MSOs for Law Firms: Succession Planning, Valuation, and Private Capital with Michael Di Gennaro

Melissa Shanahan: The attorney still owns the law firm. What changes is who runs the back office. I think I thought that private equity is rolling firms up and it becomes one firm, and that the identities aren't separate. The identities become one. Clearly, I'm very wrong about that.

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Melissa: Hi, everyone. A quick note before we dive into today's episode.

This is not my first conversation with Michael. We've had some really great conversations in the past, and I highly recommend you go listen to those. Check those out. He's he offers up a lot of education on a very important topic, I think, for listeners.

When we entered into this conversation, the idea was just all MSO conversation. I wanted to learn. I wanted to help you guys learn about MSOs, the way that they're evolving in the space, and why should you care about that? 

But naturally, as we got into it, lots of conversations about MSOs, but lots of conversations just generally about the value of your firm, whether buying or selling and really how to how to think about those things. So it was a little more all over the place than I had intended, but I think it's a really important conversation for education purposes and to expose yourself as much as possible to learning about these things, whether here on this podcast or otherwise.

So hopefully, you can stay with us as we navigate and kind of go in and out and maybe in circles, it might seem. But it was a great conversation. He's a great guy to talk to, a great guy to learn from, and I'm excited to bring you more of these episodes in the future. All right. Enjoy.

Today is all things MSO. I actually did a little research. An MSO is essentially a separate company that handles everything except the actual practice of law: marketing, technology, HR, billing, facilities, intake systems. The law firm keeps full control over legal decisions while the MSO runs the business side under a contract called Management Services Agreement.

Michael Di Gennaro: Yes.

Melissa: The attorney still owns the law firm. What changes is who runs the back office. I don't think I totally got that. I think I thought that private equity is rolling firms up and it becomes one firm, and that the identities aren't separate. The identities become one. Clearly, I'm very wrong about that. Is that correct? I think I just thought it was a company rolling up firms, an MSO that rolls up firms, and they become the firm. 

Michael: Yeah, not saying it's not correct. It dives into something without giving context or color for what an MSO is. It's been traditionally used in other regulated service industry businesses: accounting and dental and vet, et cetera.

The reason why regulated industries and why it works so well is because there are restrictions in the legal services industry. There are restrictions on lawyers sharing profits of the law firm with non-lawyers in all but a handful of states under certain conditions, alternative business structures out of Arizona or Utah. Some other states are looking at that model to determine whether it's right. The Commonwealth of Puerto Rico has that model as well.

My personal opinion is that model is really good for some things and not necessarily good for others, predominantly because the way they structure deals, or way deals are structured, are frequently in fee-sharing arrangements if you're looking to do a multi-jurisdictional roll-up. And by that I mean state jurisdictions. 

Some states have a more negative view of sharing profits with non-lawyer-owned law firm entities than others do. So it's not just a panacea that allows you to buy law firms all over the country.

Where the ABS and the MSO differ is the MSO is a more tried and true model that private equity has been using for some time in certain regulated service industry businesses, and what it does is keeps that wall of separation.

And so in a law firm acquisition, that's exactly correct. There's not a direct profit share between the MSO and the law firm in its portfolio, but it's a vendor-type relationship between the two of them because these private equity members or private capital is in there, and they may not have an operator that is a lawyer.

What they do is they take all of the assets of the law firm. Those are placed into the MSO, and then what's left is a law firm that has the lawyers, and the lawyers making decisions. All of the assets are at least back under the master services agreement to the law firm on a monthly basis. It's almost like a lease. That doesn't capture profit, but there are formulas that you can use to make it still somewhat approximate profit without tripping ethical guidelines.

And again, I am a lawyer, but I do not practice, and this is not legal advice.

Melissa: I'd be interested if you have examples or if you have experience dealing with MSO acquisition. 

Michael: Yeah, I call it an MSO-style acquisition, right? An MSO is the vehicle by which the acquisition is going to be done. The reason why it's the vehicle of choice is because it is more conducive to multi-jurisdictional roll-up than in the ABS. I have clients' ethics opinions from lawyers in over 30 jurisdictions in hand-blessing the MSO arrangement as something that's legally compliant with ethics rules.

The other take is there's always a power element in this. It's going to be very interesting to see because there is pushback now from various bars in various states, California and Illinois being the two most prominent. Unless a bar exists to strictly be a protectionist entity to preserve the salaries and lifestyle and all of the great things that lawyers have. So barriers to entry, prohibiting entrance into the state. It's okay if you're a lawyer, you've been practicing, but if you don't sit for a whole new bar exam, you're not going to be practicing law in that state.

