HBS Prep | Finance: Slater & Gordon — What kind of capital growth needs

Unit 3, Professor Martin Sinozich, Finance: Creating the First Public Law Firm: The IPO of Slater & Gordon Limited.

A law firm can carry its clients' costs up front and only get paid once the case succeeds. But when it wants to offer that service to more people, who bears the cost of waiting?

Slater & Gordon's IPO plan brought something rather inconspicuous in professional services out onto the table — time needs capital too.

Here goes — enjoy:

Case Summary

In 2007, an Australian law firm was preparing to become the world's first publicly listed law firm. Slater & Gordon, or S&G, was founded in Melbourne in 1935 and started out handling workers' compensation claims for unions and working people. By the time of the case, it had nearly 400 staff, more than 140 lawyers, and 21 offices across six states. Decades of serving individuals had given it a brand, a referral network and around 30,000 phone inquiries a year.

Personal injury litigation contributed about three-quarters of its core revenue. The key promise of this business:

“No Win—No Fee”

If the case doesn't succeed, there's no legal fee. Clients thereby get legal services they might otherwise not have been able to afford; the firm, for its part, has to screen cases, advance disbursements, and bear the risk of not getting paid. A typical case in the study lasts 6–24 months, with a typical fee of around A$15,000. The success rate on personal injury cases taken on recently was about 95%, but that rests on past screening and execution capability.

Book revenue and cash collection move on different timetables. Based on work progress, expected fees and the probability of winning, the firm recognizes part of the revenue before a case ends, creating a work-in-progress asset, WIP. In one successful case in the exhibits, the firm spends A$4,250 in each of the first three periods and only receives A$17,250 in the fourth, including reimbursement of advanced costs. The final pre-tax profit is A$4,500, after A$12,750 had been advanced along the way.

S&G wanted to bring this capability to a bigger platform. Since 2002 the firm had consolidated eight smaller firms; the four acquired in the most recent year cost a combined A$9.3 million and were expected to contribute more than A$8 million in revenue in FY2008. Small firms faced increasingly complex legal and administrative requirements, while a consolidator had the chance to share brand, client acquisition, systems and professional resources. The catch: on top of the purchase price, new cases have to be funded on an ongoing basis.

The existing shareholders' ability and willingness to put in more money were limited, debt financing was constrained by cash flow and collateral requirements, and the business changes proposed by private equity investors were not accepted. Regulatory changes in Australia at the time opened the door to outside ownership. S&G planned to issue shares at A$1 each for a total deal size of A$35 million, of which about A$17.3 million would go to existing shareholders selling shares, A$2.3 million to issuance costs, and the remaining roughly A$15.4 million to reducing net debt. Listing would free up financing capacity, but it wouldn't turn the entire proceeds into new cash for the company.

Facing this deal, the case's fund manager, Gloria Rosen, has to answer three questions:

Between a historical success rate of about 95% and a long collection cycle, how much value does this business model actually create?
Can acquisitions and an IPO let professional capability be replicated sustainably, while upholding the duty to the court and putting clients first?
Discounted at an 11% cost of capital, what is this company worth, and is A$1 per share worth buying into?

My Thinking

The profit is recognized, but the cash may still be on its way

S&G's business combines legal services, case selection and funding advances. Clients hand part of the fee risk to the firm; the firm uses its judgment to decide which cases to take, and then uses capital to fund the wait.

The A$4,500 pre-tax profit on a successful case can't be treated directly as value created today. Using the single-case model from the course materials, with six-month periods and an 11% discount rate, a case certain to succeed has an NPV of about A$1,408; using 95% as the model's success probability, and handling losing-case losses and taxes as the model does, the expected NPV is about A$890. If each period is stretched to nine months, the NPV of a successful case drops to about A$701.

As time passes, the profit on the books doesn't disappear, but the price anyone is willing to pay for it today changes.

My own take is that with businesses like this, you have to ask three questions together: do the cases have economic value, is revenue recognition reliable, and when will the cash come back? Growing volume amplifies all three at once. Faster growth can also mean a deeper funding gap.

The value of acquisitions comes from how they're run afterward

A brand can bring in cases, unified systems can cut duplicated work, and more cases can diversify some single-case risk. Professional resources can be shared too, giving previously independent small teams better support. These are all places where consolidation can create value.

But buying a law firm with revenue isn't the same as buying free growth. The buyer pays the purchase price and also takes on the working-capital needs of the new business; lawyers leaving, local client relationships drifting away, or a drop in case quality during integration can all erode the expected returns.

The base-case model in the course materials assumes A$10 million a year in acquisitions in 2009–2011, at 1.2 times the acquired revenue. When I set future acquisition spending to zero and kept everything else the same, enterprise value fell from about A$151.0 million to about A$144.2 million. In the model, this set of future acquisitions creates incremental value of about A$6.83 million.

The model supports the consolidation strategy, but it doesn't give it unlimited margin for error. As scale grows, good targets may get pricier and management distance may lengthen. Every deal still has to answer: after paying the price, are the operating improvements left over enough to cover the capital invested?

