So, you have come to the understanding that your law practice has value, but next in line is the real question: How much? This number is the one that can make you feel good, feel proud and maybe even a little boastful or on the other hand this number may make you reconsider how things are structured and what you are really trying to build within your practice. Practice income now is great (and needed), but having an exit option that can fund your next career, your move to another state or your retirement is ultimately the decision of whether to sell or buy a practice.
Valuing Your Practice: What’s Your Magic Number?
A number of methods can be used to determine a law practice’s value. Each method may be right depending on needs or purpose of the valuation. Let’s start with some of the core methods and aspects used:
1. Rule of Thumb Methods. The basic premise of these varying methods is to look at past cash flows in order to estimate future value. They are based on the belief that what has happened in the past should continue in the future (hopefully). Traditionally, the cash flow numbers that are examined are either Revenues or Net Income with the latter being applied in most professional and market valuations.
– Revenues – Law practices will typically sell for a multiple of anywhere from .5 to 1.5 of average annual revenues. A practice with average annual revenues of $500,000 may, therefore, sell for anywhere from $250,000 to $600,000 (not a bad number if you previously hadn’t considered your practice had value, eh?). The big missing element on the revenues approach is that it doesn’t consider how well the firm is run or how much profit/net cash flow it leaves an owner.
– Multiple of Net Income – Law practices will typically sell for a multiple of between 2 to 3 times net earnings. Using our example from above, if that same firm has net income of $200,000 then the value may be anywhere between $400,00 to $600,000. The concern with the net income approach alone is that it leaves out core adjustments and considerations unique to that practice that can have a tremendous impact on what a buyer would actually pay for the practice.
2. Market Comparison. In a marketplace of buying and selling law practices where most negotiations and actual deals are confidential, the public’s knowledge or some database of closed transaction prices are limited to say the least. While confidentiality adds a layer of difficulty to the overall public valuation process, those with knowledge of the marketplace and what actual numbers law practices are transferring at can be phenomenal resources. CPAs, practice brokers, other lawyers, lenders and others who focus on the legal marketplace have unique knowledge based on their involvement in these types of transactions over the years.
The market approach simply compares your law practice characteristics (financials, practice area, geographic area, etc.) to other law practice sales that have recently closed to give an opinion of value. The belief is similar to the real estate market approach in that what one sold for down the street yesterday is approximately what yours would sell for today, provided they are similar enough in core features and financials.
3. Key Value Drivers. Your law practice is unique and its individual characteristics need to be considered as part of your valuation. Some of them will help increase the value but some will also lower it. Determining where your practice stands on that spectrum can play a big part in value calculation. Some of the main factors that can create a large swing in value:
– Financial Performance
– Growth Potential
– Brand Identity
– Size of Practice
– Repetitive Client Revenues and Fee Structures
– Practice Structure and Owner Involvement
– Client Satisfaction
– Practice Area
– Client Diversity
– Geographic Location
– Quality of Employees/Staff
4. Adjustments. With any of the methods used for valuation there will always be adjustments that need to be made in addition to those from the key value drivers noted. These adjustments are typically ones that have made a financial impact on the practice, but for one reason or another would be added back or subtracted to come up with true earnings. That said, every valuation should include some adjustments.
The ‘It Depends’ Disclaimer
Hey, we are attorneys and thus understand that variables can change the rules and the end result. You and your practice are unique and those specific aspects can throw any of the methods above out the window or vary them quite a bit. However, you know your practice and if you truly want to know the value of what you have built, start with the above as a first step and then gather the right information and take the time to go through the valuation process with an expert who is fit to meet your valuation needs.
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The information and advice provided in this publication is general guidance and is not necessarily specific to your individual situation, objectives or other needs. Make sure you seek a qualified expert opinion before proceeding with your transition objectives.