Before You Sign the LOI: What Law Firm Owners Need To Know About Selling To Private Equity

Private equity’s growing interest in the legal industry has created opportunities for law firm owners to realize value from businesses they have spent years, or even decades, building. Through management services organization (“MSO”) transactions, law firm owners may be able to obtain substantial liquidity while continuing to practice law and potentially participating in the future growth of the business; however, these transactions are complicated, and the process of negotiating a sale involves considerably more than agreeing on a purchase price.

One of the most important stages of that process occurs before the parties even begin negotiating the definitive transaction documents: the letter of intent (“LOI”). A LOI is generally a preliminary agreement outlining the principal terms of a proposed transaction. In most private equity transactions, the buyer and seller will negotiate and execute an LOI before the buyer begins its formal due diligence process and the parties begin preparing the definitive transaction documents. Although most of the economic and structural provisions in an LOI are expressly nonbinding, that does not mean they are unimportant. In fact, some of the most consequential negotiations in a private equity transaction take place before the LOI is signed.

For law firm owners considering selling to private equity, understanding the importance of the LOI and the terms that should be negotiated before signing can have a significant impact on the ultimate outcome of the transaction.

Why the LOI Matters More Than Many Sellers Realize

A common misconception among sellers is that because an LOI is generally nonbinding, its terms can easily be renegotiated later. Technically, that may be true for provisions expressly designated as nonbinding. Practically, however, it is often much more difficult. Once the parties sign an LOI, the buyer, relying on the fact that the parties are in general agreement about the overall economics and terms of the transaction, will begin spending substantial time and money on due diligence, legal documentation, financial analysis, and transaction planning. Consequently, when a seller attempts to renegotiate an important term in the LOI after signing, the buyer will likely resist on the grounds that the issue was already agreed upon.

More importantly, the seller’s negotiating leverage changes the second you sign the LOI. Before signing an LOI, a seller may have multiple interested investors, the ability to continue discussions with other potential buyers, and considerable flexibility regarding the structure of the transaction. After signing, the seller will almost certainly be subject to an exclusivity provision that prohibits discussions with competing buyers for a specific period of time after signing the LOI (often for up to six months and sometimes longer). As such, sellers should thoughtfully negotiate the LOI and engage experienced counsel before signing it rather than treating it as a preliminary formality.

1. Purchase Price: Understanding What the Buyer Is Actually Offering

Naturally, the first thing most law firm owners focus on when receiving an LOI is the purchase price. Suppose a private equity investor offers to acquire the business assets associated with a law firm for $30 million. For an owner who has spent decades building the practice, that may be an attractive number; however, the seller needs to understand precisely what the $30 million represents.

Is it the enterprise value of the business, or is it the amount the seller will actually receive?

Will the purchase price be reduced by outstanding debt?

Will the seller be required to leave a specified amount of working capital in the business?

Are transaction expenses deducted from the purchase price?

Does the offer include rollover equity or contingent consideration?

These questions matter because a $30 million valuation does not necessarily mean the seller will receive $30 million at closing.

For example, assume an LOI provides for a $30 million enterprise value, but the transaction also involves:

• $3 million of outstanding indebtedness;
• $1 million of seller transaction expenses;
• $6 million of rollover equity; and
• $2 million of contingent consideration.

Depending on the transaction structure and other adjustments, the seller will likely receive substantially less than $30 million in cash at closing. In the example above, in most transaction structures, the seller would only receive $18 million at closing. That does not mean it is a bad deal, but the seller should understand these economics before agreeing to the LOI.

Ideally, the LOI should identify the enterprise value, anticipated cash consideration, rollover amount, contingent consideration, and material purchase price adjustments. Leaving these issues unresolved creates opportunities for disagreements later in the process.

2. Rollover Equity: Not All Equity Is Created Equal

Many private equity transactions require the seller to reinvest a portion of the transaction proceeds into the buyer’s post-closing ownership structure. This is commonly referred to as rollover equity. For example, an investor may offer $30 million in total consideration, consisting of $20 million in cash and $10 million in rollover equity. The rollover allows the seller to participate in the potential appreciation of the business following the transaction.

If the investor successfully grows the platform and eventually sells it at a higher valuation, the seller’s rollover equity may become substantially more valuable; however, rollover equity also creates significant risks, and sellers should not assume that all equity interests are economically equivalent. One of the most important issues is the class of equity the seller will receive. Private equity investors frequently use complex ownership structures that include multiple classes of equity with different distribution rights, liquidation preferences, and governance provisions.

For example, the investor may hold preferred equity that entitles it to receive its invested capital and a preferred return before common equity holders receive any distributions. If the seller receives common equity, the investor’s preferred return may significantly affect the value of the seller’s interest in a future sale. Similarly, the seller’s equity may be subject to dilution, transfer restrictions, mandatory repurchase rights, or other limitations.

Consider a hypothetical transaction where the seller receives $10 million in rollover equity. The seller may reasonably assume that the equity represents $10 million of value; however, if the investor’s equity has priority distribution rights or the seller’s equity is subject to unfavorable repurchase provisions, the economic value of that interest may be materially different.

