Economics of professional services - surviving recession 5: expanding the business 1

In my third post in the surviving recession series I emphasised the need not to simply freeze all new spending since this was likely to cripple your chances of doing the new things that might be required to survive a downturn. This is especially important if you want to grow the business despite the recession.

Just because the economy has gone into downturn does not mean that you cannot increase billings in your existing practice areas, nor expand into new areas. However, you also need to be aware of the problems involved.

The starting point is to understand your marketplace.

How bad is the contraction in your key areas? If the market is down by a third, and this happened in a number of professional services areas in the Australian economic downturn over 1990 and 1991, then you have to increase your market share by just over fifty per cent to maintain constant fees.

If you are already the market leader, this may in fact be impossible. In this case, you will need to consider new areas if you are to maintain or increase billings.

The next point is to understand your competition. They will be facing the same problems, and may respond quite aggressively. You need to be able to understand this and take it into account.

An example to illustrate.

The 1990 crash meant that all the big shops suddenly started looking for new work to try to cover their fixed costs, in so doing bidding for jobs that they would not have considered before. In the case in question, the firm (the consulting arm of a big consulting firm) had a survey centre whose work had dropped very sharply.

The Australian Department of Defence wanted a capability census carried out of a small but important local sector. This involved identifying and then contacting every industry participant, writing the results up in a standardised way to allow the Department to make judgements about both existing capabilities and capability gaps.

Defence industry was one of our core areas. We really wanted this job, cut our costs as much as we could while putting forward a very detailed methodology. The Defence area in question wanted us to do the job because they thought we would give the best result. However, without giving away information, they indicated that the big shop had come in with a much lower offer, making it very difficult to reject them even though their methodology was not as good. We and the big shop were invited to put in revised offers.

We really agonised over this one, Finally, we told Defence that we could not lower the price further because this would almost certainly risk a cash loss on the job. The assignment went to the big shop.

Later when we found out the tender price (tender results of this type are on the public record) we discovered that our opposition's price was 60 per cent of ours. We knew our costs very well. It seemed clear that they had no idea of the real costs involved. And so it proved. The job took twice as long as expected at a cash out cost on our estimate more than twice the tender amount.

The third point is to understand your clients. In a sense, the starting point in surviving recession is to try to keep what you have.

Now this one may seem self evident. Of course you need to understand your clients. You do, don't you?

The problem is that understanding clients is quite complicated and is actually not well done because it involves interactions at a number of different levels. Many firms are really quite bad at it.

I will look at the detail here in my next post in this series.

Next post. Previous post. Entry post.

Economics of professional services - surviving recession 4: getting the cash in

Continuing my series on surviving recession drawing from our experiences in the last downturn (entry point for the whole series here), a remarkable number of professional services firms are not good at getting cash in. Too many carry excessive work in progress, essentially funding client operations.

As recession bites, clients begin to delay payments to preserve their own working capital. In our case, we found that the average age of our receivables began to blow out from just over thirty days to forty then to sixty and even 120 days. I am talking about good clients who could pay. This tightened an already strained cash position.

To overcome this, we launched a collection program. Our problem here was to find a way of doing this without disrupting relations with clients (and especially individuals) on whom we were dependent for future work.

Many firms in this situation try to rely on individual professionals to follow up their own clients. He/she is your client, you sort it. This can work. However, many professionals find it an uncomfortable process. It is also one that can alter relations between professional and client. To overcome this, we adopted a multi-stage approach.

In most larger organisations, the direct client may authorise payment. However, payment then has to be made by accounts areas who may be operating under different rules.

We began with close monitoring.

Where our relations with individual clients were good (here I mean not just the organisation, but also the specific individuals involved) we found that we could sometimes get early payment even within thirty days by a private chat at the time of billing. In other cases where the individual might authorise but could not control payment, we focused on the accounts area. To do this, we had to understand the payment system in the client.

In our experience, the people we were dealing with in a professional role were happy to explain how their payment systems worked. Once we knew this, we could follow up.

