Debt or equity – the best funding for you

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By Legal Futures

13 October 2010

In the third part of his look at external investment in law firms (see here and here for the first two parts), Jeremy Black of Deloitte looks at the kind of funding for you and what lessons there are from other professional services firms

Australia: just because two legal practices floated there when permitted does not mean it will happen in England and Wales

If you do need additional funding, the next question is whether you should use debt or equity.

As far as law firms are concerned, this is not such an easy question. In the corporate world, there is a large body of literature – capital structure theory – which provides a theoretical framework for the right balance between debt and equity. Applying it to a law firm is problematic – even calculating the cost of equity capital is difficult for a number of reasons, such as the fact that returns for risk capital in law firms cannot really be measured, and partners in law firms are not properly diversified

However, it is fair to say that the cost of equity capital for a law firm is likely to be higher than other professional service firms for a number of reasons – size of firms, lack of control, illiquidity of investments, regulatory environment among others.

The other reason to raise equity is to realise value – or ‘sell out’. This will perhaps, in some cases, be the proverbial elephant in the room.

But some deals will happen, and will be spurred on by the unusual facet highlighted in my previous articles whereby when partners leave, they often give up their ownership rights for nothing.

It is easy to see some deals being done where partners who would have got nothing get something and investors get something at a very reasonable price. I will not go into whether this is right or wrong – that’s perhaps one for the philosophers.

Professional service businesses and external equity

So what can we learn from other professional services businesses?

In terms of analogies one firm you often hear raised is Goldman Sachs. Like some large law firms are, it was a partnership and it relied on lots of bright people. However, I do not consider this a good analogy, and this comes back to what I called scaleability. In order to make money, Goldman needs funds to invest – the more funds it has, the more money it can make. In contrast, a large law firm having more money does not necessarily enable it to make more money.

Slater & Gordon is often cited by people who say once the regulations allow we will see law firm’s float. That is what happened in Australia – and there was another one, Integrated Legal Holdings – so it will happen here. But one could turn that around and note how few there have been in Australia. So it does not really support the view that many firms will list once regulations permit.

What I do think is an interesting business to look at to gauge how the legal market may develop is WPP. Back in the 1970s and early 1980s, advertising was made up of multiple agencies that tended to do creative work, planning and media buying under a single roof. Although there were a handful of international agencies and a few publicly quoted agencies, most were nationally based private companies.

Over time we saw the emergence of larger, publicly-quoted networks which eventually became part of major marketing conglomerates like WPP, Omnicom and Interpublic. These companies are among the most global in the world and typically have around 100,000 employees who work in specialist creative, planning and media planning subsidiaries. There are also a number of regional conglomerates, like Havas in Europe and Dentsu in Japan. And there are still plenty of small, specialist agencies, many of which look similar to the small agencies of 20 or 30 years ago.

It is hard to imagine the legal sector evolving in quite the same way – but it’s harder still to imagine that the legal sector will stay exactly as it is.

  • Tomorrow’s article will be on how to value law firms.

Jeremy Black is associate partner in the professional practices group of Deloitte

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