October 28, 2016

What to Expect When Selling Your Practice

You have had a long and successful career as a sole owner of a law firm. Your clients have been loyal and have supported you. Your "brand" on the street is impeccable. Referrals keep coming in. You have hired great support staff and are "training up" an associate who has long-term potential. At your age, however, it is probably time to start thinking about succession and passing on your practice. Your associate is a keeper, but is not ready to assume control. Further, she and her husband have started a family and don’t have a lot of investment capital. You want to take care of your clients, your associate and your staff, but you also need to provide for your own retirement. You have always been a prudent saver and have an adequate – but not robust – nest egg. Frankly, your law practice is the most valuable asset you own.

How much is it worth? How do you find a buyer or a merger partner? Once you have a qualified buyer or merger partner, what is the deal going to look like? Should you expect someone to write you a check? Will you have to continue to work? If so, for how long?

These are all very important transitional questions. That said, the most important question is: Have I prepared adequately for succession? Will my clients accept a new lawyer of my choosing, or will they drift away? Will my associate want to be part of a different – possibly bigger – organization? Will my chosen successor(s) be able to make the practice grow and thrive once I am gone?

These are the most important questions. If you have not dealt adequately with client succession, talent succession and leadership succession, tackling practice valuation and working on a sale transaction are both fools’ errands. A law practice with fickle clients, a thin bench, and no clear leadership and direction has little or no value to a prospective buyer.

So, let us assume that you have done your succession homework and you are secure in the notion that clients and talent will follow you to a new home with good leadership and management in place. Now, what should you expect?

First, let’s talk about valuation. Your law firm owns three important classes of assets that make up its overall value – "hard" assets (net of any debts or expenses incurred to effect a transition), the expected value of unbilled and uncollected accounts (and/or uncompleted contingency cases), and the value of fees that your client base is likely to produce in the reasonably near future. "Hard" assets are typically cash, reimbursable client costs and advances, and office furnishings and equipment, net of any accumulated depreciation. Your firm’s balance sheet may also list leasehold improvements (net of amortization), but leasehold improvements generally have little or no resale value, unless the buyer will be moving into your firm’s space.

You should understand that your accountant may hand you a balance sheet that lists these assets and their value, which has been established according to accepted accounting principles. That said, the amounts shown on your balance sheet reflect the historical cost of these assets, not their current value. "Value" is determined by what a reasonably informed and qualified buyer would pay you for them in today’s economic climate. Cash is easy to value. It is what it is. Amounts due from clients for costs advanced are worth something only if they are collected. The other assets may be worth a small fraction of their cost if you tried to sell them. So, don’t just assume that your "hard" assets (after allowing for liabilities) are worth what your balance sheet or tax return shows.

Next, let’s talk about the value of unbilled and uncollected work. Your accounts receivable need to be adjusted for doubtful collections. For example, any account receivable over 180 days old is generally considered worthless, absent unusual conditions such as a pre-arranged payment plan. The value of unbilled work is a more complicated issue. First, the work has to be completed in order for it to be billed. That will require spending additional time on cases/files to complete them. That time has a cost that needs to be taken into account. Then, you have to further adjust for the risk that bills associated with such work may not be collected. Again, "value" depends upon how easily these assets can be turned into cash.

Finally, let’s talk about the value of continuing fees that might be generated by your client base or referral sources. In the business world, the common name for this element of value is "goodwill." Establishing a value for goodwill is a topic that could fill volumes. Case law abounds with disputes over the value of goodwill. The bottom line, however, is that goodwill is worth only what a prospective buyer is willing to pay for it. That does not suggest that goodwill has no value. It simply means that establishing its value at any point in time is a difficult proposition and, at best, an imprecise exercise.

In the business world, goodwill is often taken into account by applying a multiplier to either the firm’s historical revenue or its earnings. For example, traded stocks are valued based upon a "price/earnings multiple." But, the problem with law firms is that there is no recognized market for their ownership shares – hence, no established record of earnings multiples. So, don’t expect your prospective buyer to write a check for the value of goodwill.

In a transaction that transfers the value of your ownership interest in your firm to a qualified and reasonable buyer, however, you should expect to receive something for each of these three classes of assets. The challenge lies in how to extract the value over time. This is where the nature and intent of the sale transaction drives how you extract your value.

One way to extract value is to merge your firm with another – basically exchanging the value of your ownership interest for an ownership interest in another firm. Both firms value their respective ownership interests and the values are equalized in a swap or pooling of interests. This, of course, requires you to become an equity owner in the acquiring firm. It also requires both firms to undergo independent valuations so that the relative ownership values can be compared. Finally, by merging your firm into another, you still have to have a plan for eventually extracting the value of your practice from the newly merged firm.