Now here comes an important distinction from some firms. We did not ask our professionals to talk to accounts areas. They had neither the skills nor the time to do this. Instead, we used our own accounts people because they could talk like-to-like.

The approach was always the same. An initial call to check on the status of the account immediately following the thirty days. This was always done in a gentle, friendly fashion, seeking information. Our accounts people would always explain that they were doing cash flow planning. With on-going clients, a key aim was to establish individual relations.

In a remarkable number of cases we actually got fast payment. Where the accounting areas were operating under fixed rules - in one case an instruction to pay at 120 days! - we at least knew.

We already had tight work-in-progress monitoring systems in place, in combination with billing rules. A surprising number of firms do not - WIP can build and build. I have seen many firms still carrying WIP in the accounts that is more than five months old. This can play absolute havoc with accrual accounting systems because it creates a divergence between the firm's real position and that shown by the formal accounts.

If you do not have these systems in place, then you must establish them. Otherwise you may go broke while showing an apparent profit.   

Economics of professional services - surviving recession 3: don't freeze all new spending

This post continues my discussion on the best ways to survive recession, drawing from the mistakes we made in responding to the last major Australian downturn in professional services. Those interested can find the entry point for the whole series at the end of the post.

One of the first standard reactions to downturn is to place a freeze on all new spending.

We did this as the 1990 recession bit. Fees dropped by two thirds during the March Quarter. We were bleeding cash. We put a freeze on all new discretionary spending to give us time to respond. This proved to be a bad error.

The problem with this type of blanket freeze is that its stops all development activities in their tracks. It also increases the difficulties faced by existing activities in responding to changing market conditions. Both act to worsen the situation.

You may need to tighten spending controls sharply, but you have to ensure that cash continues to be available to support your recession responses.

Return to the entry point in the series.

Economics of professional services - surviving recession 2: know your business

In my introductory post in this series, I suggested that we had probably made every mistake in the book in responding to the severe downturn that hit the Australian professional services market place at the beginning of 1990, the last major downturn to hit professional services, at least in Australia.

Before describing some of our errors, I wanted to make a basic point: know your business. This may seem self evident, but in my experience the most fundamental error that firms make when facing trouble is to focus on corrective action without linking that to the nature of the business itself.

Most firms facing economic challenges respond in a small number of ways - they try to cut costs, they look for new business, if things are really bad they look for merger partners. Each has its place. However, the actual action taken has to be consistent with the firm's underlying business. To illustrate.

We had introduced an external director, a very senior experienced business executive with a sales and marketing background, to provide independent business advice.

As the recession hit and fees dropped, his advice was to cut back spend to the level required to restore profit. This meant retrenching professional staff. In start up, we were reluctant to do this because  it meant losing productive capacity and especially people whom we had invested in and were just becoming productive.

Both points of view were equally right, both equally wrong. Neither side knew at that point that the bottom of the downturn in the economy was then eighteen months away, a long period when you are struggling to survive.

Our director's business experience in sales and marketing lay in cyclical areas with considerable pools of trained people. The logical business response to downturn was to cut costs, then rebuild as the downturn came to an end.

Our business was different. Our productive capacity was directly related to staff time. Because we were working in a new area, developing new types of professional services, we had had to train our own people. Apart from loyalty issues, staff cuts meant a longer term reduction in productive capacity, not something that could be turned turned round quickly.

If you have to discuss serious business restructuring issues, please do so off-site. Our board meetings became difficult affairs focused on arguments about the quantum of the required cuts. Staff quickly became aware of the nature of the dispute. Enthusiasm and productivity dropped.

I said both sides were equally right and wrong. We did need to make cuts. However, instead of focusing on the cuts themselves, we should have focused on the business - what were core activities, what development activities might be deferred, how long were projected pay-back times and so on.

Had we done this first instead of moving straight to a discussion focused just on financials, we would have been in a far better position to address cost issues in a sensible way.

Each firm is different. The key lesson is that effective action in a downturn starts with the business, not the financials as such.

