The cost of succession (and who pays the price)

Alex Johnstone’s stimulating article in January’s Journal was a timely reminder to all to dust down our partnership agreements to ensure that we actually have such a document, that it is signed by all the partners and that it makes adequate provision for the multifarious issues which arise on succession.

There are, however, a number of other perspectives to consider in succession situations. Experience of dealing with what can become a vexed or even divisive scenario – one with which many readers will be familiar – shows that the most trenchant problems often arise through a simple lack of proper planning and communication of the right detail at the right time.

I shall consider these perspectives separately for the individual partner and the firm. Although there are clearly areas of overlap, space does not permit a full discussion of those and I do no more than highlight the critical considerations for the various stakeholders, in the hope that the points raised will at least stimulate some early thinking by those to whom this article applies.

The partner’s perspectives

The most neglected aspect of planning and identifying an exit route which is suitable to all parties is invariably the timing. All too often the decision is made too close to the intended date, and either there is indecent haste and perhaps neglect of important issues, or else various topics are considered but there is inadequate time to address properly each of the different elements of the post-succession equation.

Assuming that the departure is driven not by unexpected ill health but the partner simply feeling it is time to go, there are several contemporary instances of the partner having given inadequate thought to identifying a sensible and realistic timescale for their exit.

So, when is the right time?

This is a matter of personal choice and there is no blueprint, but given the importance and number of issues which require to be considered a minimum of two to three years is necessary in normal circumstances – though some of the most successfully managed situations are put in train even earlier.

In whom do you confide?

This is clearly a chestnut for many, and again no one size fits all, but it is important as a minimum to discuss future planning with family and key members of the firm, on the mutual understanding that all discussions are without prejudice and entirely in confidence. These two qualifications are paramount to worthwhile and meaningful discussions and if either is absent there is potential for serious trouble.

What has to be considered?

A partner resigning (perhaps especially from a smaller practice and maybe even more so in the provinces) faces unprecedented change in the personal and domestic arenas, and experience shows that professional people often find the management of and the transition through change particularly difficult. The individual concerned requires to be sure that he or she has made adequate arrangements for the following:

Finance. Your personal financial situation requires careful forward planning. That is something which cannot be done within the timescale I have referred to above and is a matter which ought to be in the long-term view of all in private practice. In essence planning must be put in place to provide adequately for retiral long before that decision comes. There may be issues of pension, goodwill payments, work in progress, capital and future rental income from property, but the retiring partner must ensure that irrespective of how it is done there is adequate long-term provision to enable them to enjoy the lifestyle they wish in retirement.

On capital, the historic arrangements of making a contribution either in one lump sum or by instalments over several years reaching a peak, then withdrawing it on retiral are in many cases no longer appropriate. A more novel approach is to consider a gradual increase in capital structure peaking perhaps in mid-professional life, with a view to reducing the capital either to a nil or at least a low balance on exit. A number of options are depicted in the diagram opposite which although not a blueprint for all, ought to contain sufficient variables to stimulate thought for most practices and how the structure can evolve.

The objective which many desire is to ensure that the bulk if not all of the capital has been removed simultaneously to leaving the practice.

Timing. The partner will experience immediate change from leaving a busy desk which has many demands on their time, often beyond office hours, into what can be seen as a vacuum. I have seen several very distinguished practitioners struggle enormously in coming to terms with the “new world” without phones, faxes, emails and demanding clients. The retiring partner requires to have given the most careful thought as to how as an educated, intelligent and highly trained professional they are going to use their time to maximise the opportunities which this new phase of life has to offer. One popular method is to remain with the firm (whether as consultant or not) for a period of two or three years, either in a full or part-time capacity and thus ease incrementally to the halcyon days of complete retirement. This is not a tablet of stone and may be for a longer or shorter period – and sometimes suits neither the partner nor the firm – but whether formal consultancy or not, a gradual transition is often preferred.

