Do You Know How Much Your Law Firm is Worth?

May 21, 2012

Do you have partners in your practice who will be retiring within the next five to ten years?

If so, it’s time to start developing a transition plan for when the time comes.

Understanding how the value of your practice is determined can help you plan for a smooth transition as well as implement strategies to retain or increase your firm’s value.

The price actually paid for a law firm may differ from its value. This can be due to many factors. Since valuation and value concepts are derived from financial theory, it may have little to do with agreed-upon price.

The valuation approaches and methodologies for valuing a law practice are the same as for any other professional practice. These include asset-based market data and income approaches.

In the asset-based approach, value is based upon the cost to reproduce or replace the asset. Each asset of the law practice is valued separately and then aggregated. The liabilities and obligations of the practice are also aggregated and then subtracted from the total asset value to arrive at the net asset, or book value of the practice.

Goodwill is an intangible asset that the practice has developed over time based upon its reputation and the quality of the service provided. But goodwill is not considered part of the book value of the practice, and therefore the asset approach is lacking in this regard.

The market data approach is a comparative valuation model that relies on the use of financial data from either public or private sources. Unfortunately, there is not enough market data available for the legal industry to ensure that the information is reliable.

In the absence of sufficient market data, the fee or revenue multiplier approach is often used. However, as with the aforementioned goodwill argument, this approach may not be appropriate because it does not consider attributes that are unique and specific to the firm, such as the reputation and expertise of its partners.

Profitability, which is defined as the firm’s earnings after all expenses – including a reasonable compensation paid to its owners – measures both the goodwill reflected in its billing rates and operating efficiencies.

Therefore, an approach based on profitability, such as the income approach, is generally considered the most reliable method for valuing a law practice. This approach estimates value based on earnings or cash flows and produces a value for the firm as a whole, including tangible and intangible assets, less liabilities.

Partners should focus on a number of factors to retain or increase the value of their firm, including:

Reputation Is your firm reliant on the reputation of the retiring partners? If so, a transition plan is needed to ensure that younger partners are developing relationships with key clients and gaining experience in their area of expertise.

Expertise Is most of the intellectual capital of your firm with retiring partners? This can be an issue if your firm has a mandatory retirement age.

Firms should reconsider this policy and allow partners to work longer or part-time. Implementing formal transition, mentoring, management and leadership training, as well as recruiting programs, is important. Compensation and incentive plans encouraging retiring partners to transition their book of business are also good options.

Practice Areas Is your firm a collection of silo practice areas? A team approach to servicing client needs may be the solution so clients become comfortable dealing with other professionals at your firm.

Clients Are there consistent, significant write-offs each year on certain client accounts? Retention of this type of client should be examined.

Profitability Can the firm sustain into the future? A review of the financial statements with the firm’s CPA should include an examination of the profit margins, realization, projected cash flow and overhead expenses. Additionally, an analysis of the fee structure and the revenue flow may be warranted. The firm must be in a good financial position to buy out equity partners at retirement without affecting the ongoing operations of the practice.

Some other factors to consider include the competition, your location, quality of the work product, workflow, efficiencies, lease terms and the condition of the office space. An evaluation of the overall strength of the firm and its ability to generate earnings will ultimately maximize the firm’s value. Additionally, ample time to implement strategies to transition management responsibilities and clients will ensure the best possible value.