Succession Planning: Methods for determining the value of a law practice

Editor’s note: Professional valuator Kam McQuay is the principal guest author of this column, with contributions from regular columnist Don Hopper.

McQuay

Easy question: Does a law firm have value? Absolutely. As with most professional services firms, the value of a professional service practice lies in the relationship with clients and the transferability of an established revenue stream from those clients to a third party.

A wide variety of methodologies is used in valuing such enterprises. But even more important for law firms, there are several key questions that must be answered before rendering an opinion on value. Prior to addressing any methodology issues, there are two overriding concepts that need to be addressed in valuing and assessing the net worth of a law practice:

1. Predictability. You first need to analyze the predictability of your revenue stream. At the core is the likelihood of future revenues and the risks and probability that the projected revenue stream will be realized over time. Key attributes include the difference between recurring work vs nonrecurring work, one-time engagements and sporadic jobs. Simply put, recurring work = value, nonrecurring work = limited to no value. So, annuity work (corporate engagements, wills and estate planning, etc.) creates value for a law practice, whereas one-time engagements (litigation, contingency work, etc.) have limited long-term value.

2. Transferability. The key question is whether you can transfer the client relationship. Is the client willing and does the practice have the requisite personnel and talent to assume such work? Or in the case of a transition does the new attorney possess the know-how and expertise across the entire service spectrum to perform such engagements? Is there an established infrastructure and corporate processes to perform the work? It becomes important in arriving at an overall value of a law practice to quantify the level of client transferability and to do so by person, service line and revenue source.

This is often counterintuitive for attorneys, who have spent most of their professional careers promoting their individual skills and talents and, by the end of their working careers, attract most new clients because of their finely tuned and polished reputation. As a profession, we have worked hard to obtain these characteristics and are proud of such accomplishments. Unfortunately, personal goodwill (one’s skill, knowledge, expertise and reputation) are normally non-transferable in a transaction setting and, thus, discounted when it comes to valuing a law practice.

Another issue impacting transferability is Rule 1.17 of the Rules of Professional Conduct. Under this rule, in the outright sale of a law practice, written notice must be sent to each client informing them that they have a right to retain other counsel.

Once you have assessed and quantified the predictability and transferability of the firm’s revenue stream, you must normalize this revenue stream before subjecting it to any valuation methodology.

Normalization is a process of adjusting nonrecurring revenues and expenses from the firm’s cash flows to better match what a future stakeholder would expect moving forward. The most common normalizing adjustments include: one-time expenses not expected to occur each year; personal expenses paid by the firm in order to be tax deductible (cellphones, auto expenses, etc.); items related to compensation but are discretionary in nature (owners’ health insurance, officers’ life insurance and contributions to retirement plans); and adjustments to related party rents or leases in order to make them be at fair market rates. Once these adjustments are made, you are ready to value the practice.

Most personal services entities are valued using some form of an income method, whether that be an earnings multiple such as EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) times an earnings ratio based on market data, a capitalization of historical income (of recurring work only), or the net present value of a future revenue stream discounted back to the date of a transaction. The result usually arrives at a value, heavy in goodwill with a smaller allocation to fixed and tangible assets (equipment, furniture and, where applicable, accounts receivable). Regardless of the actual methodology utilized, the result should reflect a revenue stream that is transferable within a reasonable certainty (i.e. predictable).

Rules of thumb and benchmarks

There are also some broad rules-of-thumb utilized in valuing law practices that are commonplace. Generally, over the past ten years, law firms have sold, on average, for:

• 70-90 percent of prior years’ net collections;

• A multiple of EBITDA between 3.9 and 8.4, and;

• Two to four times prior year’s net earnings or discretionary cash flows.

It is important to note that these benchmarks or formulas are rather general in nature, based often on incomplete information and normalized for an average, standard, regular and normal law practice. That is to say, if your practice is the average of the average, these rules-of-thumb may apply nicely. However, my experience has shown that each law practice is fairly unique, organized differently across industry and service lines with varying cost structures, employment arrangements and marketing techniques.

Thus, two different practices with the same annual net collections but with different service line offerings, and therefore different overhead structures, should not be valued the same. Unless, of course, you are using a rule-of-thumb of 70 to 90 percent of net collections, which would unfortunately yield the same result for both practices, even though we inherently know they are probably not worth the same amount.

So, while rules-of-thumbs are quick indicators of what a law practice might be worth and provide a good reasonableness check on actual valuation methodologies employed, it is almost always preferred to have a complete valuation performed by a qualified valuation professional in order to determine the value of the law practice.

Law practices have value. Applying the above basic concepts will ensure an equable and supportable conclusion.•

Kam McQuay is a partner at Blue & Co., LLC and is a certified business valuator by the National Association of Certified Valuation Analysts and the American Institute of Certified Public Accountants. Don Hopper is founder of Hopper Legal Consulting Services, focusing on serving solo and small law firms in developing law practice succession plans that will continue their legal legacies in their Indiana communities. Opinions expressed are those of the authors.