Quality of life. What will this be like after you leave the office? Here the important thing is to identify and pursue interests on which the individual was keen during working life, rather than await the dawn of retirement. The key, however, is to identify something in which you are enthusiastic and there is no point in joining the golf club just to conform, particularly at a time when there is no longer a firm flag to fly. Retirement may spawn other opportunities, but it always helps at least to knock on the door of opportunity.

The question is often unanswered by many partners until they have turned the key in the door and enjoyed that last drink at the farewell party. The message has to be to cultivate alternative interests now in order to appreciate that there is life beyond the firm, and not to postpone the choice until it is perhaps a very difficult one to make.

These issues are important from a personal perspective and each must be given the most careful consideration before making an announcement to the remaining partners.

The firm’s perspectives

Whilst the partnership agreement should deal with the relationship among the remaining partners and the mechanisms for making any appropriate payments to the retiring partner (a topic all of its own), there are other constituents each of which requires to be accommodated.

Clients. The firm requires to give tactful consideration to the arrangements for the retiring partner’s work, including clients, colleagues (what is to become of his support staff?) and intermediaries through whom the departing partner may have introduced much work, and to special arrangements such as the continuing flow of business through any appointments or particular personal or professional reputation of the retiring partner. Treatment of these stakeholders and the content and timing of what they are told, and when, is particularly important to minimise the disruption to the practice and create the best environment for a seamless change.

Capital. I have touched on this earlier, but a key consideration for the firm is that the capital paid out requires of course to be replenished for the ongoing financing of the firm, and that may mean additional burdens on younger partners at what is already a time of peak financial expenditure. Questions of additional borrowing or other investment may raise their head at this time.

Conversely, for the retiring partner, a healthy capital balance paid out over a period of two to three years can be a very attractive hybrid income stream before drawing down a pension, particularly when it is remembered that such payments come from funds on which income tax has already been met.

Goodwill. This is a chestnut and it is interesting in passing that many partnership agreements stipulate that goodwill will not be included in any revaluation – which of course begs the obvious question. Similarly goodwill more often than not is ignored in the financial statements. The answer is not that goodwill has no value, especially for a firm possessing a strong capital base and sustained profitability boasting a strong brand name (see dicta of Lord Milligan in Finlayson v Turnbull (No 1) 1997 SLT 613). Some contemporary examples confirm that multiples of profit can be achieved, and golden handshakes again appear in vogue.

In recent years significant sums have been paid for goodwill where a calculated assessment is taken that on acquisition of a business the client base will remain faithful, particularly where the firm name is retained and efforts are made to cultivate its existing connections and clientele, perhaps through consultant or other arrangements. Multiples of profit have been secured when account is taken of such off-balance-sheet issues as:

• the firm name;
• the client portfolio;
• location geographically;
• competition;
• quality of human resource;
• firm’s history;
• profile of work;
• reputational quality.

Work in progress. This is a very hot potato given the new accounting standards which mean that all partners’ time now requires to be included on a true and fair view. A retiring partner’s share of work in progress may now prove to be significant, depending on the practice of the firm and frequency with which, for example, interim fees are rendered – by which the sum truly representing work in progress can be significantly reduced but should of course work through to higher profits.

Debtors. This is another often neglected factor in considering the issues of a retirement, and the combined effect of those who pay late and a high level of work in progress can be substantial (even in smaller practices). The better practice is usually that work in progress and debtors are kept to an absolute minimum and this requires good fiscal husbandry long before the key turns in the door. Again thought ought to be given by the firm to other issues on the negative side, e.g. write-offs and crystallisation of long-term liabilities such as may arise under commercial leases.

The successors. What about the successors? This is another important chapter and identifies the issues to be addressed in finding the persons who will carry on the business.

• What are the tasks and objectives we are setting for the successors?
• What skills are required?
• What talents do we possess in the firm?
• Who will take on the mentoring role?
• Where do we find the talent if we are found wanting?

Some statistics which make all of these points more pertinent are that according to the figures to 31 October 2004, there are 3,500 principals in private practice, and of that number approximately one-third are aged above 50. The proverb “time and tide” turns to mind and for those who are contemplating retirement the year 2006 ought to be the one for decisive action.