Here’s why Q1 2021 could be an interesting time for legal software providers

Now that you’ve hopefully settled safely into the start of 2021, there’s a question I’d like you to think about:

How many legal software firms will change hands in the first quarter of this year?

Once upon a time, you couldn’t throw a stick without hitting an independent, owner-managed legal software firm. From the moment the first serious consolidator arrived in the early noughties, the industry exploded into activity, and the legal software marketplace was abundant with competition and opportunity. But that’s not the case any longer. The marketplace has significantly eroded, and the reasons for that aren’t hard to identify: either the owner or owners decided to retire, or they were made a Big-Ticket Day “offer they couldn’t refuse” (imagine I said that in my best Marlon Brando ‘Godfather’ accent) from another company that wanted to assimilate them into their brand. 

There have been around eight acquisitions in this space over the last twelve months, and approximately three or four of them were owner-managed. The last of those sales was almost dead-on the close of 2020.

Let’s do some math

If you’re the owner of a legal software company and you’re of a ‘certain age’, you’d probably want to get a multiplier of at least 10 x profit for your business, although 15 x profit is certainly not unheard of in this industry. 

Let’s say your business is valued at £5 million and you stormed through the 2010s feeling like the world is your oyster. You own 100 per cent of your business, and you’ve never sold a business before. With Entrepreneurial Tax Relief at 10 per cent you stand to walk away with £4.5 million, which is a nice little nest egg. 

Then, in March 2020, Chancellor Rishi Sunak announces that the Entrepreneurs’ Relief lifetime allowance is being scaled back from £10 million to £1 million. That’s because three-quarters of the relief only goes to 5,000 people, so Boris’s government has decided it’s “expensive, ineffective and unfair”, but they don’t want to discourage “genuine entrepreneurs” by removing it completely. 

(That’s nice of them.)

Still, don’t panic, because even though this dramatic slashing of the Entrepreneurs’ Relief stings, it’s not as bad for your fortunes as you might at first think. With Capital Gains Tax (CGT) at 20 per cent, you’ll get the first million at 10 per cent and then the next four million at 20 per cent, so you’ll still make £4.1 million on the deal. Not too bad at all.

But then the pandemic happens, shakes up the world and fractures the economic landscape. 

To try and keep the country afloat, the government goes into fire-fighting mode and starts haemorrhaging money as if it grows on everlasting trees.

Somebody needs to pay for that, but who and how?

Fast forward a few months, to November 11, 2020, to be exact, when the Office of Tax Simplification (OTS) publishes a report called ‘Capital Gains Tax Review: Simplifying by Design’. The report identifies a bunch of different ways in which Capital Gains Tax is ‘counter-intuitive’ and creates ‘odd incentives’ and the OTS suggests increasing CGT to 40% in order to put £14 billion a year back into the Exchequers’ coffers. 

What’s the impact on you, the independent legal software firm owner-manager who was initially looking at a shiny £5 million sale price before all of this started? Now, your nice little nest egg is a lot more cracked, because that £5 million is suddenly closer to £3.3 million, which is a drop of around 25 per cent. 

Did I say a drop? More like a plummet.

Food for thought

I wonder how many owner-managers of legal software companies have been thinking along these lines since the OTS published their paper in November?

I wonder how many acquisitions we’ll see before the end of the tax year in April?

I wonder how many law firms have signed up, or are about to sign up, with software providers that will change hands between now and the Spring Budget on Wednesday 3rd March? (although, in up-to-the-minute news, the Institute of Chartered Accountants in England and Wales (ICAEW) has just written to the Financial Secretary to the Treasury recommending that this budget isn’t the right time for tax changes.)

Just for the record, we won’t be one of them. We’re a long way off that ‘certain age’, and we’re having far too much fun doing what we love, so Insight Legal definitely isn’t for sale.

But it’s something to ponder on, isn’t it?