Law Firm Valuation 101
When it comes to valuing a law firm, understanding the purpose of the valuation is key to determining the appropriate method to use. In many respects, a law firm is just another type of business. But, there are specific factors that go into fair representation of a law firm’s true value. Law firms are different in a few key areas. First, law firms aren’t selling widgets. They’re selling professional services that result from the personal expertise of the attorneys providing them. That injects a level of subjectivity into the value determination not always present in other kinds of businesses.
In addition, each law firm has its own collection of assets, intellectual property, business practices, and liabilities. No two law firms are really exactly the same, no matter how similar they may appear to be. Looking to replicate another law firm’s results, a sole practitioner’s methods , or a specific partner’s past result can be a mistake. Each law firm’s brand of legal services has to be adequately addressed to appropriately assess its value.
There are a few circumstances which drive the need for law firm valuations. Mergers and acquisitions are the most common forms of law firm valuation. When a law firm is merging with another, there’s an extensive process of determining the appropriate share of the new law firm each predecessor firm should get. When a law firm is looking to acquire a group of attorneys, a similar process will be undertaken to determine how much contribution the new group will bring to the whole.
Without question, another critical area in which law firm valuations are conducted is at the time of a partner buyout. This is often determined through partnership agreements (and, yes, these agreements should be addressed with this situation in mind). Ongoing issues can occur when these agreements don’t adequately address how the partners’ shares are to be valued at the time of the buyout (whether that buyout is voluntary or involuntary, such as is often the case with retired or deceased partners).
Factors that Impact the Valuation of a Law Firm
The valuation of a law firm can be influenced by a number of factors, including legal services, industry or practice areas and geographic locations. When it comes to determining the value of law firms, the most influential factors can be broadly classified as follows:
Practice areas: Different practice areas within the law have different values. While this seems counterintuitive, it’s often based on the length of time it takes to realize a return on investment. For example, transactional and established, corporate practices tend to have higher values due to the time factor in their revenue generation.
Geographic Location: Some locations have more demand for their services and more room for growth. This is good news for firms in higher demand areas, which may see a greater valuation when everything else is equal.
Staff Efficiency and Productivity: Most insiders will tell you that how a firm is run will affect its value. Staff productivity and efficiency also play a role in this, as does the compensation structure and staff culture.
Intellectual Property: An intangible asset that represents a wealth of information, intellectual property has real value that can directly impact the bottom line in a positive way. For example, if you’ve spent years developing database, information and processes to improve the delivery of specific services, that ip has quantifiable value. With the right valuation, this intangibility could be one of your most valuable assets.
Brand Value: Surprisingly, brand value isn’t always an attribute of firms with the best reputation or track record. Some studies have shown that brand value may not even be highly regarded by clients. This means that while it’s not an easily quantifiable value, it can positively or negatively affect your value depending on your brand saturation and reputation.
Common Methods for Valuing Law Firms
There are several different methods used to value a law firm.
Asset-based approach
The asset-based approach, as the name suggests, is focused on the valuation of the assets of the firm. In this approach, the assets of the firm — excluding liabilities — are identified and assigned a value. A common method of assigning a value to an asset is to apply an industry multiple, which can be based on historical values from both the subject firm and other firms in the industry. Once the value of all assets is determined, they are aggregated with any associated tax carryforwards and net of liabilities to determine the value of the firm. For many firms, this approach may seem quite infeasible, as the assets of a firm are limited largely to its WIP, receivables and trust funds. One common criticism of this approach is that a firm is often made to appear as having no goodwill because the most common assets of a firm are its people and their skills and reputation, which are added to the firm largely through their work product. Since a firm must establish its goodwill in order to have the systems and people who are able to generate the revenue previously earned, an asset-based approach may devalue a firm. Despite its shortcomings, an asset-based approach has its place in valuing a firm, and it is frequently used to determine factors such as the value of partnership interests and assets left to surviving spouses.
Income approach
The income approach, unlike the asset-based approach, focuses on the income of the firm and specifically the earnings of the firm. This generally involves determining some measure of the normalized earnings of the firm and applying a multiple to these earnings in order to determine the value of the firm. The rationale behind this approach is that the value of a law firm is actually based on its ability to generate revenue over a period of time, and is really not a function of its assets. There are several problems with this approach. One major problem is that law firms can be very inconsistent in their revenue generation. In particular, a large number of firms will have one or two "rock stars" whose revenue greatly exceeds that of the other lawyers in the firm. If these rock stars were to leave, the value of the firm would be significantly diminished. This can make the relatively low value of earnings for the firm a somewhat misleading data point. A second problem is that this approach does not adequately account for the external effects on the firm and may not reflect its true value under certain circumstances. It is often used in the context of valuing partners’ interests in a firm, but must be used with caution.
