Law Firm Succession Planning – How Important is a Formal Appraisal Valuation of the Firm?

Question:

Our firm is an eight lawyer litigation firm in Portland, Oregon. We have three founding equity partners in their early sixties and late fifties, three non-equity partners, and two associates. Recently the equity partners began succession planning discussions among ourselves. Our preference would be an internal succession and transition to the younger non-equity partners in the firm. In our discussions we were discussing buy-in, buyouts, and valuation and one of my partners suggested obtaining a formal valuation. What are your thoughts regarding hiring a business appraisal firm to provide us with a formal appraisal/valuation of our firm?

Response:

While I don’t wish to downplay a formal valuation, they can be expensive and I find often not really used in the final outcome, especially when it involves selling partnership interests to others within the firm.

Most law and other professional practices sell (to outside parties) for a multiple of annual gross fee income. Often this is discounted (sweat equity discount) when assets or shares are sold to other attorneys within the firm. Generally, this rule-of-thumb method of valuing a law practice is used to value the practice. However, the eventual value of a law practice comes down to what an interested party is willing to pay. In the final analysis the value of the practice is what an outside buyer or an attorney working for the firm will pay for (or invest) the practice. The valuation process is simply a tool to use to help you begin discussions and get to this point.

Many law firms with multiple partners view the law firm simply as a compensation vehicle designed to put as much income as possible in the pockets of the partners. They do not see the firm as an investment vehicle nor do the partners expect unfunded buyouts when they retire or otherwise leave the firm. These firms try to fund retirements with 401k and other retirement vehicles so there is no unfunded buyout upon retirement. The goal of these firms is to be in a position to acquire and retain top lawyer talent. Often these firms simply require an initial capital contribution and return cash-based capital accounts and earnings to date upon withdrawal or retirement. Sometimes a founder benefit is provided for the original founder(s) of the firm as a reward for their sweat equity establishing the make and making the initial investments. Such founder benefits are often a percentage based on an average of a founder’s compensation over the past three years.

Value in a law practice is largely personal to the lawyer and that individual’s ability to attract and retain clients. The lawyer has knowledge, experience, skill, judgment, and reputation—all elements of professional goodwill – not institutional or firm goodwill. As long as clients primarily hire lawyers, as opposed to firms, this will remain a guiding principle in valuing law practices. This is not to say that some firms have not created a “brand identity” that is separate and distinct to the institution. And in larger practices, the servicing team (including other partners and other practice specialties) influence the client’s selection decisions. Those firms are rare.

Often when selling partnership interests to others in the firm affordability and terms plays a larger role than valuation.

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John W. Olmstead, MBA, Ph.D, CMC

Posted at 09:15 AM in Succession/Exit Strategies, Uncategorized

May 05, 2021

Law Firm Succession Planning – How Important is a Formal Appraisal Valuation of the Firm?

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