What Sellers Should Do: Before signing the LOI, sellers should understand the proposed rollover structure, including the class of equity being issued, the investor’s liquidation preferences, anticipated governance rights, and any material restrictions on the seller’s ownership interest. While the complete operating agreement will not be available at the LOI stage, the principal economic terms can and should be addressed.

3. Earnouts: When Part of the Purchase Price Depends on Future Performance

Another common feature of private equity transactions is an earnout. An earnout provides that a portion of the purchase price will be paid after closing if the business achieves specified performance targets.

For example, a buyer may offer $25 million at closing plus an additional $5 million if the business achieves certain EBITDA targets during the following two years. Earnouts can help bridge disagreements regarding valuation. A seller may believe the business is worth $30 million based on anticipated growth, while the buyer may be willing to pay only $25 million based on historical performance. An earnout allows the seller to receive additional consideration if the anticipated growth materializes; however, earnouts can also create significant disputes.

The most important issue is often control. Following closing, the seller may no longer control all of the decisions affecting the financial performance of the business.

For example, the investor or MSO may have authority over certain marketing expenditures, administrative hiring, technology investments, or other non-legal business operations. If the investor reduces marketing expenditures or allocates additional corporate overhead to the business, the resulting reduction in EBITDA could affect the seller’s ability to achieve the earnout. Similarly, the buyer may seek to calculate EBITDA using accounting methodologies that differ from those historically used by the seller or differ from how the buyer calculated EBITDA to value the business during the LOI process. These issues become even more complicated in legal MSO transactions because the law firm must retain professional independence, and the management company’s authority must be appropriately limited.

What Sellers Should Do: The LOI should identify the principal earnout metrics, measurement periods, and anticipated calculation methodology. Sellers should also consider whether they will have sufficient operational protections to prevent the buyer from taking actions that unfairly reduce the earnout. The precise protections will depend on the transaction and must be consistent with applicable professional responsibility rules.

4. Employment Terms: What Happens to the Owner After Closing?

Unlike many traditional business acquisitions, legal MSO transactions frequently contemplate that the selling attorney will continue practicing law after closing. For many owners, this is part of the attraction. They may be able to obtain liquidity while continuing to practice, maintaining client relationships, and participating in the future growth of the business; however, the seller’s post-closing employment or professional services arrangements can have a substantial impact on the overall transaction.

Important issues include:

• annual compensation;
• bonus opportunities;
• expected working hours;
• management responsibilities;
• duration of the employment arrangement;
• termination rights;
• retirement rights; and
• the consequences of termination on rollover equity.

Consider a seller who receives $20 million in cash and $10 million in rollover equity but agrees to remain employed for five years.

What happens if the seller wants to retire after three years?

What happens if the seller becomes disabled?

What happens if the relationship with the investor deteriorates?

Can the seller’s equity be repurchased at a discount?

These are not minor issues. A provision that might be enforceable in the sale of an ordinary business may be impermissible in a transaction involving a law practice.

What Sellers Should Do: The LOI should establish the principal terms of the seller’s anticipated post-closing role, including compensation, duration, termination rights, and the relationship between continued employment and rollover equity.

5. Governance and Control: Who Makes the Decisions After Closing?

For many law firm owners, selling to private equity involves more than a financial decision. It also involves a change in how the business is operated. Before the transaction, the owner may have complete authority over hiring, compensation, marketing, staffing, expansion, and other operational decisions, but following the transaction, certain non-legal business functions will likely be managed by the MSO. The seller should understand how that relationship will work.

For example:

Who controls the marketing budget?

Who decides whether to open additional offices?

Who approves major capital expenditures?

Who determines compensation for administrative personnel?

Who controls the technology systems?

Who decides whether to acquire or affiliate with another firm?

These questions become particularly important when the seller is expected to continue operating the law firm. At the same time, legal MSO transactions must preserve the professional independence of attorneys and comply with restrictions on non-lawyer control over legal services. The parties, therefore, need to distinguish between permissible management of non-legal business operations and decisions that must remain under the authority of the law firm and its attorneys.

What Sellers Should Do: The LOI should establish the parties’ general expectations regarding post-closing governance, the seller’s continued management responsibilities, and the allocation of authority between the law firm and MSO.

6. Exclusivity: The Provision That Can Change Everything

Perhaps the most important provision in an LOI from a negotiating leverage perspective is exclusivity. An exclusivity provision generally prohibits the seller from soliciting, negotiating, or entering into a transaction with another potential buyer for a specified period. Unlike most of the economic provisions in an LOI, exclusivity provisions are commonly binding.

From the buyer’s perspective, exclusivity is understandable. The investor does not want to spend substantial time and money conducting due diligence and preparing transaction documents while the seller continues negotiating with competing investors; however, exclusivity can significantly affect the seller’s negotiating position.

Before signing an LOI, the seller may be able to create competition among multiple interested buyers. After signing, that competition effectively disappears for the duration of the exclusivity period. This becomes particularly problematic if the buyer subsequently attempts to renegotiate the purchase price or other material terms.

