Alternative Business Structures: The Next-Generation Law Firm

Alternative Business Structures
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The legal profession is considered a risk-averse field. However, the term “risk-averse” has been misinterpreted. For example, investing in a portfolio of bonds with a nominal 1.5% annual rate of return may appear as a risk-averse investment until inflation is accounted for at 3% per annum. In this current legal environment, risk aversion and comfort are not mutually exclusive. The legal profession needs to adapt to a different environment that is comfortable yet abates risk.  This imbalance in the risk/reward profile of law firms is naturally incubating inefficiencies. However, alternative business structures (ABSs) can provide the appropriate medium for transition. Given that Rule 5.4 still prohibits non-lawyer partnerships, what options do law firms have today to better integrate with capital markets?

Litigation financing is one option.

It pairs well with the transfer of risk and liberating cash flow, but it prioritizes a portfolio of cases. Law firms may inadvertently act as a special purpose vehicle and introduce settlement derivatives that serve third-party funders who may be more interested in controlling the case itself. Therefore, greater attention is paid to a portfolio of cases that could expose firms to undue infractions on a variety of professional standards if the relationship is improperly managed.

The New York Law Journal published an article on some of the issues resulting from third-party lenders. Litigation funding certainly plays an important role in the industry, yet it fails to address several issues faced by law firms. Businesses may need further remodeling to draw more attention to the company’s long-term vision.

Spin-Off Back-Office Operations.

A hitherto untested theory would be to spin-off the back-office operations of a law firm and allow investors to acquire the spun-off entity. In this approach, all the aspects of marketing and human resources, potentially the paralegals, will fall under the new entity. Selling a percentage of the subsidiary would realign interest for both the parties from a short-term to a long-term perspective.

This approach will prove a more effective and objective strategy in terms of the firm’s operations. Maintaining shared interests and synchronizing them post-acquisition is crucial to a successful partnership between non-lawyers and lawyers.

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A planned time frame for achieving the objectives at the beginning of a negotiation can avoid future surprises. The relationship would get rather complicated if the new non-lawyer partners believe it is better to sell the business in the next seven years, while management wants to expand organically to new domestic and international regions or acquire a business that could boost market share.

This change in capital structure would create an experimental setting because the subsidiary is no longer considered a legal practice. The new entity would render the same services as before to the parent company, and the non-lawyer partners are compensated through management fees based on assets under management (AUM). This would theoretically allow the new entity to raise capital as needed.

This clearly raises regulatory risks for any law firm that decides to test this theory, but it also reduces unsystematic risks over time. The subsidiary has the option to acquire parallel businesses that operate in other fields such as accounting and investment advisory services. Additionally, the fractured state of the current legal market, combined with ABS, offers a de-risked entry point for a roll-up strategy, which could lead to more liquidity as desired by investors and prospective retiring partners.

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Furthermore, evaluating an employee stock ownership program in the subsidiary could temper staff turnover. Collectively, this concept would appropriately rebalance the risks endured by law firms today and facilitate a vision to which investors can subscribe.

For better understanding of the method, a pilot program should be run in jurisdictions such as Washington D.C. or California. California is presently contemplating amendment to Rule 5.4 after an analytical review was outsourced to Professor William Henderson from Indiana University Maurer School of Law.

Law firms could collaborate with state bars and seek approval for their proposed funding plans. Law firms would benefit from building appropriate relationships for raising future capital. This would appear as a campaign rather than an average client acquisition marketing strategy. This would be a challenging task because the legal profession currently has no financial counterpart to work with. The industry will have to create a market for itself, which appears daunting. U.S. law firms may attract more interest from foreign private equity firms and law firms initially, creating a small base that the community can use to grow exponentially over time.

Putting it in Context

Lawyers may consider this a new reformative wave in the legal industry, yet none of these concepts is new or revolutionary.

The Kutak commission of 1977 proposed a change to Model Code 5.4. Although it was rejected, some lawyers had felt the need for a change in the manner in which the legal profession interacts with free markets. Opponents of ABS should stop pretending there are no available tools to manage conflict of interests, fiduciary responsibilities, and protection of client confidentiality.

In the present day, some public corporations manage some of the most classified information available on behalf of the Pentagon (e.g., Lockheed Martin), and they have several types of investors owning their stock.

For future reference, what should remain abundantly clear throughout these discussions is that the practice of law will not change, even though its business environment will change.

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