Does A Law Practice Really Have Value After An Owner Leaves?
Every Law Practice Has A Separate And Marketable Value Of Its Own
My law practice has value? Seriously? Seriously. Like any other business, each law practice has a separate and marketable value of its own. You have built and managed a proven business model. The tasks that were difficult years ago when you started your practice are no longer obstacles, but instead they have been solved with the client base, employees, processes, checklists, knowledge base, software and numerous other elements, that make up your daily operations. All of those resources have value to someone who doesn’t have to repeat those ‘fun’ exercises of experimenting with software, training employees and the other challenges which may or may not turn out successful. However, the biggest impact on value that you and your law practice can offer is the ongoing and future access to contacts, referral sources and clients along with the trust and comfort they have with you, your team and your overall practice. In a nutshell, that business platform along with the expectation that the clients will keep coming and the referral sources will keep referring (with a little transition help), the accompanying revenues will produce your law practice’s value.
Common Valuation Methods
What’s Your 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.
a. 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.
b. 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 $400,000 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:
a. Financial Performance
b. Growth Potential
c. Management & Personnel
d. Brand Identity
e. Size of practice
f. Repetitive client revenues
g. Practice Structure and Owner Involvement
h. Client Satisfaction
i. Practice Area
j. Client Diversity
k. Geographic Location
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.
5. Transition and Payment Terms. Regardless of the value for your practice the real question becomes how to obtain the value from a buyer or successor. Payment structures vary just as widely as the practice value’s themselves, but in most all transactions the buyer and seller will agree to some form of payment over time to ensure seller is committed to transitioning the practice goodwill and client relationships to the next owner. Flexibility in payment structure is a great way to maximize price and find the right strategic buyer for you or your practice.
6. The ‘It Depends’ Disclaimer. Hey, we are attorneys, right? After all, you and your practice are unique. Those unique aspects can throw any of the methods above out the window. You know your practice. If you truly want to know the value of what you have built, start with the above as step one, gather the right information and take the time to go through the valuation process with an expert fit to meet your value needs.