Goodwill hunting – don't sell yourself short in retirement

Owners of smaller law firms who do not believe that their practice has real value to potential buyers are doing themselves out of a potential retirement windfall, writes Colin Ritchie.

Small legal practices really are different from larger practices. Nowhere does this become more apparent than when owners are thinking about preparing their practice for sale. For a start, practice goodwill can be a valuable asset in small firms. By contrast, in larger firms often there is no value placed on goodwill, with incoming partners simply contributing towards working capital. In the case of a small practice, the purchaser of that practice goodwill is typically someone from outside the firm. This may be because there is no succession plan, which in turn may be due to the small size of the practice. Whatever the case, it is important to appreciate the value of such goodwill and to take steps to factor it into any eventual sale.

Increasing the selling price of your practice – knowing what buyers want
Viewers of property shows on television will probably have seen scenarios whereby vendors are asked what they think their property is worth. They rarely discuss what buyers may be willing to pay; instead, the price they indicate is usually based on what they need to get to pursue their next project – which, of course, is irrelevant to the buyer. Likewise, selling a legal practice is all about what the market will pay. This is particularly true with smaller firms given that the sale is often to an outsider. With that in mind, however, if you have a good idea of what buyers really want, then your chances of getting more for your practice (or selling it at all, in some cases) are heightened.

So what do buyers want? Purchasers of legal practices are similar to buyers of all businesses, in so much as they are looking for certainty that the practice will continue to produce at least the results that it has in the past when the retiring principal has gone. The higher the degree of certainty that this will occur, the more a buyer will pay. Expressed another way, the more ‘boringly predictable’ your practice income is, the more it is worth. Here are some practical factors that are likely to produce that outcome.

1) The practice has well-developed referral relationships
If these relationships are transferable in the event of a new principal running the practice, that gives a higher degree of certainty of future income.

2) The practice has well-trained staff who will be staying with the practice
This provides a higher degree of certainty that the practice will predictably carry on in much the same way after the current principal has retired, as a lot of the work will continue to be done by the remaining staff members.

3) The vendor is prepared to stay on to assist in a staggered phase-out
There ensures there is a higher degree of certainty that current clients and referral sources will remain after the current owner has retired, as relationships can be progressively transferred to the new principal.

4) The financial results of the practice are stable year on year (and preferably increasing)
This leads to a higher degree of certainty about the future results of the practice.

Why are so many small practices sold cheaply or closed down?
Many principals take the view that their practice is not really worth anything. Such a sentiment can become part of the problem because, if they think that, they are unlikely to try to implement strategies to lift the value of the business. I recall running a webinar on developing a client referral system for practices. One of the webinar attendees was a business broker specialising in selling legal practices. When I asked the question: “Would a practice with this system in place be worth more?” his answer was that, of course, it would be, but that few firms ever do it.

Significantly, the same strategies that can lead to an increase in practice value are also likely to lead to an increase in practice profits. For small practice principals wanting to build up their retirement savings, this is important. Do the work once and benefit from both increased profits and increased practice value.

Is the approach different for different types of practices?
Value-building strategies may vary from firm to firm. A conveyancing-type practice, for example, may place more emphasis on building referral arrangements with real estate agents. This approach is likely to give a buyer a degree of comfort that existing work flows are likely to continue. A commercial law practice, however, may find that its best strategy is to build improved client relationships with existing clients. Indeed, in cases where clients tend to come back over time, such as commercial or estate planning-type practices, a focus on building relationships with existing clients is clearly the easiest and most fruitful way of building both practice value and profitability.

The importance of recurring income
Recurring income is the key to building a practice with ‘boringly predictable’ income that buyers will fight over to buy. Consider doctors’ and dentists’ practices. Both professions are highly rated in professionalism surveys, but their practice values often differ significantly. Most commercial lawyers would no doubt agree that a small medical practice generally has little or no goodwill value, but by contrast small dental practices are eminently saleable, with the value generally based on future maintainable profitability.

So why the difference? It really comes down to recurring income. On first glance, they look similar; people have a recurring need for a doctor, just as people have a recurring need for a dentist. And both are ‘grudge’ purchases, in the same way that legal services (and other professional services) tend to be. The difference is that the dentist has systematised the recurring income so that it is boringly predictable. In this case it is with a system of client reviews that lead to a high predictability of future practice income. While doctors could do exactly the same thing, they tend not to and, consequently, their income does not have that ‘boring predictability’ to it that the dental practice has.

The same principle can apply in legal practices, just as it can for accounting practices, financial planning practices and others. Some practices such as general commercial law firms are very much suited to building a dental-type practice (though most do not, just like doctors do not). Developed this way, the practice really does deliver compelling predictability for a buyer.
Other practices where clients do not necessarily have the same recurring needs, such as the conveyancing practice mentioned earlier or a family law practice, will need to demonstrate predictability with consistent referral arrangements, consistent enquiry levels from websites and so on.

Choose the path to profitability
The value of the goodwill of small legal practices really can be developed so that it contributes significantly to the retirement savings of a retiring principal. The strategies to do that will often have the extra benefit of adding to practice profitability, which can only enhance the financial position of the principal. Many principals choose not to go down this path in the belief that their practice has little or no value. This is a mistake that can be very costly.

Colin Ritchie is a director of Ritchie Business Solutions, a consulting and marketing advisory practice helping smaller law firms to improve profit, cash flow and practice valuation. Visit www.ritchiebusinesssolutions.com.au