The Financials of a Law Practice Value Determination Explained

Many – not all, but many – deals turn on the purchase price. The rest can typically be worked out if the purchase price is agreed upon. Obtaining an accurate valuation of the practice, therefore, is one of the most important things you can do as a seller to help you actually sell the practice. In most cases, the valuation by a law practice broker will determine the purchase price. Additionally, having that valuation can help a selling attorney avoid issues presented by an emotional overvaluing of the practice, obtain the necessary financing, and find the right buyer.

From the buyer’s perspective, the valuation is important because it perhaps takes some of the “leap of faith” out of the deal. Buying a practice is a huge investment of, among other things, time, money, and emotional, mental and physical well-being. It could ultimately be a bust; the buyer just doesn’t know. But, if he or she knows the value of the practice, and can review those factors that went into reaching that valuation, he or she can rest a bit easier.

So what goes into determining the value of a practice? In a nutshell: goodwill. Goodwill is typically calculated though by a comprehensive look at the historical, current and projected financial outlook of the practice as well as other characteristics specific to that practice, practice areas, geographic area or client-base. Practically speaking, this means putting together the necessary documents and value indicators, identifying unique valuation factors, identifying issues and solutions to those issues, selecting valuation methodology and applying all of the above to that methodology.

Documents/Evidence of Value: Your practice broker or other valuation expert will provide you with a specific list of items. It will be a long list. Here are some items that will likely be on that list:

  • Annual financial statements and tax returns for last 5 years
  • W-2s/K-1s
  • Interim financial statements through last period
  • Copies of any forecasts or projections
  • Copies of business plan
  • Schedules of compensation for employees and seller
  • Appraisals and lists of specific hard assets
  • Specific Owner Benefits being paid for by practice
  • Reports of other consultants
  • Brochures, information, website, ads
  • Resumes or summary of background and experience
  • Client Fee Guidelines/Schedules
  • Engagement Agreements/Representation Letters
  • Breakout of revenue mix by percentage, including: Direct selling; Referral driven; Advertising; and Repeat clients
  • Total number of client matters over last 24 months
  • Details of significant leases, loans and notes
  • Copies of partnership agreements or associate agreements
  • Copies of any buy-sell agreements
  • Details of key employees employment contracts
  • Details of any litigation, including pending claims
  • Details on any employee benefit plans

 

Factors: There can be a massively long list of factors that are considered in any given practice valuation. But on a transaction-to-transaction basis, the most common are the following:

  • Recurring Revenue: What are the historical revenue, current revenue, and likelihood of revenue on an ongoing basis? This includes a detailed analysis of the clients of the firm, nature of legal representation and likelihood of repeat business.
  • Size of the Practice: Revenue; Number of Employees and Partners; Number of Clients; etc.
  • Assets to Liabilities: What are the debts and obligations of the practice? In relation to its assets?
  • Type of Practice: Practice area, particularly in relation to other similar practices in the geographical region and zone of service provision.
  • Location: Is it in a major metropolis? A rural area? What is the population of the area? Demographics?
  • Dependency of clients on attorney: This again goes back to repeat business.
  • Profitability: Historical and current review of the profits and margins of the practice. Is the practice’s overhead justified by its revenue?
  • Billing Rates & Realization: A detailed review of A/R and collections. Do the practice’s clients pay their bills?
  • Employees: Number, nature and skill.
  • Technology: Review and analysis of the technological infrastructure of the firm.
  • Age of Clients: This again goes back to repeat clients.
  • Concentration Mix of Fees: How diversified or, alternatively, concentrated is the nature of the fees charged and collected?
  • Terms of Sale: The specific deal terms can have a dramatic impact on valuation, including intended purchase price allocation.
  • Buyer type
  • Hard assets to be transferred (vehicles, computers, etc)
  • Fee Agreements or ongoing revenues guaranteed
  • Transition time

That is a long list of factors. And there can be several more. In summation, they can be boiled down to some key items, including net worth, current value, cash flow and projected future cash flow, and identifying those items that most drive the practice’s value, including:

  • Human capital and customer base, including the impact of diversification, AR, and relational health;
  • Product and service offerings, including the impact of market saturation/share, the existence and extent of continuous improvement; and
  • Repeatability of business.

It is also important to note that the legal field is based largely on relationships, which come and go. Market changes and factors, client transitions, real estate issues, employee retention and profitability, and other contract needs all have major impacts on the relationships of a practice, including those with its clients and referral sources. And they all have a material effect on the current and ongoing value of the practice. All practitioners should identify and incorporate specific steps to address, improve and protect relationships for the good of the practice and its value.

With all this knowledge of what information to gather and what factors may impact the most important step is applying the appropriate valuation methodology to the results of the above review and analysis. In the legal field, that often means identifying and applying a particular multiple of profit, with a typical baseline of a multiple of profit (2-3 times), or a percentage (50%-80%) of annual revenue. The results of each approach could be similar or significantly different, and which one that is used will depend on market factors, primarily including the negotiations between the buyer and seller.

Top 10 Practice Exit Planning Mistakes

If you are considering exiting your law practice in the next few years make sure to plan ahead and avoid these costly mistakes.

1. Failing to Consider All Your Options – Should you sell your practice internally? Have you considered an external sale? Is your Associate or junior partner ready to pay?

2. Not Getting Help – We are lawyers and we of course can do everything, but sometimes getting help from those who are experts is the right thing to do. Consider having an initial meeting with your financial advisor, CPA and of course, your practice broker to walk through best options for you.

3. Being Too Reactive – If you wait till the market feels right or the practice is exactly at the right number you may miss the best opportunities to transition. Just like you can’t time the stock market picking the exact right time to exit is not always achievable.

4. Not Understanding The Timeline – Selling a law practice is about transition and preparing, finding and implementing the best exit option takes time even before that transition begins. The more time you give the process the better the value and the outcome.

5. Failing to Consider Your Financial Needs – Don’t forget that your personal financial or retirement plan are dependent on the cash flow or exit value from your law practice. Make sure you have a clear understanding of what amounts you need for your personal plan post-exit.

6. Not Knowing Your Value – What is your practice worth now? Make sure you have done your own due diligence and have a complete understanding of a realistic and defendable value for your practice.

7. Getting Distracted – We are emergency responders for our clients and some days there are just too many client fires to handle to allow you to also continue the plan for your exit. See (2) above and consider getting someone in place to make sure the planning continues when you aren’t able to.

8. Not Considering the Taxes, Taxes, Taxes – Review any exit options or potential deals with your CPA and make sure taxes are calculated and determined to predict your true net number.

9. Making it Too Complicated – Exiting your law practice does not have to be complicated. Don’t get overwhelmed with the tasks ahead. If you have chosen an experienced team they will walk you through the steps and get you to the finish line.

10. Forgetting What Is Next – If you are successful in exiting your practice make sure you have a plan for post-transition. This profession has been your life for many years and now it is onto the next stage. Have a personal plan and be ready to implement.

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