For example, suppose a seller receives an LOI offering $30 million and agrees to six months of exclusivity. During due diligence, the buyer identifies certain issues and reduces its offer to $25 million. The seller may disagree with the reduction, but the seller is now prohibited from negotiating with other buyers for a pretty significant period of time.

What Sellers Should Do: Sellers should carefully negotiate the exclusivity period and consider limiting extensions, requiring the buyer to meet specified diligence milestones, and preserving appropriate termination rights if the buyer materially changes the proposed transaction. A seller should also be cautious about granting exclusivity before the parties have agreed on the principal economic and structural terms.

7. Transaction Structure: What Is Actually Being Sold?

Legal MSO transactions present another issue that is less common in traditional private equity acquisitions: the parties must determine precisely what the investor is acquiring. In most states, professional responsibility rules prohibit non-lawyers from owning law firms or sharing legal fees. Consequently, an investor generally cannot simply purchase the equity of a law firm in the same manner as it might acquire an ordinary business.

Instead, the transaction may involve the acquisition of certain non-legal assets, the formation or acquisition of an MSO, and the establishment of a management services relationship between the MSO and the law firm. The details matter.

For example, the parties must determine which assets will be owned by the MSO and which must remain with the law firm. They must also address the treatment of employees, intellectual property, technology, contracts, real estate, and other business assets. Additionally, the management services agreement must establish a legally permissible compensation arrangement that complies with applicable professional responsibility rules, and these structural considerations can affect the economics of the transaction.

What Sellers Should Do: The principal transaction structure should be evaluated before the LOI is signed. Sellers should understand what assets are being transferred, what they will continue to own, and how the proposed MSO arrangement is expected to operate.

8. Due Diligence: Avoid Giving the Buyer an Opportunity to Retrade the Deal

Once the LOI is signed, the buyer will begin a detailed due diligence process. This process may include financial, operational, legal, regulatory, employment, and tax diligence. The buyer may review financial statements, tax returns, compensation arrangements, referral relationships, litigation history, case management systems, and other information. In legal MSO transactions, the diligence process may also involve professional responsibility considerations, including confidentiality, conflicts, attorney independence, and the allocation of functions between the law firm and MSO.

One of the most significant risks for sellers is that the buyer will identify issues during diligence and use them as a basis to reduce the purchase price or demand additional protections. This is sometimes referred to as retrading the deal. Not every purchase price adjustment following diligence is unreasonable. A buyer may legitimately discover financial or legal issues that materially affect the value of the business; however, sellers can reduce the risk of unexpected adjustments by preparing before going to market.

For example, a seller should understand its adjusted EBITDA, identify significant legal and operational issues, review material contracts, and evaluate potential regulatory concerns before entering into an LOI. The more prepared the seller is, the fewer surprises the buyer is likely to encounter.

What Sellers Should Do: Consider conducting a preliminary sell-side diligence review before signing an LOI. This allows the seller to identify and address potential issues while it still has negotiating leverage.

9. The Importance of Retaining Counsel Before Signing the LOI

Many law firm owners understand that they will need legal representation to negotiate the definitive purchase agreement and other transaction documents; however, too many wait until after signing the LOI to engage transaction counsel, and that can be a costly mistake. By the time the LOI is signed, the seller may have already agreed to the principal economic terms, granted exclusivity, and established expectations regarding the structure of the transaction. Although the definitive agreements remain to be negotiated, the seller may have lost the opportunity to negotiate certain terms from a position of maximum leverage.

Experienced sell-side counsel can help identify issues that may not be obvious from the face of the LOI. For example, an offer of $30 million may appear straightforward, but the economic value of that offer can change substantially depending on the treatment of working capital, rollover equity, earnouts, indemnification obligations, and post-closing employment arrangements. Counsel can also help evaluate whether the proposed MSO structure is feasible under applicable professional responsibility rules before the parties invest significant resources pursuing the transaction.

Importantly, this does not mean every provision of the definitive transaction documents must be negotiated during the LOI stage. That would defeat much of the purpose of the LOI. Rather, the objective should be to identify and resolve the issues most likely to affect the seller’s economics, negotiating leverage, and willingness to proceed with the transaction.

What Sellers Should Do: For law firm owners considering a private equity transaction, reaching out to legal counsel before signing the LOI can help avoid problems that may be difficult or impossible to resolve later.

The Bottom Line

The growing interest in legal MSOs is creating opportunities for law firm owners to obtain liquidity from businesses they have spent years building; however, successfully navigating a private equity transaction requires more than agreeing on a valuation. The structure of the consideration, working capital adjustments, rollover equity, earnouts, employment terms, governance rights, and exclusivity provisions can all materially affect the value of the transaction to the seller. Although many of these terms may technically remain nonbinding until the definitive agreements are executed, the seller’s ability to negotiate them changes significantly after signing the LOI.

For law firm owners considering selling to private equity, the most important takeaway is simple:

Do not treat the LOI as a formality.

The LOI establishes the framework for the transaction, shapes the parties’ expectations, and often determines which issues will be difficult to renegotiate later. A seller who understands these issues and negotiates them before granting exclusivity will generally be in a stronger position than one who waits until the definitive agreements are being prepared.

The best time to protect your interests in a private equity transaction is before you sign the LOI—not after.