But, what if you don’t want to join another firm as an owner? What if your goal is simply to find a home for your clients and employees, and to facilitate your orderly transition into retirement?

From a purely economic perspective, the cleanest way to make this orderly transition is to assign existing and future cases to the buyer (with proper client authorization), in exchange for some kind of formula compensation plan that rewards you for successfully transitioning the business and, if you so desire, for any work you do for the acquiring firm after the transition. This is the fairest way for you to extract the value of your firm’s goodwill over time. You assume both the risks and rewards for effecting an orderly succession of the potential revenue associated with your client/referral base. You and your employees, one hopes, are hired by the acquiring firm, and you get to wind down your firm and collect whatever value remains from "hard" assets, your investment in unfinished work, and your accounts receivable.

What does the formula look like? For starters, one needs to determine the length of the transition term. This can be as little as three years or as long as five. You and your successor should agree on a list of clients and/or referral sources for which you should get credit as the "originator." Note that this can get a little complicated if you and the successor share some relationships.

The next step is to determine what percentage of fees collected from these sources will accrue to your benefit over the transition term. Normally, the average percentage over the transition term is about 15 percent, although this is always negotiable. In the first year, for example, the percentage may be 20 percent, declining to 10 percent in the last year. You should also expect to receive a slightly higher percentage of fees collected from new clients that you originate during the transition period.

If you contemplate continuing to do work for clients during the transition, you should expect to be paid a percentage of the fees collected from your work efforts. This percentage is heavily influenced by the historical profit margin on your firm’s business. It can be as high as 75 percent of working-attorney collections or as low as 50 percent. Again, all terms are negotiable.

So far, the terms of succession have allowed you to extract some value for "goodwill" and for future work efforts. Now, what is the best way for you to extract the value of "hard" assets, unbilled work-in-progress and accounts receivable? As mentioned above, these assets would normally be exchanged for a comparable ownership position in your merger partner’s firm, and you would have to wait until you surrendered the new equity position to extract these values.

In this case, our assumption is that you will gradually wind up your firm’s affairs, dissolve its entity and liquidate its assets. You, as sole owner of the firm, will have eventually extracted all the value that these asset categories will have produced, after assuming all costs associated with the wind-down. Exactly how this is accomplished is largely driven by the nature of your firm’s business entity. There are different strategies for sole proprietorships, single-member LLCs, S-Corporations and C-Corporations. The important recommendation, here, is to seek competent tax advice on the most efficient strategy – one that avoids having to "front-load" a large income tax liability in the early transition years. Bear in mind also that your successor(s) might want to use some of your receivables to finance the transition for the first few months. The successor(s) will be most likely paying your associate and staff salaries, plus other costs, while waiting for the new work you generate to be collected. They often want to have some initial cash flow to cover their losses during the immediate transition period – usually for the first three or four months of post-transaction operations.

You may be asked to participate in the financing, but you should always have a strategy for recouping your investment in facilitating the transaction. Here again, your firm’s choice of entity will have a major influence on how the initial financing is structured and how you will extract your value. The good news is that there are commonly-used transaction terms that can accommodate transition financing in a tax-efficient manner. Again, be sure to engage tax and/or transactional counsel to advise on structuring the terms.

In conclusion, there are at least five points you should take away from this short article. They are:

  1. You should be able to extract the realizable value of your "hard" assets, plus whatever cash can be collected from your accounts receivable and unbilled work-in-progress. You just have to bear the risk associated with managing the transition and collecting the accounts.
  2. No business-savvy successor will pay you current money for the estimated value of the "goodwill" associated with your practice. It is fair, however, to expect successor(s) to pay a future percentage of revenue collected from your clients and/or referral sources, when and if collected. Here again, the risk is on your shoulders to make the transition work to the mutual benefit of both sides.
  3. Your successor(s) will most likely want you to stay actively working during the transition period. You should be paid for your work efforts.
  4. Your successor(s) may also want to use some of your firm’s accounts receivable to provide "bridge" financing for the transition. You should also have in place an agreement as to how you will be paid for this accommodation.
  5. The way you maximize the value of your practice in a transition is to:
    • Make sure you have a person – either from your firm or the successor firm – to whom you will transfer client and/or referral relationships. This is critical, as not having a "next generation" in place is likely to cause your clients to look elsewhere.
    • Work hard on client retention by communicating your plans to them as soon as they are in place. Don’t wait. Clients don’t like surprises.
    • Plan to stay actively involved in your practice for at least two or three years during the transition period. During that period, keep your old business entity alive. You may need to rejuvenate it, if the transition fails through no fault of your own.

You have worked your whole career to build a lasting legacy. You can and should expect to reap the value of that effort. Once you do, kick back and enjoy your retirement. You’ve earned it!