General Practice, Solo & Small Firm DivisionMagazine
Volume 17, Number 1
VALUATION OF A LAW PRACTICE
BY JAMES D. COTTERMAN
Valuing a law practice-determining fair value for a lifetime of work-raises many ethical and financial questions. What's being transferred? This very simple question is often overlooked. But one cannot value a law practice without the answer, although many people try.
The seller is providing, in many cases, a lifetime of serving clients, establishing a reputation, building contacts and referral sources, and developing the infrastructure to deliver legal services.
The buyer is looking for an ongoing stream of income that is analogous to an annuity, represented by the client base and referral sources of the seller. In addition, there are some hard assets and support that make up the practice's infrastructure. The clients are looking for consistent advice and counsel; more directly, they are looking for solutions to problems or issues.
In essence, what's being transferred can be separated into two components that should be valued separately:
$ The business: hard assets (cash, equipment, furniture, leaseholds, and the like) less outstanding debt or lease obligations that are a part of the business.
$ The practice-sources of immediate revenue, and a system for generating future revenues.
If the most valuable asset conveyed in the transfer of a law practice is the practice itself, then, essentially, what is conveyed is the goodwill of the lawyer.
Historically, the profession and the courts held that goodwill in a law practice could not be sold. They considered that, as a matter of public interest and policy, clients were not property and thus could not be sold, and that clients were ultimately free to select and change legal representatives at any time.
In matrimonial matters, both equitable distribution and community property jurisdictions have been inconsistent in their treatment of goodwill and value of practice, but this is the general area in which goodwill has traditionally been found. In a group setting, there is a built-in means to transfer the "goodwill" internally and to value it that, until recently, was unavailable to a sole practitioner. In recent years, the ABA and some state bar associations have adopted rules permitting the sale of goodwill of a solo practice.
The ABA rules can be found in the Model Rules of Professional Conduct at Rule 1.17, Sale of Law Practice. Also available are the annotations found in Annotated Model Rules of Professional Conduct, second edition, published by the ABA Center for Professional Responsibility.
The ethical considerations present problems and risks for both seller and buyer that center on protecting clients' rights, property, and confidences. Ethical considerations cover a broad gamut of issues, including client communication, attorney of record, client confidences, client files/property, client funds, conflicts of interest, competency, misrepresentation by seller of purchaser's qualifications, errors of selling attorney discovered by buyer, and other issues.
Financial aspects covered in the Rules that are important in the negotiation of the transfer are the right to have a covenant-not-to-compete provision and the fact that the buyer must purchase all or substantially all of the seller's practice. The buyer may not select individual matters and clients, but must accept the entire portfolio.
Valuing Partner/Shareholder Interests
For internal transfers, the spectrum of law firm valuation and withdrawal entitlement theory can be characterized by two polar positions. The first considers the firm as a means to generate compensation, with very little, if any, value beyond the cash-basis capital account. The second considers the firm as an investment that grows in value and is transferable.
The most common convention in law firm valuation is to establish the net cash-basis book value of the firm, plus a multiple of estimated earnings. This approach is essentially derived from methods used to evaluate stock of privately held companies. A balance sheet analysis is performed to value the assets and liabilities of the company, and an earnings multiple is used to value the goodwill or going concern value of the business.
The earnings multiple. For manufacturing concerns, the base multiplier is usually about eight times earnings. For service concerns, the multipliers are lower; for professional service firms, lower yet; and for law firms, generally much lower. Manufacturing concerns typically have ongoing franchises and productive machinery to sustain them. Sustaining the profitability of a law firm, however, greatly depends upon whether the firm is able to retain and develop its base of clients and the lawyers responsible for attracting them.
The value of an individual's practice depends on his or her ability to attract and retain clients. Therefore, that value is personal to the lawyer. Even when client relationships are transferred, it is ultimately the new lawyer's personal ability and relationship with the client that determine whether the client will stay or leave. This is why the multiples are so low.
There is readily acknowledged value in the establishment of a business enterprise. Starting a business involves soliciting business contacts, banking relationships, and vendor relationships; designing and outfitting space; finding and training staff; creating forms and procedures; and generating cash flow. Any individual who has started a business understands the value of an ongoing entity. For this reason many firms restrict entitlements to their founders, in recognition of the value that successive owners will inherit. In some cases the cost of buying out founders is spread across two or three generations in order to facilitate the transfer.
