Law Firm Succession/Exit Strategies: Valuation of the Firm

How Much Is Your Firm Worth

By John W. Olmstead, MBA Ph.D CMC

Succession/exit planning is a highly personal process. There is no off-the-shelf solution that is right for everyone. An effective process involves a using a methodical, logical and rational approach. Most law firm owners or partners spend more time planning a family vacation than on planning their succession/exit from their law firms.

A succession/exit plan is a comprehensive roadmap to successfully exit a law firm. It asks and answers all the business, personal, financial, legal and tax questions involved in exiting a firm. Typical phases consist of:

Phase I – Objectives/Internal Review
Phase II – Valuation/Analysis
Phase III – Strategies & Plans
Phase IV – Implementation

One you have determined your succession/exit goals and objectives a valuation of your firm should be conducted. This will give you a feel for the value of your practice.

A comprehensive valuation is one of the cornerstones of the succession/exit planning process. Without a good idea of what your firm is worth, it is impossible to make informed succession/exit planning decisions. Without a valuation you will not be able to plan for retirement, do comprehensive tax planning, formulate a good estate plan or understand the full extent of various exit options. A business valuation impacts virtually every component of the succession/exit planning process, including:

Retirement

How much will the transfer of ownership shares provide for retirement?

Estate Planning/Tax

Impact upon estate planning. How much estate tax exposure is attributable to the firm?

Life Insurance

Is life insurance adequate given the value of the firm?

Buy-Sell/Shareholder/Partnership Agreements

What value should be included in buy-sell agreements for transfers and buyouts? Will a valuation formula work? Should the agreement call for a formal independent valuation?

Financial

How much loan collateral might be available? How much is the firm worth in a sale, merger, or internal transfer?

You cannot begin to formulate a succession/exit plan without a baseline valuation.

Getting the Valuation Process Started

Unless you have a financial background and experience in law firm valuations you will need help from an outside source. Professionals that can assist with valuations include:

Law firm management consultants
Exit planning professionals
Certified public accountants
Commercial appraisal firms
Attorneys

Select a professional to work with that has experience with valuing law firms similar to yours and has extensive experience with law firms.

Once you have selected a professional to work with – collect and provide the following information to your advisor:

Headcount and census data for the past five years.
Financial statements for the past five years
Income tax returns for the past five years
Attorney compensation data for the past five years
Documents outlining/illustrating long term commitments

– Pension obligations
– Loans payable
– Leases (building lease)
– Other commitments

Copy of last malpractice insurance application
Copies of the following Reports

– Accounts Receivable Report
– Contingency fee case inventory pipeline report of projections
– Summary Work In Progress Report
– Timekeeper Productivity Report
– Cash Receipt Fee Allocation Report
– Area of Practice Productivity Report
– Cash Requirements report from report showing unpaid payables and other
liabilities
– A copy of the firm budget

Documents explaining the present partner and associate compensation system, bonuses, production of partners for the past 5 years; etc.
Documents related to succession plans of the firm
Partnership Agreement, Buy-Sell Agreement, etc.
Strategic or Business Plans
Marketing Plan

Determining Value

There is no one “right answer” when valuing a law practice. There are different types of valuations performed by different advisors for different reasons. Valuations can be extensive or ballpark estimates. If you are planning on transferring your ownership interests now (within a year or two), it’s a good idea to get more than a ballpark idea of value. However, if you are three to five years away from transferring your ownership interests, a ballpark estimate should suffice for planning purposes. You should update this ballpark estimate annually.

While law firm owners and partners would like a simple “plug and play” approach to establishing a value for their firms, such an approach does not exist in the real world. There are too many variables that come into play. However, the following four valuation approaches/methods are standard practice and an understanding of these approaches can help you understand the process:

Valuation Approaches/Methods

Asset-Based Valuation

The asset-based valuation method is based on the premise that the value of the firm is best determined by adding the value of all the firm’s assets and subtracting the liabilities, leaving the net value of its assets. An asset-based valuation is further segmented into five approaches:

Book value
Replacement cost
Appraised value
Liquidation value
Market value

Since most law firms maintain the financial records on a cash-based method of accounting, their cash-based financials are adjusted to accrual-based financials for valuation purposes since the largest assets of a law firm are typically accounts receivable and work in progress. Asset-based valuation methods ignore the importance of a firm’s earnings and cash-flow. For this reason, this valuation approach generally is not used to determine the market value of a firm.

