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What is needed to value a law practice?

30 June 2017 - By Geoff Adlam

Old fashioned desk with phone, typewriter and lamp

Retirement, dissolution of a partnership, the addition of new partners or directors, merger or relationship property: there are a number of reasons why valuation of a law practice may be needed. Like any business a law firm will have a value which will differ according to the point of view of whoever is asked and the stake they hold.

Sam Bassett sam.bassett@markhams.co.nz is a Director with the Auckland office of accountants and business advisors Moore Stephens Markhams. He has a particular interest in the valuation of law firms and also carries out an annual financial benchmarking survey of Auckland law firms. He has answered some questions about the process and information used to value a law practice:

What sort of information is used to value a law practice?

  1. Copies of the firm’s financial statements for the last three financial years,
  2. A copy of the firm’s current year to date management accounts and budget,
  3. A copy of fees by author reports produced from the firm’s practice management system,
  4. General detail of gross fees by type of legal work, eg, 70% conveyancing 20% trusts and estates 10% commercial, etc,
  5. A list of the top 20 client fees by client group, and type of work undertaken – this is to assess risk or reliance on single large clients and to assist with making an assessment regarding transferability of work,
  6. A list of equity partners and their ages, non-equity partners and legal authors.

What are the most important determinants of a law firm’s valuation?

The two key factors are profitability and transferability of client work. If a firm is very profitable and there is an assessment that the clients and work is relatively easily transferrable to either a new firm or a new partner, this firm will command a higher valuation as a percentage of gross fees over another firm.

What are the most common stumbling points/contentious areas?

I sometimes see existing firms where many years ago an inflated goodwill value was placed on the balance sheet. This value has not been reassessed and when a new partner is asked to buy into the firm, they question if it is reasonable that they buy into a firm’s balance sheet that has an over-inflated value of goodwill (which is historical and dates back many years). This is often where I end up assisting the firm and the new partner to work out the correct value for the goodwill element in a law firm.

Another contentious area can be work in progress, or WIP. Most small legal firms do not “book” WIP on their firm balance sheets. However, true work in progress that is going to turn into cash to the firm once invoiced and paid does represent value. This value needs to be discounted to reflect such things as write-offs, potential bad debts and the time it will take for WIP to turn into cash. Work in progress is often an area that needs to be worked through carefully before there is a change in equity partners in a firm.

Firms that have sizeable WIP and debtors balances or “lockup” indicate that there is a significant funding requirement, often by the existing equity partners or owners. It can be daunting or challenging for new equity partners to work through how they are going to fund a current account or share of the firm’s funding requirements in such circumstances. These issues can be worked through but it is always easier to work through the funding requirement for efficient profitable firms where the funding requirement is not as high.

How long would a valuation take?

A valuation can be undertaken for various reasons. If a full Independent Valuation Report is required in accordance with the CAANZ Advisory Engagement Number 2 (AES 2) then I would allow for 3-4 weeks or so for a valuation to be completed. In other circumstances where an indicative valuation range for goodwill in a firm is required, I would allow for a week.

Are there any rule-of-thumb metrics which indicate the likely valuation/sale price of a law firm (such as annual billings, areas of practice, etc)?

Certain percentages of gross fees are often quoted as a rule of thumb way to value a firm. However, the results that such a rule of thumb approach throw up can be wildly inaccurate. There is a huge difference in the value of the firm with $1 million gross fees and a net profit of $500,000 over another firm with $1 million gross fees and a net profit of $150,000.

Generally, valuation of a law firm is undertaken by applying a multiple to “super profits” or business profits that are produced by the firm over and above a fair allowance for the efforts of the working equity partners. This allowance is referred to as a “notional salary”. Unlike many other commercial businesses, there is usually a heavy reliance on the equity partners of a law firm for the production of the firm’s profit. Therefore, a valuation needs to make an assessment of this reliance on the individual practitioners and their contribution to overall profits. A multiple is only applied to the assessment of “super profit” or future maintainable business profits that are produced by the firm over and above a fair recognition of the individual partners’ efforts.

Sometimes for a small sole practice there may not be any “super profit”. Therefore, the firm has very little value.

Are there any valuation differences between partnerships and incorporated firms?

The underlying valuation principle of applying a multiple to the firm’s super profits is still applied to value the goodwill of a firm whether it is an incorporated firm or not. This value then needs to be incorporated into the company’s balance sheet with some adjustments to determine the share value for an incorporated law firm. With an incorporated firm, issues such as shareholder continuity requirements for imputation credits and the allocation of company dividends prior to a shareholder change need to be considered if the valuation is being completed for a proposed change in shareholding of the company.

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Last updated on the 30th June 2017