Return to the entry point in the series. 

Why law firms don't plan - the law firm entrepreneur

Interesting short post from Tom Collins on the morepartnerincome blog, in part quoting Jerry L Mills.

Based on his experience, Tom notes that he frequently encountered first generation firms, often founded by two or three attorneys who bonded together in their prior firm and who broke away to create their own. Usually one of the three is the clear leader. The role of the team in this case is to keep their entrepreneur leader from getting too many big ideas too often.

In these firms, there can be a real reluctance to commit the firm to a clear mission or purpose because this may impede the freedom, the flexibility of the business and especially that of the entrepreneur.

Here Tom quotes Jerry L Mills from his book The Danger Zone. According to Mills, entrepreneur law firm leader thrive on change. They don't want things formalised, but instead draw from a set of core values that they bring to the organisation. These values give the enterprise its characters and unity the law firm. Mills suggests that memorialising those core values has a better chance of improving and focusing the business than traditional planning steps.

I think that Jerry Mills is almost certainly right, and for a very practical reason.

A core challenge in any new business lies in the creation of common values and a common culture that will unify the entity and drive success. These values form in the early days and are remarkably persistent.

If the new organisation is successful, then it usually but not always follows that the values created have met market acceptance. There is, however, a danger that the entrepreneur in his/her desire to do new things will go in too many directions. In these circumstances, memorialising core values can be an effective way of keeping the entrepreneur on track.

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.

Conclusion

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.

Reflections on Professional Practice and Practices

This Al Jazeera International photo shows a helicopter water bombing during last year's Australian bushfires. The point of the photo is that once you have to start putting out fires from on-high you are already in trouble. It is generally better to deal with the fire at source while it is small, and that comes back to improved management.

I have been musing about issues associated with professional practice, trying to clarify and structure some confusions in my own thinking. One of my key concerns has been a feeling that I need to find a better way to focus, link and present my own writing and thinking to make it more accessible.

Three Overlapping Knowledge Domains

In an earlier post, Towards a Discipline of Practice, I suggested that there were three overlapping knowledge domains within professional services:

1. The profession itself, whether it be engineering, medicine, law or training. What we do. Most professional education and training focuses on this.

2. The application of the profession in practice by individual professionals. Doctor/patient, lawyer/client etc. Essentially, how do we do what we do.

3. The management of the overall practice. Essentially, how do we manage what we do. I am using the term practice in the broad sense to cover the variety of business structural arrangements found within professional services.

We can think of these domains in terms of a matrix with the three knowledge domains and their various subdivisions down one axis, the various professional services fields and their subdivisions along the other.

The Challenge

When I began this blog my focus was, as the blog name suggests, on number 3, the management of the professional services practice. This remains my core focus. However, I have in fact found myself writing across all three knowledge domains.

The problem with this is that it can create confusion in the minds of individual readers. To tease this out a little, hopefully encouraging debate, I am now going to look briefly at the first two knowledge domains.

Knowledge Domain One: the Individual Profession, Knowledge Domain Two: Application of the Profession in Practice

While these two areas are very distinct, I have linked them together because collectively they bear upon one of my key interests, ways of enhancing cooperation between professions to facilitate true multidisciplinary working. This links to a second interest, the extent to which professions can learn from each other.

Originally, there were arguably three great professions, law, medicine and theology.

One of the features of the process of professionalisation was the way each developed its own knowledge domain, creating a separation and mystique from other fields of human activity and knowledge. Linked to this was the creation of self-governing processes giving the profession the capacity to define and recognise its own practitioners. As other professions emerged, they attempted to follow the same route, creating a professionalisation process.

In saying this, I do not want to become involved in the debate as to what constitutes a true profession. To me, the key distinguishing feature here is that a profession has a focus on the work of the individual professional. Rather, my concern is on the way professions and professionalisation create intellectual and cultural divides that limit cooperation and knowledge transfer between professions.

