the Australian Financial Review, 27 October 2006, in a response to the proposed float of Integrated Legal Holdings

To suggest, as this Perth barrister did, that goodwill has no value is absurd. Worse, it is one of the key factors sounding the death knell for partnership structures.

I discussed this issue last July in Professional services: mergers, acquisition and goodwill. Partly because of the difficulty of attracting partners, many firms abolished the goodwill component in valuing partnerships.

This action has had a number of adverse impacts.

It treats the true value of the firm - the client base, accumulated intellectual property and business systems - as though it has no value. The reality is that it does, thus opening the firm up to acquisition offers that allow equity partners to realise at least some value from an asset otherwise counted as zero value.

The approach also has often unrecognised behavioural impacts.

In Self-employed professionals vs business builders, I looked at the behavioural differences between self-employed professionals and those trying to build a business. I suggested that the first group, the majority by number, focused on return from cash flow. By contrast, the second focus on building a business looking for a return from the combination of cash flow and business sale.

This is not just a semantic difference. There is a very real difference in business decisions focused on short to medium term cash flow maximisation as compared to decisions concerned with building longer term business value. There is no point in the second if you cannot realise value from the investment.

In abolishing goodwill, partnerships moved themselves from the longer term business building category to the cash flow maximisation class to the detriment of firm and client.

Economies of Scale and Scope

Economies of scale arise where the unit costs of delivering a particular good or service fall as volume increases. Economies of scope are similar except that volume relates to increases in volume spread across a number of goods or services.

Economies of both scope and scale have become more important across professional services over the last fifty years. Reasons include greater investment in IT systems and knowledge management, as well as increasing insurance and compliance costs. This will continue.

All this drives firms in the direction of growth. This is another area where corporatised law firms have advantages, especially when it comes to acquisitions.

Take, as an example, the approach of the WKK Group to tuck-in acquisitions, acquisition of smaller firms whose business can be tucked in to compliment the broader business. I know of law practices that follow this approach. However, it is just much easier to make this work in a corporate structure.

A particular advantage for listed firms is that they can offer shares that have a clear value without all the problems that can be involved in slotting new partners into a partnership structure. This links to a broader issue, the way in which staff shareholding schemes can be used to reward staff for growth in ways not possible in partnerships.

Risk Management, Multidisciplinary Working and New Business Activities

I have grouped these three together because while they are very different, they also share some common issues.

As we saw in the case of Courdert, if something goes wrong in a partnership, the results can be disastrous for all. Corporate structures can help quarantine risk.

This is especially important if firms want to enter into new, linked, business activities.

The question of whether law firms should enter into activities outside legal services or stick to the knitting raises different issues. The reality is that many firms have diversified, often turning related activities into new revenue sources. Again, corporate structures facilitate this, while also quarantining any risks that might be involved.

This also links to the question of multidisciplinary working, the grouping of different, normally related professionals, so that they combine their different skills in an integrated approach.

I discussed this area some time ago in a preliminary way (here and here). Depending on local regulatory structures, these forms of working can be accommodated within partnerships. However, corporate structures can make the process easier.


As I said at the outset, the analysis in this post is not intended to be rigorous. My objective has been to point to some of the reasons why corporate forms can make sense compared to traditional partnership structures.


Legal Eagle said...

Awesome counterpoint to my post, Jim. Will have to think up a post in reply, linking to yours.

Jim Belshaw said...

Thank you, LE. The questions you raised in your post were all valid ones written from a lawyer's perspective.

Apart from my constant desire to improve management, I try to put change into a context, to show why something is happening.