In the last thirty years, many firms have substantially grown or developed on the back of the efforts of one or more highly driven entrepreneurial partners, some of whom are now approaching retirement. These partners have enjoyed income rewards but it is understandably hard for them to contemplate having to hand over their firm as a free gift to their successors. Some cling on to partnership into relatively old age, and others may have carved out a preferential founding partner’s bonus to reward them for their entrepreneurship. But memories are short and younger partners can quickly grow to resent the continuing present of perceived past-it old-timers or the continuation of a founder’s bonus scheme which they feel should have run its course a while ago.
This is not an easy issue and I cannot pretend to have a complete answer. What is clear is that there are many different ways in which these issues have been traditionally handled depending on the history of the firm, its size, its context and jurisdiction. A review of typical retirement and succession methodologies show that they have traditionally fallen into three basic types.

The three traditional basic methods are

1. “Naked-in-naked-out”. This methodology has become extremely popular in law firms in the West and particularly in Europe. Incoming partners provide a measure of fixed capital contribution (which may well bear interest) and get this (and no more) back when they retire from the partnership. The firm therefore is considered to have no assets and no value apart from the tangible assets in the balance sheet. Goodwill is written out of the accounts. Equity Partnership carries just the right to participate in profits and the risk of having to share losses. It is of course by its nature the least unattractive of models for the young incoming partner who does not have to face paying for any part of the value of the firm. This system sees the law firm as an income-producing vehicle alone. Under it, the older partner gains no value for his or her share of equity on retirement, and is expected to have provided for his her retirement out of income.
2. Annuity/Pension rights. A number of larger firms give partners (who have been with the firm a long time) the right to a pension or annuity when they retire. These arrangements were often brought about as a way of cutting out goodwill from the accounts of the firm. However, the duty to pay retired partners gets carried forward as an unfunded liability of the firm and is borne out of current income. Hence the existence of unfunded annuity/pension rights has caused a block to many a merger. In the recent demise of Dewey & LeBoeuf, apparently Dewey Ballantine at the time of the 2007 merger with LeBoeuf, owed close to $80 million to former partners for deferred compensation and pension obligations, according to sources familiar with the firm’s finances. It is a mystery why this obligation (which helped to cause the firm’s eventual collapse) was not uncovered – or maybe was ignored – at the due diligence phase.
3. Equity Valuation. In contrast to 2 above (which places the obligation to reward retiring partners upon the firm), the third method places the burden directly on the shoulders of continuing partners. Under this model, each partner holds shares in the firm and these get revalued any time a partner joins or leaves. Continuing partners then purchase shares on an individual basis from retiring partners. The methods of valuation vary and some are flawed in that they are often not aligned to modern methods of law firm valuations. For example, one method I have seen is for the shares to be valued on a fixed multiple of average profits over the last five years. Where a multiple of EBITDA is used as a method to value a firm, the multiple is not fixed and is applied to anticipated future earnings rather than past performance. The other problem with this methodology is that it provides fixed points of sale/purchase (ie entry and retirement of partners) rather than making it a matter of choice. I am however seeing an increase in the use of this methodology with the following adaptations
• The valuation being carried out on agreed methodology or formula aligned to current valuation techniques
• In some cases, partners not being obliged to sell their shares on retirement but being allowed to retain them in the hope of a stream of dividend income
• Share option schemes to allow participation below partner level
• Aggressive and acquisitive firms using their share-holdings as a currency with which to acquire other law firms, in the same way as other commercial organisations
• Where allowed, a currency is also created which could allow for external investment
The main headache with this system is that many law firms are proving to be worth little or nothing on a modern valuation basis. There are three main reasons for this. First, many firms,  particularly but not necessarilysmaller law firms are far from profitable – by the time partners have been paid a reasonable ‘draw’ there is simply no residual profit left over to provide the basis or foundation for a valuation.  Secondly, client relationship and the expectation or probability of future income is attached to individual partners rather than the firm. If such partners leave the firm, the effect on revenue can be substantial. Third, even in firms where the firm-specific capital is high, law firms revenues can tend to be episodic and it is hard to ‘prove’ or demonstrate the probability of a consistent and sustainable flow of free cash going forward. Hence law firms which have achieve a value (such as Slater & Gordon which became the world’s first floated law firm) often achieve success through being able to persuade investors that their volume and repetitive business lines gives confidence that they will continue to develop a consistent and reliable revenue profit line into the future. There is another issue here which is the affordability and attractiveness of an equity valuation system for incoming partners. According to one stockbroker assessment in the UK, magic circle firms could be worth £6.7bn if they went public – equivalent to £3.9m for each partner. If such a firm used this methodology, the only way an impoverished but able young lawyer could afford to purchase a shareholding is by substantial deferred compensation methods.

What is clearly important – in law firms which can demonstrate a value – is that these issues should be faced and decided as early as possible and this clearly will need some open and honest discussions amongst the partners – both those on the phase towards the retirement and younger partners. The difficult equation is to provide a structure which is fair to partners who have built the business, affordable to younger partners and not an obstacle for new partners joining.