To some degree these divides are both inevitable and necessary. Every profession needs its own language, its own defined areas of knowledge, to facilitate development of and work within that profession. But problems arises when the divides are such that they blind professions (and professionals) to the gains that can arise from cooperation and cross-fertilisation. Problems can also arise for professions and professionals where professional barriers act to prevent the profession responding too needs that they were created to serve.

Let me try to illustrate all this by an Australian example.

Ophthalmology and Optometry

In Australia as in many other countries, there have been concerted efforts at official level to break down competitive barriers previously protecting the positions of certain professions. These efforts have been opposed by some professions under perceived threat, at times supported by professions who saw potential gains.

As part of this process, there were moves in different Australian states to grant optometrists prescribing rights for certain drugs, thus broadening the range of optometric practice. These moves were opposed by many ophthalmologists and by the Royal Australian (now Australian and New Zealand) College of Ophthalmologists on the grounds that optometrists lacked the knowledge, skills and judgement required to diagnose, prescribe and treat safely.

Despite these objections, the Victorian Government decided to grant certain certain prescribing rights and then asked the College to specify what additional training should be required before individual optometrists could exercise those rights.

The outcome here is described in a case study on the Ndarala Group blog. To provide the necessary advice, the College had to specify just what knowledge and skills were required to diagnose and prescribe safely and effectively so that this could be embodied in training activities. To do this it adopted a competency based approach, applying knowledge and skills drawn from the training profession. In turn, this has fed on into major changes in the approach adopted to the training of ophthalmologists in Australia and New Zealand.

The Lessons

All this may sound a bit arcane, but if we look at the case it does have broader relevance and not just to Australia.

To begin with, this project combined knowledge domain one (what we do) and two (how we do it). The College actually had to specify key elements in both and show how they were related.

This brings me to my second point. In doing this, the College laid down a methodology capable of application across the professions, one with the potential to demystify professions and, in so doing, to lay the basis for broader cooperation while also opening individual professions up to greater competition.

This may sound extreme, but consider this.

Both Canada and Australia face a problem in regional areas because of an aging lawyer population. Young lawyers are reluctant to take on country general practice positions, preferring instead to look to bigger city specialisations. I may argue that this does not make sense in financial terms if you look at average financial returns, but it is (I think) a practical reality.

Track forward. If certain areas cannot get conventional legal services, then other ways will have to be found to give them that service.

One way of doing this, one that is already happening with conveyancing, is to take out chunks from legal services and allow others to provide the services involved. Another alternative, again one that is already happening, is to move to on-line delivery of certain legal services. These two could, of course, be combined.

Add in the emergence of both corporatised law firms and multi-profession firms including lawyers. At what point do we move to listed entities combining a variety of delivery modes and professional areas?

The initial move to float Integrated Legal Holdings as Australia's first listed law firm ran into a variety of problems including opposition from current legal regulators, although the float is likely to proceed in February. However, this is just a first straw in the wind.

My feeling is that the dynamics already in place guarantee major change over the next few years. I also think that within this change process, the capacity to define knowledge domains in the approach pioneered by the ophthalmology case is going to become increasingly important.

Professional services - pricing, positioning and service areas continued

In my last post I suggested that each firm needs to analyse and understand its own business, taking current and prospective clients into account as well as any variations between fields of law. From experience, particular problems can arise where the firm operates in several different fields with different patterns. The most common problem is simply failure to recognise the differences, leading to the application of firm wide policies and procedures that do not properly take variations into account. This can be a particular problem where firms are moving into new fields of practice.

I thought that it might be worthwhile teasing the last point by taking an actual example.

Take a firm whose largest area of business is commercial law.

In market terms, the firm positions its pricing policy so that it is charging a little below the big CBD/national firms. The competitive strategy is better value for money as compared to those firms. Rates are moved up in lock-step fashion with the national firms. Billing is generally monthly, with a major performance focus on individual charge performance combined with fast WIP turnover. The complex nature of some of the work means that leverage (ratio of more junior time to senior time) is low.

