The legal industry is competitive. The American Bar Association (ABA) reports that there are approximately 1.3 million licensed attorneys in the United States. Those attorneys work across more than 400,000 law firms—with the overwhelming majority being small law firms having nine or fewer attorneys on staff. Given the numbers of these law firms, it begs the question of how these law businesses are continued as ownership changes over time. In many ways, a law firm is similar to other businesses. One of these is that it can be bought or sold.
The first step in buying or selling is always to look at what’s the value of the business. However, there is an inherent challenge that comes with valuing a law firm for when considering an exit planning, sale, or purchase. Whether you are considering selling your law firm, buying a more significant stake in your current practice, or buying a separate law firm, it is imperative that you know how much it is worth as a benchmark to set other details in place. In this article, you will find a comprehensive overview of the key things to know about how to value a law firm.
Every Firm has a Marketable Value—But It Can Be Difficult to Determine a Precise Number
Every law firm in the United States has a marketable value. It is worth something to somebody. The core challenge of buying, transferring, or selling a law firm is that it can be challenging to put a precise dollar figure on the value. A law firm’s “goodwill”—an intangible asset that encompasses its reputational value—plays a big role in the valuation of a law firm.
An Overview of Methods to Value a Law Firm
There is no “one” correct way to value a law firm. There are several different common methods that are used to determine how much a law firm is worth. What makes the most sense for your situation depends on the specific factors. Some methods that are used to value a law firm include:
- Rule of Thumb Approach (Revenue): Known by the short-hand “rule of thumb” method, this law firm valuation approach looks at revenue. The law firm’s value is presumed a multiple—usually one or less—of a single year’s total revenue.
- Asset-Based Approach: With the asset-based approach, value is assigned to the tangible and intangible assets held by the firm. The approach can be useful for law firms that own significant tangible assets, such as receivables, cases in progress, or other non-goodwill assets.
- Market Comparison Approach: The market comparison approach looks at similar sales that have occurred in recent months or years. A comparator law firm can help to provide a baseline.
It should be noted that law firm valuation methods are not “either/or.” In most cases, it makes sense to consider multiple different valuation approaches to determine the proper valuation for a law firm and when a true valuation analysis is done more approaches are utilized and typically weighted by how applicable they may be to the subject law firm.
Many Factors Affect the Valuation of a Law Firm
A law firm should always be valued on a fact-specific basis that considers all methods, but also the non-financial aspects of the firm that may make it unique and push the value up (or down). A careful assessment is needed of the law firm’s prior, current, and future financial position along with these other factors. There is a wide range of different things that will impact the core value of a law firm. Specific factors that can impact the valuation of a law firm include:
- Revenue (both historical and year-to-date)
- Size of practice (number of attorneys and staff)
- The value of hard assets
- Ongoing financial liabilities, including debts
- Historical and current-year profitability
- Type of practice area
- Location of the practice
- Involvement of the owner-attorney in legal work
- Marketing and brand
- Demand for practice area
- And many more.
Law Firm Valuation Tip: Documentation is key. Whether you are buying or selling a law firm, it is crucial that you thoroughly review all of the firm’s financial documents and records. This includes everything from annual financial statements to business tax returns to appraisals of hard assets. To determine the true financial picture of a law firm a comparison and new model of the financials are usually built to show the true normalized financials.
Both Buyers and Sellers Need to Get the Valuation Right
Price matters. A seller of a law firm that undervalues their business is getting less than they deserve. An enormous amount of time and effort goes into building a successful law firm. Along the same lines, a buyer that pays more for a law firm than it is actually worth will be in a challenging financial position. It may be difficult to make out well on the investment.
The Bottom Line: A law firm is inherently difficult to value, but market value metrics and experts are available to help more now than ever before. A wide range of different unique factors must be considered to determine how much it is actually worth and a skilled professional who has experience with law firm valuation can help you determine the value.
The Law Practice Exchange is a Leader in the Valuation, Buying, and Selling of Law Firms
At The Law Practice Exchange, LLC, we were built by lawyers for lawyers. If you have any specific questions or concerns about how to value a law firm, we are here as a professional resource. Contact us today to set up your fully confidential initial appointment. We are also proud to be the nationwide leader in law firm brokerage services.