Market comparison approach
Similar to the market approach used in many business sales, a market comparison approach will look to compare the subject firm with other comparable firms. This can be done by either directly comparing firms using key metrics, or by comparing firms which have either been sold or listed for sale. The metrics used in this type of approach can include revenue per partner, profit per partner, or revenue per timekeeper. In this way, the analyst can apply techniques similar to the market approach to valuing the firm, and can assign a value based similar metrics. While not exactly the same as a market approach, the market comparison approach is perhaps the most reliable of the three approaches as it allows the analyst to compare the firm to other similar firms that have actually transacted in the market. However, because of the often significant variations in the characteristics of the firms being compared when using the direct comparison approach, the data may not be as reliable as a market approach. If the subject firm is similar to the firms on which the data are based, the use of this approach can be quite effective.
The Influence of Financial Statements on Law Firm Valuation
Financial statements are at the core of a law firm’s valuation. They provide the data that will be used to make the determination. In the case of solo and small law firms, taxation may not be as large of a consideration since the owners are typically partners in the firm. The net income is taxable to the partner the same way that it would be for a C corporation similar to the net income earned by a sole proprietor. However, this does not mean that the S corporation or C corporation status is not important since it impacts future taxes to the owners and a potential buyer.
Gross revenue from a firm or client group is one of the most important metrics in determining how a law firm is valued. Gross revenue is an important management and revenue forecasting tool that is helpful for a number of reasons. Firms with newer clients can use this metric to forecast for the future and measure productivity. For more established firms, revenue generated can be used to determine profitability and shareholder value.
Expenses are analyzed knowing that valid adjustments can be made when the value of allowances like group health insurance and retirement plans are considered. Any consultants that are necessary for the firm should be disclosed. There are also provisions in place for the valuation of goodwill under GAAP. For the purposes of valuation, an analysis should be performed to determine if all goodwill has been deployed within the 5 years leading up to the date of the valuation.
Depreciation and amortization are two other areas where adjustments may be made during a valuation. There may also be a need to adjust earnings for non-operating items, losses, gains, assets acquired and liabilities assumed on line of credit notes and loans. To the extent that it adds value to the business, deferred income and accumulated other comprehensive income are taken into consideration.
Intangible Assets and Future Income in Law Firm Valuation
Adjustment for Intangibles and Future Earnings
The value of a law firm goes beyond tangible data, such as the number of partners, associates, staff and hours of billable work they do. A law firm can have substantial intangible assets and multiple ways of achieving future profits. For example, a firm with a niche practice in an area that has little competition is a lot more valuable than a firm with general practice that competes with many others.
The single most important intangible asset, though, is goodwill. Goodwill in this context refers to two factors:
A law firm’s goodwill can be evaluated by the firm’s history of financial performance. Take a look at their annual revenues and profits over a period of five or more years. Is the trend ascending or descending? If it is a down trend, does the firm have a plan to reverse it? A firm that has positive trends and can clearly articulate its plan for future success is worth a lot more than a firm that has been losing business.
A firm’s client list is another consideration for future earnings. A firm with a long history of quality clients that are locked in for a predetermined amount of time , such as via retainer agreements, will be more valuable than a firm that relies on volatile annual contracts. It’s also important to look at purchases made by their clients. Are these purchases likely to recur? If so, their clients are committed to the firm for a longer period and thus provide a more solid base for future earnings.
Another consideration of intangible assets is awareness of the laws and regulations that are relevant to their clients. A firm that keeps their clients up-to-date with the latest laws and regulations, and stays on top of legal research, has the potential for future earnings and the opportunity to keep their clients’ business for a long time.
A quality training program for new employees that teaches them how to perform while helping them develop their own careers is one more indicator of the value of a firm and its opportunity for future earnings. Firms that treat their staff well are also likely to have a low turnover rate and a greater ability to attract and keep outside talent and experience.
Valuation Difficulties in the Law Firm Sector
One of the most significant challenges in valuing a law firm is the ever-changing nature of revenues and costs. Particularly in firms that are dependent on one or two key partners, the firm’s future may be simply the continuation (or absence) of those partners. Because of this, it is common for valuators to forecast changes in cash flow after a couple of years of actual cash flow in order to measure the impact of future events. In addition, there may be additional expenses associated with the departure of a key partner that are not expected to recur (e.g., removal of an accrued bonus), which can result in a significantly different valuation outcome.
