The legal profession by nature encounters far more business valuations and economic damage calculations, in some form or another, than any other occupation or profession. In its simplest form, a business valuation is the act or process of determining the value of a business enterprise or ownership interest therein. Many attorneys nearing the age of retirement are interested in learning the value of their practice in a prospective sale. Although valuation of a law practice is based on the same fundamental concepts and methodologies as formal valuations regularly seen in the judicial system, many other factors affect value in preparation for and during the process of selling a practice.
This article will provide an overview of business valuation standards and approaches and the differences in valuing a practice for purposes of buying and selling, and it will illustrate ways to maximize the value of your legal practice. Although internal retirement transfers happen every day, the focus of this article is how to value a practice for the purpose of selling to an external buyer. Note also that this article will not cover in detail the ethical guidelines governing the sale of a law practice per ABA Model Rule of Professional Conduct 1.17, the adoption of which varies from state to state; for more on this topic, see the article “The Evolving Ethics of Selling a Law Practice.”
When Do I Need a Business Valuation?
In general, there are four basic purposes for performing a business valuation: tax, litigation, transactional, and regulatory. Some examples are:
- estate taxes, gift taxes, and family limited partnerships;
- employee stock ownership programs;
- partnership disputes, dissenting shareholder actions, and marital dissolutions;
- business damages and intellectual property infringement;
- buy/sell agreements and key-man life insurance justification;
- financial reporting for purchase price allocation and goodwill impairment testing;
- fairness opinions, mergers and acquisitions (M&A), and purchases and divestitures; and
- bankruptcy determinations and eminent domain proceedings.
Who Is Qualified to Perform a Business Valuation?
Many self-proclaimed “experts” will offer no-cost “ballpark” valuation estimates to a business owner as part of a sales pitch. Relying on these estimates for any material purpose is not a good idea. In fact, regulatory organizations have begun to offer more and more guidance discouraging haphazard valuations. For example, in the past, people would ask their CPA to provide an estimate of a business’s value. In 2007 the American Institute of Certified Public Accountants (AICPA) issued the Statement on Standards for Valuation Services (SSVS), which prohibits CPAs without specific training in business valuation from providing such estimates.
It is important to have a qualified professional perform a business valuation, one who understands the best methods to be used with each unique valuation and the additional factors involved in the buying and selling transaction process. In addition to the AICPA, credentialed business appraisers are governed by ethical and reporting standards of several organizations, including the National Association of Certified Valuators and Analysts (NACVA), the American Society of Appraisers (ASA), and the Institute of Business Appraisers (IBA). When a business valuation is needed, find a trained professional with experience and credentials pertinent to the engagement at hand. For example, if you intend to sell your practice, look for a valuation professional with M&A or sell-side transaction experience.
Business Valuation Standards
Value means different things to different people. Over time, three standards of value have been defined with varied acceptance by the courts, government agencies, and professional associations: (1) fair market value standard and (2) fair value standard are typically seen in tax and litigation settings, whereas (3) investment value standard involves M&A, purchases, and corporate finance transactions.
Business Valuation Approaches
Once the standard of value is identified, the appraiser will normally use one or more methods to value the practice. My assumptions for this article are that the practice is operating as a “going concern” and using the investment value standard. Every valuation is unique and may not apply; I will cover the two most common methods used in buying or selling a practice: the market approach and the income approach.
Market approach. Guideline transactions are weighed against one another for an “apples-to-apples” comparison. Application of this approach to value law practices is difficult owing to lack of comparable transaction history. For M&A transactions in general, the market approach is typically the primary choice for the seller when establishing acceptable offer ranges and typically the secondary choice for the buyer in the transaction.
Income approach. The valuator estimates the future earnings power of the practice and then applies a multiplier derived from the inverse of the perceived risk rate. Estimating future earnings and the risk rate requires special judgment and knowledge. The income approach is most appropriate for many service businesses, including law practices that lack significant assets on the balance sheet and market comparables.
Valuation Factors When Buying or Selling a Practice
When selling a practice, the seller is starting out with a price disadvantage because of the limited number of buyers available. The purchase of a law practice requires admission to the bar and a considerable investment in formal education. This does not mean buyers will have the final say, however; it means in order for sellers to be successful, they must be proactive with their sale. First, sellers need to stand apart from the crowd and catch the eyes of multiple buyers in the market simultaneously. Sellers only get one chance at a first impression, so they have to make it count. Second, they must understand the negotiation process and how to capitalize at the point of greatest advantage. Lastly, they must survive final due diligence.
Now, let’s examine the M&A process from the buyer’s point of view. First, the buyer will identify synergies that yield the most value and search for sellers that fit the description. Synergies could be specific areas of the law, geographic location, client base, etc. Second, after buyers screen the potential targets based on synergy strength, they will narrow down the list to a handful of qualified prospects. Finally, one seller is selected and confirmatory due diligence begins.
If sellers wish to attract more qualified buyers, increase their bargaining strength, and shorten the sales process, the areas to focus on are:
- historical financial performance, growth, revenue, and margins;
- successful attorney track record, expertise, and reputation in a specific area of the law;
- depth and breadth of client and referral base;
- modern office and furnishings in a desirable geographic location with up-to-date IT, computer, and phone systems;
- qualified and trained in-place workforce with established client rapport, familiarity of the firm, and working relationships with landlords, utility companies, government officials, court clerks, banks, and vendors;
- three to five years of audited financial statements; and
- a favorable long-term lease with sublet, assignment, and/or buyout options.
