Valuing a Legal Practice By SAM COUPLAND, DIRECTOR, FMRC LEGAL If any business is to be valuable it must be profitable, organised and able to achieve replicable results through quality systems. In many respects law firms are not that different. There are however some aspects of law firms that make the valuation process unique. The value of a legal practice usually involves both the net tangible assets and goodwill (if it exists). 1. Net Tangible Assets The first step in any valuation is to work out what is being bought and what is being sold. This requires analysing the balance sheet to calculate the net tangible assets (i.e. tangible assets less tangible liabilities). Intangible items such as goodwill are calculated separately. 1.1 Calculating Net Tangible Assets A legal practice is rarely sold on a walk in, walk out basis. Usually the vendor retains some of the assets and liabilities. Calculating net tangible assets is a balance sheet issue and is best demonstrated below: Balance Sheet (as reported) Adjustment Balance Sheet (adjusted) Assets Cash 1,000-1,000 0 a. WIP 120,000-100,000 20,000 b. Debtors 45,000-45,000 0 c. Equipment 50,000 10,000 60,000 d. Goodwill 150,000-150,000 0 e Total Assests 366,000 80,000 Liabilities Creditors 20,000-20,000 0 f. Loans 25,000-25,000 0 g. Employee entitlements 15,000 0 15,000 h. Total Liabilities 60,000 15,000 Net Assets 306,000 65,000 Note In this example the balance sheet shows Net Assets of $306,000. If the firm were being valued for sale, a number of adjustments would need to be made to reflect the true position of what is being sold. These following adjustments give rise to a net tangible asset value of $65,000. a. Cash: the vendor will keep all cash. To fund the firm the purchaser may have to make an initial capital contribution.
b. WIP: where possible it makes sense that as much work-in-progress (WIP) as possible is billed prior to sale date. The resultant debtors are then collected by the vendor. There may be special situations such as conveyancing matters which cannot be invoiced while the matter is still running(see below for guidance). Purchasing WIP may have tax consequences. c. Debtors: the vendor should collect all outstanding debtors. d. Equipment: the balance sheet will show the written down value of equipment. This may need to be adjusted to reflect the replacement value. e. Goodwill: this will be valued separately. f. Creditors: the vendor should be responsible for all outstanding creditors. g. Loans: the vendor usually pays out all outstanding loans. h. Employee entitlements: if employees are remaining with the practice, the purchaser will usually assume all employee entitlements. 1.2 Valuing WIP of conveyancing files Valuing the WIP of conveyancing can be difficult. One option is to split the total value of all active matters at sale date evenly down the middle. This produces a reasonably accurate estimate of WIP as the matters will be at varying stages of completion. Where little professional time has been spent on a new file this will usually be offset by an almost complete file in which substantial professional time has been spent. An example of this 'swings and roundabouts' approach is: Number of active files at sale date 25 Average professional fee per file $1,200 Total value of conveyancing files $30,000 In this example, the WIP will be $15,000 for each of the purchaser and the vendor. 1.3 What about a strongroom full of deed packets? Many vendors view their deed packets as an asset that can be sold. The difficulty is working out a value due to the uncertainty over: Whether the packets will convert into a probate file if they do, when this will happen What the likely professional fee will be, and What the cost to service the probate will be. The table below sets out an example of this dilemma: Number of deed packets 1,000 Percentage that may become a probate file 10% within the next 5 years Average professional fees for a probate file $5,000 Firm profit margin (after principals salaries) 15%
Based on this, the best profit outcome from purchasing the deed packets would be $75,000 over a five year period, or $15,000 per year. There is little point paying dollar for dollar in profit, so the actual saleable value of deed packets (if you can determine it) is likely to be relatively low. 2. Goodwill The second component of law firm valuation is goodwill. For goodwill to exist, the practice must generate profit beyond a commercial salary to the principals. As a financial exercise the calculation of goodwill involves the following broad steps: Note i. Average profit $400,000 This may be the weighted average profit over the past three years. Any payments to the equity principals need to be added back. ii. Less notional salary to equity principals ($300,000) The notional salary is the salary the principals could earn as employees in another firm. In this example I have assumed 2 equity principals and a notional salary of $150,000 each. iii. Equals 'Super Profit' $100,000 The super profit is the profit the practice generates in excess of notional salaries. If there is no super profit, then commercial goodwill does not exist. iv. Capitalisation 1.75x See below for details. rate v. Total value of goodwill $175,000 Super profit multiplied by the capitalisation rate The capitalisation rate is largely a function of how much someone is willing to pay given an assessment of the risks and rewards of the practice. In the legal profession capitalisation rates usually range between 1.0 times and 3.0 times. Rule of thumb capitalisation rates (such as using 2.5x) are dangerous as they do not take into account the unique nature of each practice. In determining an appropriate capitalisation rate you should consider the factors set out below. 2.1 Profitability of the practice Any business should return a salary to all working owners. Saleable profit is the amount of income generated after salaries and expenses, including reasonable market salaries for all working principals. Firms are moe valuable where there is a history of consistent profits. They are mote valuable still if profits are being generated by the operations of the firm as a whole rather than by any one individual. These circumstances minimise risk for any purchaser. Consider two firms that return the same profits to the principals. One is a high end litigation practice that relies heavily on a senior partner for client development and fee generation. The
second is a property practice with a number of developer clients who are serviced by a team of lawyers and paralegals. All other things being equal the property practice should attract a higher valuation. 2.2 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. When it comes to goodwill, firms with low levels of WIP and debtors will attract a greater value than firms carrying large amounts of inventory. WIP and debtors should be valued separately from the goodwill as part of the net tangible asset calculation, so large amounts of WIP and debtors (if sold) would have the capacity to increase overall sale price. 2.3 Investment payback term The investment payback term (IPT) is the maximum period a purchaser would accept before receiving a total return of funds invested. It involves, 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 practice that is subject to significant risk may be profitable with desirable cash flow but the inherent risk will give rise to a shorter IPT (say one year). 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, regardless of profit levels. This is of particular importance for external sales. When determining an IPT you should consider factors such as: Brand awareness recurrent nature of client base level of reliance on current principals for fees and clients areas of law practiced, and competition. 2.4 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 firm s with effective delegation 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 won t be involved in the practice beyond sale one could reasonably expect a lesser value
2.5 Recent investment in operations 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 fit out. 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 fit outs or improvements haven t been deferred to take place immediately after sale. 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. 2.6 Vendors role post-sale Depending on the circumstances the intentions of the vendor post-sale may impact on the valuation. Practising restraints imposed upon the vendor under a restraint of trade clause to be included in the agreement for sale of business, may bear significantly upon the value of the goodwill. Some purchasers would like to retain exiting principals 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. 3. Tying it together From the examples in this article, the total value of the practice is the sum of the net tangible assets and goodwill: Net tangible assets $65,000 Goodwill $175,000 Total value $240,000 Practices seeking an eventual sale should focus on: Developing a track record of annually increasing profitability ensuring as much legal work as possible is systemised and process driven and where possible delegated to employed fee earners having robust management accounts as well as an up-to-date and accurate client data base, and developing repeat clients who can be readily transferred to a nominated successor or new owner of the practice. Sam Coupland is a Director of FMRCLegal, a specialised consultancy providing financial benchmark research, training and management advice to law firms.