Another challenge faced by valuators is the interdependence of firms’ personnel. An attorney’s departure may result in the loss of clients, suggesting that the value of the firm is now less than it was before the departure (assuming the partner cannot bring clients with them to a new firm). On the other hand, the firm may be better positioned without the aggrieved partner, and the partner with little replacement value may recruit away attorneys who are essential to the success of the team. And partners at smaller firms may have overlapping clients, meaning the loss of one partner could be inconsequential, as another partner at the firm could step in and handle the remaining client. The sponsor-financed market that is based on annual multiples of cash flow may not be able to account for this interdependence of a firm’s personnel.
Utilizing a Professional Valuation Expert
Although there are some basic questions that can be answered using one of the methods described above, a full valuation is usually required if accurate and certain answers to the following questions are needed (for example, to satisfy the requirements of a buy-sell agreement or to get ready to sell the firm), if the buyer and seller have different wants or needs, or if there is a material issue as to the value of the firm or the ability to sell the firm. Buying or selling a firm is a complex business transaction, and the assistance of a professional valuator may be needed to maximize the benefit to the parties. Any business broker, banker, lawyer or accountant with experience in firm mergers, acquisitions, sales or equity partner buy-outs will tell you that these transactions require a qualified, experienced and discreet mediator. A valuator, who must be independent (abiding by the CICA Code of Ethics), is hired to function as this mediator. This may mean that a professional valuator will need to be involved even if the parties are amicable because the valuator will be required to answer questions on the value of the firm and the likely structures, eventual pricing and timing of the deal because all of these things can materially impact the value of the deal and the price the seller can expect to receive for the sale of the firm.
Insights into Valuing Law Firms through Case Studies
In 2017, we worked with a 10-lawyer law firm that had been in existence for nearly 20 years. The firm had three founding partners and seven "associates" (all of whom were actually lawyers with varying interests in the firm). This was a difficult "in transition" type of valuation in that the firm was in a transitional state of closing its doors to clients at their original size and transitioning to a smaller firm. The founders were quite wealthy so they were looking for a way for the 7 associates to have some degree of ownership and earn significant income from the firm without having to fund (except for sweat equity) any ownership interests in the firm they built. As part of the valuation process we worked with them to value their Rent (or leasehold interest) and we determined that they had a net value to them of $425,000 (which simply means the cost of moving to a new space less any net proceeds if we sold the space and took a net is that example). We also did a small brand analysis and determined that their brand had a net value to them of ($70,000). In the end, we suggested that they bagged their rent and brand and simply closed their doors rather than sold their firm. They were happy because they ended up with as much money as they would have gotten had they sold and they were able to determine the fate of their associates. In the end they kept one of the associates , referred 6 to the firm everyone would have referred them to in the first place and closed down the firm in a relatively clean way without fighting. It is a happy story and it started with valuing their brand and rent. In another transaction we valued the law firm of a $45 million revenue New York City law firm acquired by a $900 million revenue Boston-based law firm. The firm had gotten to a point where it felt that it needed to acquire a competitor in order to continue its growth. The Boston-based firm was looking for a New York based firm and acquired this firm for a reported $225 million in cash, stock and earn out. The target law firm had been in existence for 10 years up to that time and had 100 lawyers with 8 practice groups. It serviced hedge funds and private equity clients exclusively. In our analysis we determined that this firm AUM (Assets Under Management) was quite significant and we believed it had a delta of 4 – 7 times EBITDA (which basically is its profit margin) and after extrapolating the EBITDA (profit margin) forward, it implied a multiple of 11.5 – 17 times. We determined that the three most important areas in order to quantify a reasonable multiple of EBITDA were: (1) reputation; (2) clients; and (3) Human Capital (within the context of quality control). When you looked at all of these factors, this firm’s reputation was not all that strong but their clients were very high quality and their Human Capital was excellent. So we simply performed a simple DCF (Discounted Cash Flow or Net Present Value) analysis and determined that the firm was worth between $254 million (if you valued it based on reputation) to $400 million (if you valued it on the basis of clients). But the client really was worth $405 million in 2018 dollars. In the end, we concluded that the Boston-based firm overpaid for this New York based firm. Clearly there is a lot to be learned from this case both in the context of good and bad comparables.
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