The firm moves into a new area of law with a private client/family business focus to create a new growth focus while reducing reliance on commercial law. The new initiative struggles despite an apparently strong potential market. Analysis shows:

1. The new market with its mix of small and large clients has different and generally lower pricing structures. Application of pricing policies based on commercial clients therefore creates a very real problem. Moves to manage this through application of fixed price to certain activities helps reduce impact, but then creates another problem through higher WIP write-offs.
2. Service delivery structures are different. There is a larger back-office function, return depends upon achieving greater leverage, more combination of individual resources. This creates management problems (more active management is required), measurement problems (while team performance measures are used, there continues to be a strong measurement focus on individual performance) and recruitment problems (deciding what staff are needed, getting them, at a time when the firm is trying to control overall head count).
3. WIP and billings patterns are different. Instead of monthly billings, many clients are now billed against specific milestones. Monthly billings, the previous core perfomance measure, is no longer an accurate performance measure but needs to be combined with WIP.
4. Finally and perhaps most importantly, these various differences create a major difference between the culture holding in the commercial law area and that required in the new area.

Professional services - pricing, positioning and service areas

I finished my last post by commenting: Even in a single professional field like law, there are considerable variations between customer types and fields of law in areas like pricing, the pattern of WIP creation, write ups, write offs and billings. These need to be understood and accommodated.

Because I am still mulling these issues over in my mind, I thought that I would make a short supplementary comment, taking law as an example.

To begin with, there is considerable variation within law as to the extent of fixed price quotes. This varies between customers, law firm practice and fields of law.

Some customers demand fixed prices, others require firm estimates, still others are prepared to accept conventional time based billings. The willingness of law firms themselves to accept fixed prices varies. It is common in some fields of law - estate or conveyancing for example - for service offerings to contain a mix of fixed price and time based elements.

There is also considerable variation in customer payment patterns. Again, this varies between customers, law firm practices and fields of law. Some firms bill monthly, some against milestones, some at the end of the job. There are some fields of law - estates and conveyancing are again examples - where there can be quite long lead times in translation of WIP to billings.

Each firm needs to analyse and understand its own business, taking current and prospective clients into account as well as any variations between fields of law. From experience, particular problems can arise where the firm operates in several different fields with different patterns.

The most common problem is simply failure to recognise the differences, leading to the application of firm wide policies and procedures that do not properly take variations into account. This can be a particular problem where firms are moving into new fields of practice.

Consolidation among accounting firms

In my last post (Professional services : mergers, acquisitions and goodwill), I talked in part about mergers and acquistions.

The first round of action by the aggregators in Australia - those acquiring accounting firms to fold them into listed entities - had some spectacular failures. But the trend continues.

I say this because I recently looked at the web site ofthe WKK Group, one of Australia's leading aggregators. See - http://www.whkgroup.com.au/ . Before going on, chaps, when are you going to turn your web site into a real marketing tool?

Being insatiable curious, I dug down into the detail on the site, looking especially at the investor section. Now the beauty of this section is that it includes all the public announcements about acquisitions. So one can look at patterns.

I was especially interested in what WHK calls tuck-in acquistions. These are small firm acquisitions that can be tucked into existing operations. There are a lot of them, with WHK using a mix of shares and cash to acquire the firms. This greater acquisition capacity is one of the reasons why the aggregators are likely to become very major players in accountancy.

Professional services : mergers, acquisitions and goodwill

My Saturday July 8 report focused on role clarification within partnerships. 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.

In response, one of my colleagues commented that this sounded simple and effective. He asked what I saw as the potential pitfalls or points of resistance.

Key Resistances

I suggested to Mike that there were a couple of key difficulties/resistances.

To begin with, the very transparency/accountability offered by the approach is of itself a key difficulty. Partners don't want to loose control, while the approach also forces them to address differing performance levels between partners that may have simply been swept under the carpet.

This problem can hit early in that you have to start with some allowance for existing levels of partner remuneration before you can strike a notional real profit.