You know, I'm a quite jaded, sardonic person, as you know, despite the smiles, which are predominantly for your audience. And you, of course. You deserve all smiles.

One might view state bars as putting up these walls not to protect the consumer, but to protect their members from competition. I really feel that that's going to be scrutinized very heavily if significant challenges are mounted to this by the state bar.

Melissa: Yeah. 

Michael: Also, my belief that the state bars are fully aware that this is going on in their backyard and that they're just not saying anything about it because they know that if they challenge it legally, they are going to be crushed. This is the way MSOs came about in other industries as well, dental, et cetera. You start inhibiting competition. FTC will step in and prevent that, hopefully. I'm a member of the New York State Bar. I think the state bars do a wonderful job for their members and the public and clients and all.

What I would really like, instead of legal battles and legal challenges, is some sort of understanding or agreement as to when an MSO model could potentially be very beneficial both to the lawyers and to the consumers of legal services. And I think there's a strong argument for both of them.

We're in a weird time where social justice advocates and private equity are hand in hand supporting the charge of this, simply because it's an access to justice issue, right? We can infuse resources and technology and bring the cost of legal services down, make them more accessible to the public, then more people will be served by the justice system and by law firms. And that is a big deal.

There's a lot of concern within the state bars themselves about legal deserts. And legal deserts are effectively, if you're in a rural area and there's one law firm there, the partner is senior and decides they want to retire, now you have to go to the big city to get your legal services. And the big city lawyers charge a lot more than the little rural lawyer does. Many folks are simply priced out of the justice system.

And so this is one avenue for that in terms of protecting or providing broader access to justice. If a law firm could roll into a larger MSO project that has a lot of infrastructure, in my opinion, that's a lot better than evaporating. Now your staff and your attorneys need to find new jobs, and there could be a scramble for that, which may mean moving and relocation. Hopefully, you can direct them to alternative legal services, but in a lot of times, again, in rural areas, you can't. What I see this as is a more orderly progression to exit, with causing the minimal amount of disruption to clients and employees of the law firm.

There's an additional benefit to this as well, and there's a lot of advocacy by the state bars themselves for succession planning. I think primarily because they are concerned about what happens to those clients if there's no succession plan in place. 

Well, the MSO can be a brilliant succession plan. Let's say you're an attorney. You haven't formed your succession plan. You haven't decided whether you're going to do an internal sale of equity or some other type of internal arrangement, or you're going to merge with another law firm as your exit strategy, or have some other type of external sale. Hopefully, the ones that we specialize in, which is true sale of a law firm, cash down, and purchase price adjustment

But let's say you don't have that, and all of a sudden, you're hit by a truck. And we've had this situation, not hit by a truck, but passing for another reason. Now your family has a clock ticking, presuming that none of them are lawyers. And there's a fuse and sale of practice rules under the state bar for how long they have to dispose of that law firm.

And I think, as I've mentioned on a lot of your other episodes, a lot of what is being sold in a true sale of a law firm is the goodwill and client base of that law firm. That also takes time. So sale is predicated upon the seller staying in place, not necessarily to practice law, but to make sure there's an orderly transfer of the clients and goodwill to the new owner, hence the benefit of the bar transaction, if you will.

That plan's not in place. There's nothing orderly about it. You come to me as a as one of those family members and say, "Help me sell my law firm." I know where the auction is to sell office furniture and telephones, but that's really what I'm going to get you for your law firm. It's extreme, but in some instances, it's spot on. Depends on the type of law firm, of course, and the difficulty of goodwill transfer. But yeah, this gets around it because if you can hold MSO equity, if you're a non-lawyer, and hence the family members that we talked about were non-lawyers.

And so maybe that ticking fuse, maybe there are transferability rights in the MSO equity that that lawyer held previously, and maybe the family members will have to liquidate that equity eventually back to the capital that's holding the MSO or other MSO members. It can be done in a much more orderly fashion where you're not fire selling the law firm. And I believe Tom Lenfestey of Law Practice Exchange wrote an article that was featured in Bloomberg: MSOs as an effective succession planning tool.

That last point is actually the most valuable for your clients. MSOs aren't the titans of Wall Street as a vehicle. 

