Mastering Due Diligence in Law Firm M&A

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Mastering Due Diligence in Law Firm M&A, Guest article from Harry Winkley, lead solicitor for SME law firm M&A at Herrington Carmichael. Harry has worked on a number of our deals, and feedback on his services from clients is always very positive. Harry’s LinkedIn profile is here: https://www.linkedin.com/in/harry-winkley-1478871b4/

While any M&A transaction involves a range of legal and commercial considerations, the acquisition or sale of a law firm brings with it a distinct set of regulatory and structural complexities. Whether you are an existing partner considering retirement or a buyer looking to grow through acquisition, it is essential to understand these sector-specific issues and to factor them into both your pre-transaction planning and your legal due diligence investigation.

Legal Due Diligence

Legal due diligence is the exercise undertaken by a prospective buyer to verify and validate the underlying legal “value” of a business. Across most sectors, this will involve a typical suite of risk areas, such as corporate history, employment, litigation, property and key contracts, among others. However, when buying or selling a law firm, there are a number of additional areas that the parties should build in a focus to.

Why is due diligence important for both parties?

For buyers the purpose is simply, legal due diligence ensures that a buyer enters into a transaction fully aware of any hidden risks / liabilities and works to validate the underlying value of a business. Importantly, if a risk area is not investigated, the long-established principle of buyer beware will usually apply. A robust due diligence exercise is therefore as much about protecting value as it is about identifying deal-breakers.

For sellers, if unknown risks or inadequacies are identified the due diligence process can be time-consuming and often can result in reductions in price, delays and/or increased risk under the purchase contract. For that reason, it is crucial for sellers to understand the “key” risk areas relating to their business pre-sale, so that you can identify and resolve any potential issues before the buyer’s solicitor does. In our experience, this almost certainly leads to sellers receiving a higher value for their business, as the price isn’t chipped away at during legal due diligence!

Unique considerations when acquiring a law firm:

Below are some of the areas that commonly require enhanced focus in M&A transactions in the legal sector:

(a) Professional indemnity insurance (PII)

PII is a critical area of due diligence in any law firm acquisition. Because of the regulatory framework governing legal services, any gaps in cover or historic non‑compliance can create serious ongoing liabilities for a buyer as well as practical challenges for the seller. Particularly for a share purchase where existing PI cover is to be maintained:

• Buyers will want to understand the scope of the current policy including any exclusions.
• It is also important to confirm that the firm has only undertaken work within the scope of its cover, as any uninsured work may create exposure.
• A review of the adequacy of cover should include the level of insurance, excesses, endorsements, and whether the firm has maintained continuous qualifying insurance in line with SRA requirements.

Whether a share purchase or an asset purchase, buyers should assess the firm’s claims and notifications history, as this provides insight into both the firm’s risk culture and any potential future liabilities.

Finally, the buyer should consider how the transaction structure interacts with run‑off and successor practice rules. If run‑off cover is to be purchased, the cost and responsibility for funding it must be understood early. Alternatively, if the buyer intends to become a successor practice, it must ensure that it is comfortable inheriting that exposure as part of the agreed deal structure and liaise with its insurer as required.

(b) Regulatory Compliance / Successor Practice Status

Regulatory compliance is a uniquely sensitive area in law firm M&A because it is important to understand whether the buyer will be treated as a successor practice for PII purposes. If so, it will inherit responsibility for historic advice and related claims exposure that would otherwise remain with the seller. To manage this, targeted file reviews can help assess:

• the quality and accuracy of advice provided
• compliance with SRA requirements
• adherence to AML obligations

This helps identify any issues early and allows the parties to agree appropriate protections in the purchase agreement if required. Buyers should also review the firm’s client engagement documentation. This includes checking that the firm’s key client‑care and regulatory information is presented clearly and meets SRA expectations. Any inconsistencies or outdated templates can create regulatory risk and may also affect the enforceability of fees. Sellers who proactively update their client care suite before going to market can reduce the scope of buyer queries and strengthen their position. Alongside this, any past or ongoing SRA investigations, disciplinary matters or compliance breaches should be fully disclosed. Whilst from a regulatory perspective these do not themselves transfer to the buyer under successor practice rules, they may crystallise into civil claims (which could transfer to the buyer as explained above), and in any event they can indicate underlying compliance concerns that both parties will need to address in the transaction.

(c) Work In Progress / Debtors:

For law firms, unbilled work in progress (WIP) often represents a significant unrealised asset. Sellers will typically expect to receive credit for WIP as part of the transaction with a mechanism included within the purchase contract for its reconciliation. It is important that a buyer analyses the target firms’ WIP (and 90-day WIP) to understand the systems and policies in place. From a financial perspective, this will help ensure that the Buyer does not overprovide for WIP, but it will also work to identify wider operational risks associated within the business. For example, the procedures for client WIP approval, cash-flow / transaction cycles and fee-earner recovery rates. This analysis goes hand in hand with debtors. Buyers will want to understand how the target firm manages debtors. Debtor information is also useful to understanding the behaviours of long-term clients when it comes to paying invoices. This becomes especially relevant where the buyer expects to take on live matters post-completion as it informs:

• client attitudes to money on account; and
• the likelihood that further time incurred will ultimately be paid.

(d) Key Contracts:

Beyond standard supplier arrangements (IT, software, case-management systems etc), law firms often have more bespoke contracts and arrangements that are fundamental to the continuity of the business. For example, are there lender panels, accreditations or framework appointments in place that must be retained following the acquisition? If so, what consents or notifications are required? Similarly, where a firm’s work is materially relationship-driven, buyers will want to understand the arrangements governing any key referrers or introducers. Ensuring continuity of those relationships and understanding any change of control implications (formal or informal) can be critical the future perfor