Considerations in Valuing a Law Practice
Since the ABA’s amended Model Rules of Professional Conduct (1990), which added Rule 1.17, most states have adopted the authorization for a practice to sell its goodwill. Changing demographics and the aging of the United States population (and legal practitioners) contribute to the competition for a client base in a desirable geographic area; particularly, where there is a glut of such practitioners. There are an estimated 1,044,000 employed in the legal profession according to the U.S. Bureau of labor statistics with this number continuing to grow by 2.5% annually through 2006.
This has produced increased competition for legal services and has contained legal fees and created nominal client loyalty, where many clients retain firms on a project-by-project basis. An increase of less costly mediation and Alternative Dispute Resolution (ADR) is occurring. In turn, more paralegals and associates are performing legal work to contain costs.
A law practice’s sale tends to be based on both the value of tangible and intangible assets. The intangible assets are often referred to the economic return expected from the bundle of rights associated with the collection of the tangible assets and staff. The most commonly referenced intangible is goodwill.
Determining goodwill value requires certain business metrics, such as number of clients, transferability of client base and stability of flow of revenues. A law practice is a service business where even larger firms have clients that typically develop a relationship with one practitioner. It is unique from most other service businesses as it requires a license and a considerable investment in education, which limits the pool of potential buyers.
Practice goodwill is more easily transferable and includes location, nature and duration of practice; capital structure, employee and supplier relationships, agreements and advertising.
One’s professional goodwill is not readily transferable and includes one’s education, experience, skills, reputation resulting from client trust and respect, work habits, demonstrated earnings power and comparative professional success and personality. The transferor might engage in efforts to maintain goodwill, such as an announcement and personal introductions and may remain at the practice for an agreed upon period.
Generally, the larger and more diverse a firm, the greater the transferability of practice goodwill is due, at least in part, to client retention. Conversely, if the practice’s success relies upon professional and/or client referrals to a specific individual due to specialized services, transferability is much more difficult as another cannot simply “take over” and expect the referrals to continue uninterrupted.
The nature of the client base tends to differentiate the value of one professional practice from another. This is particularly true when “chemistry” between a practitioner and the client is of greater importance than the technical ability of the practitioner. A more desirable practice is one that is able to provide services to its clients on a recurring basis versus direct marketing. Practices may be worth more in areas of large competition as it may be less expensive to purchase an existing client base, when transferable, than attempting to start one from scratch.
Areas of goodwill that must be considered are competition level, referral base, client type, work habits, age and health of practitioner(s), fee schedules, length of time in practice, source of new clients, area demographics and costs associated with setting up a new practice and attracting new clients comparable to the revenue benefits of the firm being valued. This last item addresses the time-value of money. In other words, how long would it take to generate similar excess earnings to that of the firm being evaluated?
Other intangibles may be organizational; technological and proprietary know-how; client lists; (computerization) of databases; contracts agreements; favorable leases; reference library; procedures and manuals; non-compete covenants; telephone numbers; supplier contracts; and trained and assembled work force, to name a few. The asset’s remaining useful life is also very sensitive particularly if it is less than 10 years.
The value of the goodwill is likely based on expected future earnings, which may fluctuate depending on the type of law practiced, the fee basis and general economic conditions. The issue is the predictability of future returns (risk). Goodwill may really only have value if it increases future earnings. Justice Benjamin Cardozo in Marriage of Brown (NY 1926) expressed that goodwill was the tendency for customers to return to the same location or business because of its name or other attributes, regardless of its location.
This may be compared by examining the revenues of a new practice versus an established one with the difference likely to be that of the goodwill. In Marriage of Holbrook (Wis. App. 1981), it was the position of the Court that the goodwill of the firm existed in the salary. In Hanson v. Hanson (Mo. 1987), the court characterized “going concern” value as the opportunity to walk into a successful situation and start work, earning money immediately without having to “build a practice”.
It may be argued that the cost to assemble tangible assets combined with the efforts of ownership, and other intangibles, to duplicate a similar amount of annual revenues, to the entity being appraised is, in part, the goodwill of a business. The efforts of ownership can be viewed as assets – human capital – based on the income stream that can be expected in the future. “Human capital” is the term used to describe the capitalized value of increased stream of earnings that will flow to an individual who has been the recipient of an investment in skills and knowledge.
The past efforts of one with existing goodwill will produce higher future earnings than one in which this asset is absent. This mimics the component of “sweat equity” of a buy-in by an practitioner whose efforts earns, at least in part, the right to an ownership interest in the practice.
The middle ground between Marriage of Powell (Kan 1982) and Marriage of Fenton (CA 1982), likely lies with the Missouri Supreme Court definition of goodwill. This was expressed as the value of the practice which exceeds its tangible assets and which results from the tendency of clients to return or recommend the practice irrespective of the reputation of the individual practitioner.
The most common method to measure any goodwill is to capitalize (apply a multiple to) excess earnings, where Revenue Ruling 68-609 methodology is used. A historical pattern is important and is weighted under the belief that past performance is a predictor of the future, keeping variables, such as market influence in mind.
The other is the difference between sales price and tangible asset value. The tangible assets of a law firm are usually represented by capital and undistributed profits in the form of fixed assets and cash. Rarely does a purchase include a share in the practice’s accounts receivable or work in process that may exist at the time of transfer.
It is not unusual to see a 100% capitalization of total earnings (includes reasonable owners’ compensation) compared to 20% to 35% after-tax earnings after consider for reasonable owners’ compensation. Future growth of the practice will require subjective judgment as will considering risks associated with this versus alternative investments.