Melissa: That's what it seems like. I've heard you on previous episodes talk about a sale for $50 million MSO-style acquisition of a firm. Is this a thing for small firms? Should they even consider this? 

Michael: I think the purchase price was in the thirties earlier today on another $30 million deal, which I hope will knock on wood close next week.

Melissa: Okay. So it was a $50 million annual revenue. The sale was for $30 million. I know this is outside of what most of the folks listening to this will be dealing with.

So I'm wondering, in that deal specifically, if you can recall and if it feels okay to share, what was the multiple? Because it would be multiple of EBITA, not the revenue. So what was the multiple? 

Michael: My recollection serves me, I think the multiple was somewhat over four and somewhat sub five on the… I think the reason why it's been nudging up is because while private capital thought they're just going to throw money at these firms and they'd be snatched up like that, the law firm deals are a lot more complex.

And you're dealing with a relationship-based deal. The sellers are going to be involved with you. This is not, hey, we value your law firm for $30-something million. Here's a bunch of cash, gold, silver, bearer bonds, whatever. And I'll bring this suitcase out and hand it to you over the table, and you give me the keys and parties walk away. No, you're going to be in bed with this person for years after the transaction. And so, given that relationship-based nature, these deals are a lot more complicated.

I think right now, there's probably about 20 players in the space that have successfully pulled off law firm acquisitions of this type, the higher value law firm acquisitions, because there's a lot of variables that they need, not just money. They need one, good client-facing ability.

And I can tell you, dealing with private equity, I've seen a lot of people that start telling a lawyer how smart they are and talking down to the lawyer because they're 26 and graduated from insert Ivy League college of your choice, whatever. And that's great. That's nice. That's cute, actually. That's precious. You blow up an $80 million deal because you're acting like an ass. The lawyer doesn't want to work with you ever again, or who you represent. You're so smart that you just blew up an $80 million deal.

Melissa: Ego and youth. 

Michael: I get it. I think it's exciting, but at the same time, there's a lot of value in wisdom and how to chat with clients and how to make them feel excited about working with you.

In a lot of these deals, I would say most of these deals, it's not about how much assets you have under management. It's not about the US News and World Report ranking of the undergraduate and business school that you went to, and it's not about the size of your genitalia.

Quite honestly, what it's really about is tell me who your operator is. I want to see your operator. That's what the seller wants to see. Who's spearheading this project? I really want to know that. They successfully started and exited businesses. What's their background? Are they a lawyer? Do they have counsel of lawyers in the space? Is there a law firm or a legal services company that's an investor in the project that can give you guidance on how to operate and manage law firms? That they'll be involved in the direct operation and management of the law firms, but they're going to be handling all the business functions, and they need to understand the business to a degree. 

When you show up with a really competent operator that can wow the client, the seller, that's when I know that your project will succeed. And the multiples change because the Q of E on the buy side and the Q of E on the sell side don't line up, and there's all sorts of battles over price.

At the end of the day, deals get worked out when there's a trusted operator involved in the deal alongside a capital partner that's reasonable, not behaving like a shark necessarily, to extract the most amount of monetary benefit from the deal as possible.

So yeah, this is what I've seen in the space in terms of a deal. When lawyers are involved, there's definitely ego, but I also see him with private equity involved, there's also a lot of ego, and that doesn't make for deal success. 

Melissa: I was thinking about this last night, actually, thinking about us talking today about ego and how it's involved and fear. There's almost this facade, and I'm thinking from my side, the people that I work with, I think that it would be natural for people to puff up and have a bit of armor because they want to protect. They feel they should get. They aren't as educated as what they could be. So there's a protective mechanism going on that doesn't help anything.

Humbleness will get you the most out of the deal. But I think people are afraid to not be whatever the version of a shark is in that kind of a deal. You know what I mean? Because they really believe there's a chance they'd get taken for something, the deal wouldn't be as great for them.

Which, again, I guess just goes back to you need the right partners around you. You can't do that on your own, and you shouldn't. You shouldn't think that all the things you're trying to protect, you need a team to do that for you, not you putting up a front. It's so easy to do. And even thinking of the 26-year-old Ivy League grad who is insecure, maybe arrogant, is coming across arrogant, whatever. It's probably trying to get a big deal done for his company and just all the fronting that happens.

I hope that if all listeners could just take away from that that you have to be humble, and you have to be willing to learn, and you have to invest in having the right partners around you. There's no reason for you to act as if.

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