Rule of Thumb

The rule-of-thumb approach is simple and direct. Multiply one year’s gross revenue by a factor of x. The result will be the stream of income’s value.

We usually suggest that you average the firm’s gross fee revenue over the past five years to even out any peculiar ups or downs in the revenue stream. Then multiply this average year’s gross fee revenue by a given factor. The factor varies with the industry and even with geographic location. Accounting firms, for example, are valued at 1.0 to 1.5 times (100 to 150 percent) annual gross fee receipts. A well established standard is still in its infancy in law firms. Some argue that the multiplier for the rule-of-thumb method for law practices should be between 0.5 to 3.0. However, based upon what we have seen in recent sales of law practices, the multiplier for the rule-of-thumb method for law practices is ranging between 0.6 to 1.0 (60%-100%) of annual year’s gross fee revenue. Another way to look at it would be 1.2 to 2.0 (120% to 200%) times net income. (Based upon partnership method of accounting and not including owner’s compensation as an expense) Whether the multiplier is in the lower or higher level of the range depends on the following:

How much repeat business is expected
The nature of the law practice
The number of clients
The transferability of client relationships
Dependency on only a few large clients
Whether the firm has been “institutionalized” or is a personal practice and uniquely the owner.

If there is a great deal of repeat business and client loyalty can be transferred, the multiplier will be higher. In the sale of a law practice, a portion of the clients and referral sources will not stay with the practice, by reason of the close personal relationships usually developed. This factor must be considered when determining the multiplier. If the firm is dependent on a few large clients the multiplier will be lower.

Comparable Firm Transactions

This method involves researching what other law firms similar to your firm are being sold for in the marketplace and then applying that data to your valuation. Since law firms are privately held access to this sort of information is difficult to obtain. Therefore, this method of valuation is of limited value. However, even if limited information is available such information can be used to supplement other method(s) being used to value your firm.

Discounted Cash Flow

Valuation experts often consider this a superior method of valuation since it is based on projected future financial performance of the firm, rather than historical financial performance. This method used estimates of a firm’s future cash flows and the expected rate of return a buyer would reasonably expect on those cash flows.

Typically combinations of two or more valuation methods are used when valuing a law practice and there are pros and cons of each method.

Is There Goodwill

There is currently a lot of discussion on the question of whether there is goodwill that has value in a law firm and whether law firms are even marketable. The short answer is – it depends. Clients of law firms often advise us – “we hire the lawyer – not the firm.” If this is the case – will these clients stay with the firm if the lawyer with whom they have the relationship is no longer with the firm? Law firm management consultants typically refer to the following types of law firm goodwill:

Personal or Professional Goodwill
Practice Goodwill

Personal goodwill is the value associated with an individual lawyer in your firm and practice goodwill is the value associated with the firm as an entity or organization that goes beyond the reputation of the individual attorney(s). Personal goodwill ceases when you are no longer with the firm – practice goodwill continues after you are no longer there.

Practice goodwill is what future partners or buyers are interested in and which impacts value. Unfortunately, many law firms have a lot of personal goodwill and little practice goodwill. These firms need to be finding ways to institutionalize their firms to enhance practice goodwill and incorporate these strategies into their succession/exit plans.

The Bottom Line

In the final analysis the value of the practice is what your partners will agree to or what an outside buyer will pay for the practice. The valuation process is simply a tool to use to help you get to this point.

Dr. John W. Olmstead, MBA, Ph.D., CMC, is a Certified Management Consultant and the president of Olmstead & Associates, Legal Management Consultants, based in St. Louis, Missouri. The firm helps law and other professional service firms improve the operations and management of their practices and the lives of their practitioners. The firm, founded in 1984 serves clients across the Globe assisting them with implementing change and improving operational and financial performance, management, leadership, client development and marketing.

Dr. Olmstead’s assignments have covered the spectrum of management issues. However, in recent years most of his time is focused on engagements helping firms with: Partner Compensation, Governance, Succession/Exit Planning, Strategy & Competitive Business Models, Profit Improvement programs, Client Service Programs

Dr. Olmstead is the Editor-in-Chief of “The Lawyers Competitive Edge: The Journal of Law Office Economics and Management,” published by Thomson West. He is currently serving as Past Chair, Illinois State Bar Association Standing Committee on Law Office Management and Economics and as a member of the Legal Marketing Association (LMA) Research Committee. Dr. Olmstead may be contacted via e-mail at jolmstead@olmsteadassoc.com. Additional articles and information is available at the firm’s web site: www.olmsteadassoc.com