In simplest terms this can be done in two ways. Take existing partner drawings (most partnerships have some form of drawing system) as a given and simply deduct them. Alternatively, agree among the partners a national existing base salary level for partners or partner equivalents and then deduct this. The balance between the notional salary and existing drawings represents the equivalent of dividends.

A second linked technical issue is to get an agreed definition as to what constitutes profit. This may sound simple and it should be, but difficulties can arise simply because partners are not used to thinking in these terms.

Structural issues can arise. Most partnerships have service companies. Some have other companies as well. Then there may be trusts. The issues associated with income stripping, transfers of costs and income to maximise tax benefits, have recently become a real issue with the Australian Tax Office. So the existing partnership structure needs to be analysed and understood to identify issues that might arise from a partner perspective. It may simply be too hard to do something.

Finally, practical issues can arise in terms of the way existing accounting and information systems are structured. The firm really needs to be able to fit the approach within its existing systems.

Introduction to Mergers and Acquisitions within Professional Services

The idea of separating returns from equity and work links to another key issue within professional services, the increasing trend towards mergers and acquisitions.

Why is this important?

All professional services firms are facing the challenges created by structural change within the professional services sector broadly defined.

Increased compliance costs are one element of this. We have seen this among my own Ndarala Group members because of the impact, for example, of increased professional indemnity requirements and costs. A second element is increased investment requirements for new systems and services.

These changes are placing great pressures on both smaller and mid size practices to get bigger or get out.

Demographic changes are adding to these pressures.

The average age of partners/senior managers is rising especially among smaller practices, while recruitment of new staff with partner/senior manager potential is becoming more difficult. Not only are numbers in entry level age cohorts in decline, but attitudes have also changed. Staff are less willing to stay with the one firm, have greater immediate expectations, are less interested in partnerships or ownership, demand greater flexibility.

The scale of the challenge posed by these changes is far greater than commonly realized. Without having crunched numbers in detail, my best guess is that over the next five years as many as a quarter of current practices across a wide range of professions will have to close or merge.

This makes issues associated with succession, mergers and acquisitions of great interest to all those within professional services and especially to those of us advising professional services firms. The very scale of the challenge makes for significant market opportunities in assisting firms to manage the change process.

Goodwill and the Change Process

One technical element forcing change is the changing treatment of, and valuation placed upon, goodwill.

Traditionally realization of goodwill, the value placed upon the business over and beyond its immediate tangible assets, has been the major way of realizing value upon exit. However, this has become more difficult for two reasons.

First, the value of goodwill depends upon the stability and sustainability of the income stream attached to that goodwill. Heightened competition threatens sustainability, making sale of goodwill more difficult.

Secondly, the number of people willing and able to take on the responsibilities of ownership has declined. This has hit hardest at the small end of town, but has also been a problem for the bigger practices where traditionally entry level junior partners have essentially mortgaged their assets and alienated immediate income in order to get future rewards. With professionals less willing to do this, many of the bigger firms have responded by abolishing goodwill, admitting new partners in return for payments linked simply to net tangible assets.

This may have assisted firms to meet immediate needs, but it has also created a new set of problems.

Problem one is a behavioural one, the way in which the new approach has shifted partner focus from creation of value for later realization to maximization of cash now. Investment still takes place to meet immediate development needs and to ensure maintenance of cash flow, but the time horizons and service focus have shifted.

Problem two is a structural one, the way in which abolition of goodwill has in fact opened up professional services to further structural change. The reason for this is simple.

Regardless of all the arguments, the reality is that the firm's intangible assets do have potential value. Obviously the real value depends upon the firm's business. In some cases, the real value may be very low or even zero. But in other cases, the real value may be very significant. So long as these intangible assets are valued at zero, then opportunities are opened up for acquisition of the firm by someone who can offer the owner/partners some capital return.

Two cases to illustrate the point.

So long as market P/E rates are higher than the value offered by existing realization paths (and this almost definitionally follows when intangible assets are valued at zero), then listing or the acquisition of the practice by a listed vehicle holds out the possibility of unlocking capital value.
At the smaller end of town, people's inability to sell their practices creates opportunities for profitable bolt-on mergers or acquisitions to build volume or enter a new service or geographic area.