The case for listing has to rest on the funding cycle

S&G's need for financing has a clear business basis: it needs to pay for acquisitions, and it needs to carry the time between putting money into cases and getting it back. Equity capital has no fixed maturity or repayment requirement, and public shares can also provide employee incentives, liquidity for shareholders and currency for future deals.

The corresponding costs are just as concrete: issuance and ongoing disclosure costs, dilution of existing shareholders, the market's demands for short-term results, and more management attention diverted to capital markets. Equity also requires a return; its cost doesn't vanish just because there's no interest bill.

To back a company's IPO, you first need a clear view of what the money is for. Of this IPO's A$35 million deal size, nearly half goes to existing shareholders selling shares. Giving long-term shareholders liquidity is reasonable in itself, but investors can't count the entire amount as a cash reserve for future growth.

According to the course model, free cash flow for 2009–2011 totals about negative A$21.64 million. Reducing net debt frees up some financing room, but further growth still needs a workable funding plan. For an entrepreneurial company, deliberately slowing growth should stay on the menu too. The financing approach has to support the company's operating rhythm.

The boundaries of professional judgment must be written down before the capital arrives

When law firm clients buy services, they often struggle to judge professional quality independently, and they also have to hand over sensitive information and trust the lawyer's judgment. So conflicts arise between shareholders' pursuit of returns and professional duties, and these need to be explicitly dealt with.

In the case, S&G wrote the order of priority into its offering arrangements: duty to the court comes first, then duty to clients, and then the company's other obligations and shareholders' interests. This was the arrangement in the case at the time, and it can't be directly extrapolated into a rule for every country and every professional services firm.

The capital structure can change, but responsibility for professional judgment must not become blurred. If whether to take a case, when to settle and whether to keep investing are all driven by short-term profit metrics, what shareholders end up buying may be eroded client trust.

My own leaning is to support, conditionally and where the rules permit, public ownership of professional services firms. The conditions include professionals retaining the necessary judgment, a board that can handle conflicts of interest, disclosure that lets investors understand business quality, and incentives that don't look only at short-term revenue. Accounting firms also face their own constraints, such as audit independence, and can't simply copy the law firm's answer.

Using the professor's specified 11% WACC and the course model's base-case assumptions, enterprise value is about A$151.0 million. Subtracting post-issue net debt of about A$5.4 million gives equity value of about A$145.6 million; divided by about 107.78 million shares, that's about A$1.35 per share.

The number is attractive, but it also has obvious dependencies: the present value of the terminal value accounts for about 83% of enterprise value. The model uses a 24% EBIT margin, whereas the case's historical margin in 2006 was about 17.8%, and the 2008 forecast only reaches about 24.2%. Future efficiency gains have to be delivered by operations.

Holding everything else constant, if the margin falls to 20%, the per-share value is about A$0.96. If organic growth also drops to 5%, the margin to 22%, and the acquisition multiple rises to 1.5 times, the per-share value is about A$0.90. An offer price below the base-case valuation doesn't eliminate operating downside.

If I put myself at the IPO decision point in the case, my in-class choice is: participate conditionally, and in a small way. The conditions are confirming the quality of WIP, the ability to finance the expansion period, and the priority of professional duties in actual governance. The price I accept is that the headroom shown by the base-case valuation could be eaten up by changes in margins, collection times or acquisition costs.

Takeaways for Arcus42

Reading this case, I thought about how professional services handle the relationship between growth, cash and trust. What can be borrowed here are a few operating principles.

First, look at delivery, revenue recognition and cash collection separately.

Each answers a different question. Growth planning has to look not only at what has been done for clients, but also at when the investment happens and when the money comes back, leaving enough slack for the wait.

Second, distill service standards into reusable capabilities.

As scale grows, what can be shared is process, knowledge and quality management. Professional judgment still needs clear ownership, and more clients or more revenue can't substitute for evidence of delivery quality.

Third, match the time demands of capital to the service cycle.

Long-term relationships require continuous investment. When choosing a financing approach or a growth rate, put the time by which capital expects a return on the same sheet as the time it takes the service to actually create value.

Fourth, settle the order of decision-making before conflicts of interest arise.

When client interests, professional responsibility and business goals meet, an organization needs to know who decides, on what basis, and how it's documented. The clearer the boundaries, the more a partnership can rest on expectations everyone understands.

In Closing

Before class, my vote goes to this line: the capital growth needs must be able to wait until value turns into cash.

This piece is based on the HBS case Creating the First Public Law Firm: The IPO of Slater & Gordon Limited (Benjamin C. Esty, E. Scott Mayfield) and the accompanying Slater Preclass Worksheet. The case character Gloria Rosen and her fund company are fictional, created for teaching. The valuations in this piece are classroom estimates made from the standpoint of the 2007 IPO decision using the course assumptions, and do not draw on post-listing outcomes; the single-case calculation follows the tax timing in the course DCF table. The views expressed are personal learning reflections and do not constitute a current securities trading recommendation or legal, tax or investment advice.