Is your law firm a valuable business

Accurate valuations of law firms require a rigorous analysis of a range of factors that partners often overlook, writes Neil Oakes.

Most law firms are small law firms. Among these firms, equal profit sharing is common and ‘goodwill’ is considered a valuable asset. At FMRC, we are regularly asked to value law firms formally and more regularly asked informally: “What do you think the firm/my share is worth?”

If any business is to be valuable it must be profitable, organised and able to achieve replicable results through quality systems. Some degree of inimitability is an advantage, but relatively unusual; in many respects, most law firms are not that different from their competitors. There are, however, some aspects of law firms that make the valuation process unique. Any rigorous valuation should take into close consideration the following essential elements.

1. Profitability of the practice

One obvious rule stands out: the greater the return on investment relative to risk, the greater the value of any asset. Potential purchasers will pay a premium for a practice that delivers high returns. Any business should return a salary to all working owners. Astute purchasers will not buy a salary; you can generally get one for nothing. Saleable profit is the amount of income generated after salaries and expenses, including reasonable market salaries for all working partners. In a partnership structure these may be ‘notional salaries’.

Value will be greater when there is a history of consistent profits. Value will also be higher if profits are generated by the operations of the firm as a whole rather than any one individual. These circumstances minimise risk for any purchaser.

Consider two firms that return the same profits to the partners. One is a high-end litigation practice with a heavy reliance on a senior partner for client development and fee generation. The second is a property practice with a number of developer clients that are serviced by a team of lawyers and paralegals. All other things being equal, in our experience the property practice would attract a higher valuation.

2. Free cash flow

A constant challenge for firms is improving the speed with which activity, or work in progress, becomes cash. When it comes to valuing a practice, a commercially astute purchaser will want to examine how quickly a firm converts work-in-progress into debtors and debtors into cash.

A rigorous valuation will include a free cash flow factor in determining the profit multiplier applied. When considering goodwill, firms with low levels of WIP and debtors will be valued greater than firms carrying large amounts of inventory. Note: WIP and debtors are usually valued separately from the goodwill, so large amounts of WIP and debtors (if sold) would have the capacity to increase the overall sale price.

3. Investment payback term

The investment payback term (IPT) is the maximum period a purchaser would accept to receive a total return of funds invested. It is, in part, an assessment of the risk involved in purchasing the firm.

In many respects this is a balancing act. The payback term should not be too short or too long.  A shorter IPT (say, one year) indicates the cash flow and profit of the firm is subject to significant risk. A less risky business may have a payback term of three, five or more years. Although contradictory on face value, the logic is that the lesser the risk associated with a practice the greater the likelihood of any purchaser adopting a longer-term view and the greater the valuation. This is of particular importance for external sales.

Considerations when determining IPT include:

• brand awareness;
• the recurrent nature of the client base;
• the level of reliance on current partners for fees and clients;
• areas of law practiced; and
• competition.

4. Client concentration

The personal nature of the law means that clients often identify more with a lawyer than a firm. Branding and promotion of individual partners and employed lawyers has distinct marketing advantages, but it devalues a practice relative to a circumstance where work is attracted by the brand of the firm and evenly distributed.

Law firms with a strong delegation culture and good leverage usually attract a greater value. Conversely, if a rainmaker who takes pride in personally serving his clients is selling his share of equity and will not be involved in the practice beyond sale, one could reasonably expect a lesser value.

In a recent valuation we completed a series of sensitivity value calculations to demonstrate to the rainmaker principal the higher business risk and lower value resulting from a high concentration of clients. The calculations involved changing the IPT, as client management was identified as a key value driver.  The partners agreed to implement a series of strategies to improve the transfer of client management, which resulted in a higher IPT score. The outcome of the valuation can be summarised as:

Value with an IPT of 7 years:  $2,550,000

Value with an IPT of 5 years:  $2,275,000

Value difference:                       $275,000

5. Recent investment in operations

Occasionally we see some creative approaches to profit maximisation. Profit in any period can easily be maximised on a profit-and-loss account by deferring necessary upgrades and investments, particularly in IT and office fitout.  Purchasers should be wary of aging IT platforms as the likelihood of a major and costly upgrade could be around the corner. Similarly, beware that scheduled office fitouts or improvements have not been deferred to take place immediately after sale. Well-run, organised businesses will amortise necessary assets over their workable life.  This demonstrates a stable business and reflects in the value of the firm.

A review of the depreciation schedules usually indicates the investment program. Similarly, any valuation should consider a comparative review (using comparative financial benchmarks) of lease expenses for computers, software and any deprecation amount appearing in three consecutive profit-and-loss accounts.

6. Vendors’ role post sale

Depending on the circumstances, the intentions of the vendor post sale may impact on the valuation. Some purchasers would like to retain exiting partners on a consultancy basis to ensure an orderly transition of clients and management. Other purchasers may place more value on exiting the principal from the business at the time of sale. Obviously there are no concrete rules here, but it is an important consideration.

7. Premises

Premises commitments are deal specific. Any purchaser would be interested in the duration of the lease commitment and how any lease incentives have been packaged. To reflect fair value, incentives should ideally be amortised over the duration of the lease. If a firm is committed to paying premium rent, having traded rent free for a period should be reflected in value. In the circumstances where some partners are landlords and others are tenants, a commercially reasonable lease, reflecting fair market value, should be in place.

Banks have traditionally seen value only in assets, lending on a safe percentage of WIP and debtors. Increasingly, progressive bankers are lending on the intrinsic value of the business. Entering partners and purchases are able to finance their purchases, secured by the value of the business.

Goodwill is also alive and well in small, profitable firms. Any sale should be preceded by a timely, rigorous valuation that considers all of the idiosyncrasies that set law firms apart from other small businesses.

Neil Oakes is the director of FMRC, which has provided research, training and management advice to law firms throughout Australasia for the past 30 years.

www.fmrc.com.au.

For more information on law firm valuation, see www.fmrc.com.au  or telephone Sam Coupland on (02) 9262 3377.