Consequential Issues

While the changing treatment of goodwill opens up opportunities, these have to be handled with care. We only have to look at the failure of some of the listed aggregators within accounting to see the risks that can be involved.

Four issues are of critical importance from the viewpoint of the acquiring firm.

The first is the need to be absolutely clear on the reasons for and potential value of the potential acquisition. The second is the need to set a price that locks in the potential gains. The third is the need to do proper due diligence. Finally, there needs to be a clear and effective strategy for ensuring effective integration of the acquired entity

On role clarification within partnerships

As a professional adviser, one of my core arguments has been need for change within many professional practices to better delineate otherwise conflicting roles and to facilitate more effective governance and management. I believe that this is critical to improved performance and indeed survival in some cases.

Partnerships Under Challenge.

The partnership is the traditional organizational form within professional services and remains important today. In this form the world is dominated by the equity partners who essentially own the game. The practice grows by admitting new partners generally recruited from within the ranks who pay a price for partnership. In turn, this facilitates exit by existing partners. Partners receive their return from the profit pool, the pre-tax net remaining after deduction of expenses.

This traditional model is under strain. Risks associated with equity partnership have increased. There is growing reluctance among younger professionals to accept partnerships. At the same time, the availability of partnerships has also declined for those that are interested. Increasingly, partners themselves want more flexible life styles.

There is not scope in this type of post to canvass all these changes and their implications. Instead I want to focus on one thing drawn from organizational theory, the way in which role clarification can assist a partnership to manage change.

Confusion in Roles

All of us who have been involved as managers or advisers on people issues know that clarity in job role is critical to performance. People need to know what they have to do, how their performance will be measured. This is also critical when it comes to remuneration. Lack of clarity about the links between role and pay can and does create significant management problems.

Unfortunately, the traditional partnership approach breaches the clarity principle. Partners traditionally receive an agreed share of the profit pool. In return, they are expected to do a range of things that may have little direct connection with either the size of the profit pool or their share of it. This can create significant tensions within the practice and may make it hard to easily address performance problems at partner level.

Clarifying Roles

In my view, the first key step in addressing this problem is to make a clear distinction between the partner's equity and work roles.

Equity partners in the firm should receive a return on the capital invested in the practice, while their work roles should be remunerated with payments directly related to those roles and associated contribution to the practice. These payments should then be counted as a cost from a management accounting perspective, creating a notional profit directly related to equity.

Once this separation principle has been established, the definition of roles and the remuneration to be attached to those roles can then be dealt with using conventional job analysis and remuneration principles.

Impact of Clarification

This simple approach to role clarification offers a number of very real performance gains.

To begin with, it makes partners more directly accountable for their own work performance. In turn, this makes it easier to assess partner contribution and vary remuneration accordingly.

It also makes it easier to admit staff or non-equity partners in that they can be paid using the same principles as applied to equity partners for their work.

Finally, it can increase flexibility for equity partners in managing their own affairs.

Take leave as an example. An equity partner on leave would still be entitled to a return on his/her investment. Any other payments can then be handled on the same basis as applying to other staff.

Selling your practice: the self employed professional case

In my last post I spoke of the difference between the self-employed professional and those trying to build a professional services business. I suggested that one key difference lay in the attitude to final sale.The self employed professional does not think of sale, the business builder does.

One of the things I try to do is to get my self-employed professional to consider the sales option.

I recognise that sale of practices has become more difficult in many areas. The doctor who used to think of sale of practice as an integral retirement option may now struggle to find a buyer because of changes in the profession. The aging principal in many smaller engineering or legal practices may conclude that he (it is still usually a he in these cases) has no choice but to close the pratice.

Yet despite all these difficulties, sale is still a far realler possibility than many people realise. The key need is to identify and test the possibility well in advance. You can then put it aside or, alternatively, start planning for it.