The Management Services Organization (MSO) model has emerged as the leading vehicle for private investment in law firms. We have represented investors, law firms and strategic acquirers in their MSO investments, transactions and formation activities. In this article, we provide a high-level overview of the most common issues in structuring and negotiating MSO investments.

The MSO model involves the separation of legal work (and certain other assets) and services required to operate a law firm into separate legal entities. The services are provided through the MSO entity, allowing investors to gain exposure to legal services economics while complying with professional ethics rules that generally prohibit non-lawyer ownership of law firms.  

While this bifurcation may seem simple, the MSO model is complex and requires careful planning and thoughtful negotiation with law firm parties to ensure alignment post-closing.

1. High-Level Economics

• If not fee-sharing, then what? As a general rule, “fee-splitting” or “fee-sharing” by law firms with non-lawyer owned entities is prohibited under professional ethics rules. Investors cannot simply require a law firm to pay a defined percentage of its revenue to an MSO entity. Investors have spent significant time considering how to create a fee structure that is defensible under ethics rules but also provides synthetic exposure to the economics of operating a legal services provider. MSO fees are most often structured as “per lawyer” fees or “usage” fees, or a combination of the two. The economic structuring of these fees ranges from simple (one fee for all lawyers in a firm) to complex (fees vary based on practice area, seniority and usage of certain resources).  
• What can the MSO charge for? MSO fees need to be defensible in terms of the price charged for the service versus the value of the service provided. Examples of services that almost all MSO models include are accounting, billing, marketing support, intake and information technology. MSOs utilize economies of scale to lower the cost of services typically provided to law firms, such as legal research platforms, document processing, and certain software subscriptions. Many MSOs will employ non-lawyer support personnel who previously were employed by the subject law firm. Many MSOs will also employ paralegals through staffing agreements between law firms and the MSO. Despite the shift of services and some personnel to the MSO, legal work must be performed and controlled at the law firm level.
• What’s in it for the lawyers? In addition to the strategic advantages that an MSO can provide, discussed below, with respect to scale, capital investment and technological innovation, a successful MSO can provide increased cash flow to equity partners in participating law firms. In the most common structure, equity partners receive cash consideration and “rollover” equity in the MSO entity (or a holding company that owns the MSO) in exchange for the non-legal assets that are transferred to the MSO. In many structures, this consideration is a mix of cash at closing and purchase-price payments made over a period of time after closing. Most equity partners also receive equity in the MSO entity as part of the consideration for the non-legal assets. This model generates increased short-term cash flow for partners, with the expectation of increased compensation over time as the MSO model takes hold. Lawyers continue to receive compensation from the law firm after closing, although in many cases it is less than their pre-closing compensation. Of course, MSO performance is closely tied to the compensation that partners receive but most models prepared by sophisticated investors indicate lawyers will receive increased compensation over time.

2. Revenue Visibility and Practice Areas

• Durability of MSA Revenue Stream: The value of an MSO as a long-term investment or marketable asset rests almost entirely on the Management Services Agreement (MSA), which is the primary contractual agreement between the MSO and the law firm. MSAs are entered into simultaneously with the acquisition of a law firm’s non-legal assets. Emphasis is placed on structuring MSAs to incentivize lawyers to generate sufficient revenue to justify the MSO vehicle’s fees while not being so punitive as to dissuade lawyers from entering into these arrangements in the first place. Investors will also need to work carefully with ethics counsel to ensure that prohibitions on lawyer non-competes are not triggered by overly burdensome protections that can be interpreted as quasi-non-competes or restrictions on the practice of law. As noted above, law firm partners should be incentivized to generate sufficient legal fees to support the MSO's operations.
• Underlying Business Model: Law firms operate on different business models depending on their practice area focus. Personal injury (PI) law firms have been an early favorite of outside investors due to economic features of PI practices. These firms operate on a different economic model from law firms providing legal services to other businesses (B2B) based on a billable hour model. In structuring the MSO arrangement, significant deviations in material terms may exist between PI firms and B2B firms given the difference in revenue models. Even within the same verticals, we have seen MSO models vary significantly to address law firm concerns or economic nuances specific to certain firms and their business models. It is crucial that investors understand that there is no “one-size fits all” approach to MSO investments and the underlying economics in an MSA.
• Pricing Flexibility: The ongoing operation and expected revenue under an MSA are typically directly tied to the valuation an investor has applied to its acquisition. This relationship is complicated by the fact that law firms generate almost all of their revenue from third-party clients who are paying rates based on a market that is not connected to the fees charged under the MSA or, in the case of PI firms, to litigation outcomes or settlements. Significant deviations (up or down) in revenue from legal work can create challenges under the MSO model. The most successful MSOs have built in flexibility to provide tailored upward and downward adjustments to the rates charged to law firms for services or windfalls from favorable judgments in the case of PI firms. A common feature to address this variability, and to ensure lawyer salaries are paid by the law firm, is a 'deficit funding' provision. This allows the law firm to operate at a deficit to meet its salary obligations to lawyers while satisfying its fee obligations to the MSO. Other options include financing provided by the MSO to the law firm to cover its obligations under the MSA.

3. Exit Visibility

• Clear Path for Investors: Generation of cash flow is an attractive attribute of a successful MSO, but most private equity investors are focused on the prospects of an exit within three to five years after their initial investment. Sponsors are familiar with the challenge of keeping their management teams invested through the duration of their investment and into the next investor’s ownership. This challenge is central to a sponsor’s successful exit from an MSO. An investor’s path to exit is typically clearly defined and free from restriction in an MSO’s organizational document. The economic returns for investors are fairly straightforward and easy to model in a manner similar to other investments. Whether or not investors have a preferred return or “hurdle” that is paid to them before any sale proceeds are payable to rollover investors is a negotiated point and varies from structure to structure.  
• Partners on the Hamster Wheel: For law firms where partner relationships or skillsets are crucial to revenue generation, providing security to buyers that these partners will remain properly incentivized is crucial to capturing value in an exit for MSO investors. While buyers are likely to implement their own incentive mechanisms, most MSO investors prefer to create mechanisms to keep partners invested in the MSO following the investor’s exit to make the platform more attractive in a sale process. In our view, mechanisms to accomplish this are bespoke and proprietary but crucial to a successful investment.
• Incentives for Growth: MSO investors have taken different approaches to facilitating growth and equity investment from lawyers who are not equity holders at the time of investment or who should see their equity position in the MSO grow over time. Traditional sponsor tools like management incentive plans and change of control incentives are an option for MSOs. MSOs will also typically include a feature to allow for additional equity to be issued or transferred to lawyers who the firm and investors agree are important to include in the equity stack. Like the exit provisions, these issuance and transfer provisions are bespoke and depend on numerous factors, including the type of law firm involved, the age of key equity partners, and the 'stickiness' of firm client relationships.  

The Hunton Andrews Kurth Professional Services M&A group is active in the legal MSO space and advises investors, potential investors and law firms on the structuring and execution of MSO transactions. As discussed in this alert, the circumstances of every MSO transaction are unique and require careful consultation with counsel and advisors who have experience and expertise in MSO transactions.