Exit payments and anti-embarrassment provisions in partnerships and LLPs

Partnerships and limited liability partnerships (LLPs) have traditionally been the preserve of professional services businesses and have functioned in same way for generations. Of late, however, these professional services businesses, and in particular law firms, are starting to look like increasingly smart investments.

They’ve proved to be resilient to market disruptions, with law firms across the board seeing healthy and, in many cases, record-breaking, profit rises over the past year – where other sectors struggled during the pandemic and are facing a rocky road ahead with inflationary pressures.

Forward-looking investors in the non-traditional asset sector might be tempted to look again at these desirable businesses. Whilst private equity investment or listing is not without its challenges in perception and, as such, remains a relative rarity at present, those law firms that have taken the plunge have seen tidy sums in cash and share options paid to equity partners.

Aside from the headline-grabbing private equity and floatation activity in the legal sector, there is also a buoyant acquisition market. Partnerships and LLPs are appreciated as more than just ‘people’ businesses whose value depends upon its partners and members. The culmination of cultural changes in firms over many years have institutionalised the client base, giving it a tangible value.

Changes in laws firms

For example, restrictive covenants prevent partners and members from taking clients and key staff with them on exit. Garden leave facilitates the embedding of client relationships with other team members. Cross-departmental workstreams encourage a holistic services approach, and business ‘brands’ have in many cases become more important than the people within.

Furthermore, in recent times, firms have made significant investment in IT systems and automated ‘lawtech’ products. They may also have diversified, either within the firm or through a subsidiary business, into complementary business lines or joint venture arrangements.

The peculiarity of partnerships and LLPs is the short-termism inherent in a full profit-distribution model, and investment on a ‘capital in equals capital out’ basis. In effect, there’s no long-term investment in the business, as the ‘value’ is extracted throughout the individual’s period of participation in the business.

While this worked in the days of the traditional partnership lockstep, the new value model in a professional services firm has been turned on its head. Much of today’s law firm business is monetarised beyond the services performed by the individual partners. This is particularly the case in a highly commoditised practice, or firms which look to provide packages of services, such as in-house counsel function.

The long-term view

All of this leaves a savvy equity partner taking a longer-term view; considering how to extract value on an exit, other than on a sale of the business. Without any kind of synthetic goodwill entitlement, either on or after a partner or member’s retirement, issues around succession planning come to the fore.

Indeed, it may prove to be a key impediment to retirement for a senior partner, who has seen the value of the business accumulate significantly beyond partners’ capital value. Alternatively, it may be a disincentive for a junior partner, where the anticipated profit return over the partnership tenure may not reflect the investment in time and money in the business.

The sale: value extraction

In each case, these concerns are exaggerated where a business sale is in prospect: will a senior partner look to crystallise value before retirement by forcing through an accelerated sale? Will the junior partners decide to sell the business as soon as a senior partner has retired? In the world of limited companies, so-called anti-embarrassment clauses whereby recently exited shareholders participate in the proceeds of a sale, are commonplace in shareholder agreements. This is not so in partnership and LLP deeds.

Having agreed the concept of value extraction at or after retirement, the issue of how to do this is often complex and, to date, not a well-trodden path for partnerships and LLPs.

On the sale of a business, very few firms at present provide for any legal obligation to share capital gains with former employees who were partly responsible for that gain. Turning first to the anti-embarrassment provision, traditionally the retired partner would have a contractual entitlement to share in the value of the business, where the business is sold within, for example, three years of the retirement.

These clauses can become extremely lengthy once they come to contain tapering payment structures or conditional entitlements. Navigating the competing interests of the partners or members inevitably makes drafting these clauses somewhat tricky.

The second issue of a synthetic goodwill or exit payment on retirement from the firm cannot be so easily addressed by drawing on the corporate equivalent.

To optimise the capital gains tax for the retiring partner, the exit payment will need to qualify for Business Asset Disposal Relief – formerly Entrepreneurs Relief. Broadly speaking this is treated as a disposal of the retiring partner’s interest in the business to the other partners.

The difficulty with this approach is that, in the absence of capital reserves, the continuing partners’ capital interests are devaluated possibly to an unacceptable extent.

Particularly in fund management LLPs, a model where a retiring member’s interest ‘vests’ over a period of years is preferred. Often amounts payable under a vesting model will be based on an annual ‘goodwill’ valuation, subject to exit conditions – the so-called “good leaver/bad leaver” clauses – and are likely to be tapered.

There may also be a combination of vesting payments and anti-embarrassment clauses, under which outstanding vesting payments are crystallised on a sale. Often the complexity of these clauses is compounded by the fact that no amount is ascribed to the value of the goodwill of a partnership or LLP in the statutory accounts. Instead the post-retirement payments tend to be based on a pre-determined formula, often linked to profitability and other conditions.

The reticence of professional services businesses structured as partnerships and LLPs to share an uplift in value with its participants is somewhat anomalous, but perhaps not surprising as the industry is, at times, so resistant to change.

It is anticipated that as firms develop a more corporate ethos, and partners become alive to the value of their businesses, appropriate anti-embarrassment and exit payments will be commonplace in a well-drafted partnership and LLP deed.