Buyouts beyond the return of cash-basis capital in a law firm can be valued and paid in many different ways. Some plans are simple; others, complex. This variety makes comparisons of buyouts among firms difficult, but a present-value analysis allows various plans to be reduced to a common standard. Once an amount is calculated, a comparison can be made between that amount and partner earnings at withdrawal. The result is a standard multiple of compensation that is common in legal practice buyouts.
Once the standard multiple is determined, it can be adjusted up or down to reflect facts and circumstances of the firm that make it different from the norm. The factors include stability of the client base, ability of remaining lawyers to perpetuate the business, name recognition, type of practice, profitability, size of firm, stability of partner group, reinvestments to fund growth, risk taking, and the like. The process of establishing an adjusted multiple is both subjective and judgmental. There is more art than science in the assignment of bonus points or risk reserves based upon various factors.
Generally, earnings multiples range between 0.5 to 2.5, which means the value of the practice will vary from one-half of normalized annual earnings to two and one-half times normalized annual earnings. (Another method often referred to is a multiple of revenues, generally .75 to 1.25 of value; such figures are less precise than earnings multiples.)
Table 1 depicts how one might assign factors and points for a small law firm to arrive at a reasonable multiple. Based on the table, a benefit of 1.05 to 1.80 times earnings (calculated as taxable income plus pension contributions) appears appropriate.
Valuing a Solo's Practice
For external transfers, get to know the seller! Interview lawyers, judges, bankers, accountants, and other contacts who can tell you something about the individual. The buyer should look to this person to assist in the transfer of the relationships. It is for this reason that so many of these deals have lives of one to three years.
Value the business. The method for valuing a sole practitioner's business is very similar to the internal transfer method of valuing the capital of a partner. Essentially, the business is valued on the net cash-basis book value balance sheet.
Review the following business areas before making your offer:
$ Filed federal income tax returns for the past three to five years.
$ Title to all assets.
$ Debt agreements, equipment and office leases, maintenance contracts, and subscription agreements for library services.
$ Filed business and payroll tax returns.
$ Malpractice insurance policy and applications, with attention to availability of "tail" and "prior acts" coverage.
$ Other liability such as discrimination or harassment claims insurance and workers comp, fire and theft policies, and applications.
$ Salaries, bonuses, benefits, and evaluations.
Protect yourself against the quality of the work in progress and accounts receivable and the level of debt and accounts payable. Although you may not be buying these assets and liabilities, you could inherit the problems that are hidden within.
Value the practice. Valuation of the practice is a valuation of goodwill. Goodwill can be determined as follows:
1. Determine the firm's net tangible assets on an accrual basis.
2. Reconstruct net income by adding back benefits, "perks," and compensation to reported net income and subtracting a reasonable compensation package.
3. Calculate reconstructed net income for three to five years and average.
4. Multiply net tangible assets from the above figure by a reasonable return rate.
5. Subtract the reasonable return from average reconstructed net income (the result is excess net income).
6. Capitalize the excess net income to arrive at goodwill.
Rules of thumb borrowed from firm buyouts indicate that goodwill is roughly one times earnings.
Take the following steps in addition to determining value:
$ Review annual client fee lists for several years and compare the fee detail lists to fees reported on the tax returns. Do a conflicts check.
$ Review practice management procedures (file opening procedures, tickler systems, conflict check systems, and the like).
$ Review pending open matters, and deadlines.
Consider a structure that values retrospectively but pays prospectively. If you are buying a future stream of income, then pay based on future income. This is riskier for the seller, and may mean a higher multiple.
The Seller's Perspective
The seller of a law practice is primarily interested in assuring that the clients will have quality legal services, payment will be received, and personal liability will be protected.
One risk to the seller is that the buyer may not be competent to handle certain areas of the current practice. Clients may not continue their relationship with the new lawyer. Payments may not be made. Financial risk to clients and the purchasing lawyer may result in liability.
Therefore, a selling attorney must undertake due diligence that includes:
$ Verification of purchasing lawyer's expertise and credentials.
$ Verification of purchasing lawyer's reputation.
$ Assessment of purchasing lawyer's philosophical approach to clients and practice. Will the sale result in effective relationships?
$ Determination of availability of "tail" insurance coverage.
James D. Cotterman is a principal with Altman Weil, Inc., in Newtown Square, Pennsylvania. He advises clients on economic issues, mergers & acquisitions, compensation systems, governance, and management.