Some of these areas are more difficult to change than others, but nonetheless, all will have some impact on the value of the practice. It can take years to successfully sell a practice start to finish, and even then there is no guarantee. Unfortunately for some sellers, an adequate time frame might not be feasible depending on individual circumstances. What is certain is that, as in today’s real estate market, the faster you have to sell, the more of a liquidation it will be. So get started “polishing” the relevant drivers above. Every moment of procrastination now will leave a proportionate amount of cash on the table for the buyer later.
Balance of Negotiating Power
It is important to understand the psychological balance of negotiating power between the buyer and the seller when selling a practice, for it can have as much of an impact on the final price of a practice as some of the drivers listed above.
The letter of intent (LOI), or conditional offer made by the buyer to the seller to purchase the practice, acts as the tipping point on the teeter-totter of negotiation power between the buyer and the seller.
A seller’s greatest leverage and negotiation strength exists prior to signing the LOI with the buyer. It is at this point that the seller needs to negotiate any potential weaknesses in the deal while there are still other interested buyers present. After the LOI is signed, the leverage and negotiation power shifts to the buyer. Post-LOI, the seller is off the market while confirmatory due diligence is being conducted, enabling the buyer to “beat up” the seller over any inconsistencies found not disclosed prior to signing the LOI.
How Do I Maximize Value Now?
Create what investor Warren Buffett calls an “economic moat” around your practice—a business’s ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.
As with business valuation, there is no one-size-fits-all solution. But by separating the core issues from the noise, individual practice remedies can be found:
- Identify and rank the most significant contributors of revenue specific to your practice in need of improvement.
- Implement a measurable process or tracking system for every value driver.
- Embrace technology and social media.
- Delegate anything that costs less than your billable hour.
Revenue stream. Make your revenue stream defensible. Break down all sources of revenue into buckets: current and past clients, client referrals, referral sources, and all channels of business development that produce new clients. Diversifying your revenue stream will add value by decreasing the impact on the bottom line of the loss of any one source.
The transition to the prospective buyer of clients, referral sources, and the in-place workforce is critical in maximizing value—or a deal breaker. Together, the buyer and the seller need to effectively and consistently communicate with all involved, “hand holding” if you will, to solidify the relationships throughout the entire process. It is industry norm for the seller to stay on with the new owner post-transition for a period of two to five years before riding off into the sunset, so plan accordingly. Also, consult with employment counsel for creative long-term incentive plans to retain key employees post-sale. (For more, see the article “Pass It On: Secrets to Succession and Transition Planning.”)
Providing exemplary customer service will make the heart of your revenue stream “sticky,” enhancing predictability and transferability. According to law firm marketing expert Stephen Fairley in his article “The Top Six Customer Service Strategies Critical for Attorneys to Convert Prospects and Retain Clients,” you must make sure your clients know you appreciate their business by staying in front of them in a way that provides value—e-mails, newsletters, blogs, etc. There are several affordable customer relationship management (CRM) systems available that will make your life easier as you do this.
Marketing Plan: Hire a Professional
Marketing and business development have become more complex, intertwining traditional marketing with search engine optimization (SEO) and social media. There are thousands of marketing professionals who do this for a living; you should not be one of them. Some actions that can efficiently attract and sustain new client business in a practice are:
- Update your website for SEO and incorporate a blog into your website where potential clients can ask questions.
- Record a couple of short YouTube videos that answer some common questions asked by your clients and insert them into your website.
- Ask all your clients for recommendations to be posted on your website.
Depending on budget, comfort, and effort level, you will get out what you put in. The website, SEO, print marketing, and social media should all tie together. This may seem overwhelming at first, but it is the way of the future. If you intend to be in it, take advantage before your competitors do. Not only will a new client look you up on the web before contacting you, but so will a potential buyer.
Increasing Profit Margins
Increasing profit margins indicate a durable advantage over the competition that a buyer may be considering. This is a very attractive trait to a potential buyer. Put simply, increase revenues and/or cut costs by working smarter, not harder. As much as a third of a sole practitioner’s day is spent dealing with the day-to-day hassles of running a business—drafting and proofing documents, catching up on e-mails, and the like. In this day and age, technology is your friend. Wherever possible, invest in state-of-the-art software programs and/or delegate to third-party providers. This will free more time for billable work. Legal software innovator Matthew Piercey, creator of www.est8plans.com, cites the example of drafting and proofing legal documents: Historically a paralegal-grade employee or greater was required to draft and proof legal documents, but with today’s technology, a clerk or intern-level employee can do so in less time and with greater accuracy than previously possible. The difference between the billable hours and the amortized cost of the software goes straight to the bottom line.
There are many factors to consider when valuing a law practice. These factors include understanding the business valuation standards and approaches; the different ways of valuing a practice for purposes of buying and selling; and the techniques used to maximize the value of your legal practice. During the entire transaction process, it is important to have a qualified professional engaged to maximize the value of your practice and increase the likelihood of a successful exit into retirement.
I would like to thank the numerous attorneys and third-party legal vendors whom I interviewed in preparation of this article. The valuation profession is an often-overlooked component of successful business transactions and litigation preparation.
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