Several rules of thumb exist. They are 40% to 100% of annual fee revenue (may require earnout). Firms specializing in estate work would approach 100%.Goodwill at 2 to 4 times excess earnings after taxes (may require earn out). Only a small minority of all professional practice sales are on an “all-cash” basis. Balances may not be fixed, but rather may be contingent on future events eventually resulting in an earnout.
Working Capital (cash & inventory less payables) may need to be included. “Earn outs” are a method of structuring the sale that allows the buyer to pay in installments with the balance contingent on the financial results of the practice. Variables include size of down payment; length of earnout period; ceiling and floor regardless of client gains or losses; and basis of earnout base (revenues, net earnings, total cases, etc.) Obviously, the longer the earn out time period the greater the impact of inflation on discounting the sales price.
The value of most professional practices is based upon the timing, riskiness and volume of future cash flows generated. It is important to remember that buyers are interested in paying the seller an amount based not on what the seller generated in the past but what the buyer considers a likely return in the future. This cash flow comes to an equity holder in two forms: compensation for labor and return on equity in the form of distributions or capital gains.
Distributable cash is available to the owner after meeting all necessary operating expenses and reasonable compensation.
Many Courts perceive goodwill’s value to be speculative in nature and prefer a value that reflects net book value to include accounts receivable and unbilled work in progress. It may also exist when it is not recorded on the balance sheets of a “cash” basis entity and would also include fully depreciated equipment and leasehold improvements. Cash basis accounting may require adjustment to accrual basis to reflect work-in-progress, accounts receivable and payable as well as other financial items. Accounts receivable include business booked, not performed and business concluded, not paid or aged and sent to collection.
This may require discounting of aged receivables based on payment history. Occasionally, contingency fee practices account for work performed, but not yet billed; however, payment may be based on a successful outcome. If many cases comprise this contingent asset, then a historic average of actual case win rate and awards may be necessary to establish some value as well as billed hours expended on each case.
Firms that operate with contingency fees, which is likely in the instance of personal injury and other accident related events, are more difficult to value as the nature of the case and its outcome is unknown, as opposed to calculating billable time for hourly fee practices. Assumptions will be required to determine the average time to settle a case; the average fee per case settled; the expense ratio per case; and the number of cases that are not average and non-recurring as when a large settlement is obtained.
One of the risks associated with the purchase of an interest in a professional practice is continuity. The establishment of a payout and vesting periods for a specific duration, agreed upon by the seller and buyer is ideal. The existence of distribution of gains and losses should be capped annually. A notification of withdrawal within a certain time with forfeiture of interest and a non-compete provision are all integral components to a successful transfer. The non-compete provision is difficult to enforce; yet no buyer wants to pay “good money” if (s)he knows that the seller may open practice nearby.
Purchasing an interest in a practice based on its size is a relevant criteria due to structural (operational, financial and legal), transactional and market differences. In most cases, a smaller practice has not created durability that allows for the departure of a key attorney with nominal economic impact to the practice. In smaller practices, a purchaser is “buying a job”, so equity will be mostly attributed to owners’ salaries. Sources of reasonable compensation may be found through Altman Weil Pensa’s Annual (Small) Law Firm Surveys as well as some bar associations and head hunter specialists.
This survey would suggest a 3rd year associate may be looking at $80,000 in annual average salary at a private law firm, but based on what number of hours performed? This salary is very important in order to determine earnings in excess of reasonable. The excess earnings is what is capitalized to determine goodwill.
Detractors of this method believe that higher compensation is part of the drive and risk associated to a profession, especially when one is self-employed.
There are seldom discounts for minority interests held in a professional law practice as most interest holders have prerogatives of control unless there are minimal benefits associated with ownership.
A buy-sell and/or buy-in agreement(s) may provide an interest holder with a degree of liquidity by specifying a value. If the firm has a history of buying out prior interest holders under a buy-sell or other agreement, the marketability discounts are lower. There are seldom discounts for minority interests held in a professional law practice as most interest holders have prerogatives of control unless there are minimal benefits associated with ownership.
It is obvious that lawyers do value practices when firms merge; when new partners are brought in; when an attorney is compensated for his interest due to disability, retirement, withdrawal, retirement or death; and during a marital dissolution.
To summarize, while no real standard has not yet been developed for law practices, the multiple is likely to be higher if repeat business is expected. Smaller practices will have lower multiples of earnings; even below one, if the perspective of the buyer is that client relationships will not be retained. A specialized practice tends to rely on referrals from other professionals who base their referrals on the reputation of the specialist. A more diverse practice tends to sell at a higher price than one that is specialized.
There are limitations on the potential pool of buyers. Those with the professional license, skill and financial means to purchase. What will a willing buyer pay for the practice of a willing seller when both have reasonable knowledge of the circumstances and neither are under compulsion to buy or sell? The true reality test is the marketplace.
Brown, Ronald L. Valuing Professional Practices & Licenses (New York: Aspen Law & Business, 1998) Chapters 16 - 18
Feder, Robert & Stacy Collins Valuing Specific Assets in a Divorce: Legal Practices (New York: Aspen Law & Business, 2000) Chapter 11
Fishman, Jay E., Shannon Pratt, J. Clifford Griffith & D. Keith Wilson Guide to Business Valuations (Fort Worth, TX: Practitioners Publishing Company, 2000)Volume II, Chapter 11
Pratt, Shannon P., Robert Reilley & Robert SchweihsValuing Small Businesses & Professional Practices (New York: McGraw Hill, 1998) Part IV pp.557 – 670
West, Thomas L. and Jeffrey D. Jones Handbook of Business Valuation (New York: John Wiley & Sons, Inc., 1992) Rules of Thumb pp. 123 – 124
Zukin, James H. Financial Valuation: Businesses and Business Interests (Boston: Warren Gorman & Lamont, 1990) Chapter 20