The Importance of Due Diligence When Buying a Law Firm
It is crucial to conduct due diligence ahead of the purchase of any business. When the company in question is a law firm, however, the factors worth considering are notably different. Paul Dodgshon, Sales Director of national business broker network Business Partnership, outlines the importance of conducting due diligence when buying a legal firm.
While there may be many reasons why a buyer wants a particular firm – its location, expertise in a specific area or a lucrative client book – the prospective buyer must do proper due diligence. This process is the most important part of your search and should be initiated at the earliest opportunity and before exchange of contracts or completion of a purchase.
The primary purpose of carrying out due diligence is to acquire enough information about the firm to discover if the business you are buying is what you are expecting. You will also need to find out if the risk in the practice is being properly managed, is a sound commercial investment and whether the business is worth what they are asking you to pay.
Due diligence is effectively an audit of a firm’s affairs to establish its assets and liabilities and evaluate its commercial potential. It is a vital step when buying a business and will give a thorough review of financial records, legal issues and the market positioning. It will also look at historical records and future projections, as well as any possible risks that may exist.
The due diligence process allows a buyer to better understand the business they are buying into and learn whether the price they have offered is fair. If the due diligence process is carried out early on, it allows you to deal with any issues upfront or hidden liabilities which may not have been disclosed. This information can then be used as a strong bargaining tool to negotiate terms, including deferred payments.
Conversely, the buyer may be able to seek warranties and indemnities from the seller. This essentially gives the buyer a right to claim a portion of the purchase price back if any of the foreseen problems arise.
If the due diligence process is carried out early on, it allows you to deal with any issues upfront or hidden liabilities which may not have been disclosed.
There are specific rules for a solicitor’s practice regarding Professional Indemnity Insurance (PII). This is a requirement of the Solicitors Regulation Authority (SRA) for anyone in practice and the costs of this insurance vary greatly according to the type of work undertaken. For example, a small immigration solicitor will generally pay a lower premium than one dealing in conveyancing. This relates to due diligence on two levels.
- Firstly, if you are buying a legal practice, you must ensure PII exists and that it is at the right level for the work being undertaken. Trading without adequate PII is a serious breach and a firm will be prevented from trading or closed down by the SRA. You cannot risk buying a legal practice that then cannot trade, so examining the PII cover must be part of your due diligence work.
- Run-off cover is also something that needs to be considered as part of the sale. For a successor practice, it is imperative that you find out which party’s insurance will carry the run-off cover. Again, the detailed documentation and understanding of the cover, premiums and any conditions should be examined closely during due diligence to ensure no party is left exposed to future claims.
Another area to consider is the bank of wills that family lawyers often build up and for conveyancing firms, it is the bank of deeds. Holding documents such as these in safe storage can add value to a sale because it brings clients back to do repeat business with a firm. But they only add value if they are accurate and accessible. There is no point in holding 5,000 wills if, for example, half of them relate to people who have already died or who have subsequently made revised wills elsewhere. There needs to be a disciplined approach to keeping these documents current and this should therefore be part of your due diligence checks.
For service industries like solicitors, some still do not invoice until a job is completed, which gives rise to a few potential issues. You pay for a will when it is ready for signing and for conveyancing when your house sale or purchase completes. As a result, lawyers often have a large amount of ‘work in progress’ or WIP for which they have not yet been fully paid.
Some of this work will be paid without questions, but some will be disputed. As the vendor, it is therefore important to close as many of the WIP cases as possible before completion, or to schedule new work around the sale completion date if possible. As the buyer, your due diligence needs to be examining this WIP and assessing if the accuracy of the costs is being accrued. However, solicitors will sometimes take payments on account in advance of starting work to cover this WIP and this should be accounted for and identified separately.
For service industries like solicitors, some still do not invoice until a job is completed, which gives rise to a few potential issues.
Connected to this is the debtor ledger. Traditionally, solicitors have not been the quickest to chase overdue invoices, leaving a large debtor figure in the financial accounts. As the vendor, you should be chasing outstanding invoices well ahead of a sale completion to minimise this debtor figure. As the buyer, you need to be confident that any outstanding debtors are not going to turn bad.
Legal firms are no different to other businesses in this respect. If you can demonstrate well-managed financial records with systems in place that call in payments when due, it will make the proposition of a purchase much more appealing to buyers.
Below is a checklist of what a buyer needs to cover as part of their due diligence process:
- Corporate information – company structure and any subsidiaries, shareholders, option holders and directors.
- Business and assets – business plan, key assets and equipment, material contracts with customers and suppliers.
- Human resources – employees, employment contracts, directors’ contracts, salaries and wages, handbooks, disputes and pensions.
- Property – properties owned, leased or occupied by the business.
- Information technology and intellectual property – software and equipment used, maintenance and support contracts, intellectual property (IP) used or owned by the company, including all license agreements for domain names, website design, trademarks and copyrights.
- Data protection – how data is stored, safeguarded and used, privacy policies and GDPR compliance.
- Litigation and regulatory – any disputes the company is involved in or likely to begin, and any licenses or regulatory consents.
- Health and safety – any relevant policies, log of incidents.
- Insurance – claims history, insurance policies, premiums.
- Financial – accounts, assessment of tax liabilities, loans, charges and borrowing, VAT. Includes clients’ accounts as they will need to be properly audited with suitable controls in place to prevent fraud.
Take some time to reflect on what your due diligence has revealed before making your final decision and it will also show you are serious about investing in the firm. Do not, however, get stuck in ‘analysis paralysis’ where you may find yourself in a perpetual cycle of due diligence, afraid to make a decision.
Some prospective buyers fail to do careful due diligence and end up regretting it later, often having to face unexpected financial shortfalls. Due diligence is paramount as it can uncover risks, anomalies or unforeseen liabilities that could undermine negotiations and ensure you do not get stuck with a business that has no future.
Paul Dodgshon, Sales Director
Winnington Hall, Winnington, Northwich, Cheshire, CW8 4DU
Tel: +44 0161 393 6978
Paul Dodgshon is Sales Director of Business Partnership, a unique national franchise network of 25 regional offices in the UK connecting business sellers with business buyers. With over 15 years of experience helping businesses sell quickly at maximum value, Paul understands the practical and personal issues involved in selling a business, and Business Partnership provides a personal, professional and confidential service to buyers and sellers alike.