The approach to how companies, including law firms and other corporations, are valued has changed significantly in recent years. As such, organic expansion is probably not going to be sufficient when law firms determine there are areas of the law or regions they should practice in—possibly because they would be complementary to an existing practice or location. Considering mergers or acquisitions as part of a firm’s overall growth strategy is essential. In this regard, law firm valuation can play a role in a merger and acquisition as well as for recruiting partners by providing insight into the valuation of the business for strategic decision-making. This article aims to provide a complete guide to law firm valuation.
Law firms and their valuation
Basically, law firms are businesses and, like any other business, have to be valued for several reasons, including financing, mergers, acquisitions, or recruitment of business partners. As a matter of fact, law firms are often sold or acquired based on valuation. In order to make an informed decision, law firm valuation can provide a snapshot of the firm’s financial strength, risk profile, and growth prospects. As such, valuation plays a key role in the decision-making process for law firms as part of a strategic growth plan.
Why should you value your law firm?
For law firms to expand into new practice areas or geographic areas (maybe because they would be a good fit for an existing practice or location), organic growth alone is unlikely to be sufficient. As such, acquiring or merging with law firms becomes crucial to a firm’s growth strategy. However, any potential acquirer of a legal practice faces a wide range of questions. Perhaps the most crucial concern is, “How much should we pay for that other law firm?”.
Following are a few examples drawn from situations wherein law firm valuation plays a significant role:
- Merger – Profit sharing will be governed by the original distribution of shares/equity participation and the partner remuneration scheme of the newly amalgamated company. Together, they ought to safeguard against dilution while accurately reflecting the relative value generated by the parties both at the time of the merger and going forward. A crucial aspect of this procedure will be the newly combined firm’s financial forecasting and participation modeling. In essence, the “goodwill” that existed prior to the merger is being converted into future earnings that will be shared equally by the partners. In order to analyze, evaluate and segregate all this, valuation becomes vital.
- Acquisition – Suppose a seller gives up ownership and management of its business in an acquisition, even though its partners may continue to participate in the acquiring firm. In that case, the acquirer will pay for net assets as well as any goodwill. The extra value an acquirer anticipates will determine the value of goodwill, if any. Unless there is a considerable gain in profit per equity partner, an acquirer is unlikely to want to pay much only for an increase in the size of the business reflected by the addition of its revenues to those of the seller. These terms and considerations are framed based on valuation and its result.
- Recruiting partners – Typically, procedures or standards are in place to control the addition of new partners, the sale of their shares, and profit sharing. Any added value to continuing partners will, in any case, depend less on synergies and more on the retention of clients and referral sources as well as the profits “liberated” by retiring partners because the partners are already familiar with the business, in contrast to an acquisition by an outside party.
Factors that affect law firm valuation
The first thing to keep in mind is that there are several distinct approaches to valuing a firm. As a result, when valuing a law firm, you need to take into account several important factors, including:
- Attorney and staff – Demonstrate how you can assist your coworkers in learning something they may not already know or be comfortable with, such as completing a timesheet correctly or conducting legal research. If someone is new to the law firm, you can help them understand how things work; but even seasoned attorneys frequently change jobs, dockets, or practice areas. If you have insightful observations about people, processes, and procedures, share them! As they contribute to your firm’s growth.
- Location – Purchasing a legal practice in a populated location gives you access to attractive marketplaces and additional revenue streams. This allows a better working environment that is accessible and conducive to professional development. As such, valuation experts believe that the location of a law firm is an important consideration in regard to its business valuation.
- Lease terms – A lease’s terms include the parties’ respective responsibilities and other provisions outlined in the agreement between the lessee (often the tenant) and the lessor (generally the landlord). Everything will affect the value of your business.
- Transition – A buyer’s trust in paying at greater multiple increases the more you are willing to stake on the reliability of your revenue. Higher firm goodwill that is being transferred to the new buyer indicates lower upfront payments.
How to value a law firm?
There are several methods that can be used to value a law firm. Essentially, some mathematical calculations, assumptions, projections, and comparisons with similar businesses can be used to determine a firm’s value. It is essential to note that these methods can be applied in combination with other approaches in order to provide a more robust valuation. However, before moving forward with the actual methods and calculations, let us consider the factors before valuing a law firm.
Factors to consider before valuing a law firm
Since the objective of a valuation is to establish a firm’s fair value, however, the valuation process entails internal and external factors. Following is a list of factors that should be considered in order to arrive at an accurate valuation:
- Cash flow – A thorough valuation will take into account free cash flow when calculating the profit multiplier to be used. Businesses with low levels of WIP and debtors will be valued higher when goodwill is taken into account than businesses with high inventory levels. WIP and debtors are typically appraised independently from goodwill; thus, having a lot of them could raise the price of the sale as a whole.
- Investment payback period – The investment payback term (IPT) is the longest amount of time a buyer would agree to wait before receiving a full return on their investment. It includes an evaluation of the risk associated with buying the company.
- Profitability – Any asset will be worth more in relation to risk the higher the return on investment. A profitable business will command a higher price from prospective buyers.
- Concentrations of clients – Clients frequently associate more strongly with an individual attorney than a firm since the law is so personal. Although branding and promoting specific partners or employed attorneys have clear marketing benefits, it devalues a practice in comparison to a situation where clients are drawn to the firm’s reputation and are evenly divided.
- Post sale vendor’s role – The vendor’s post-sale intentions could affect the valuation depending on the circumstances. To guarantee a smooth transition of clients and management, some buyers would choose to keep departing principals on a consulting basis. Other buyers might place a higher value on the principle of leaving the company when it is sold. There are obviously no set guidelines here, but it is a crucial factor to take into account.
- Premises – Deal-specific commitments apply to the premises. The length of the lease agreement and the way any lease incentives have been structured would be of interest to any buyer. Incentives should preferably be amortized throughout the course of the lease to reflect fair value. The value ought to represent a firm’s commitment to paying higher rent after having traded rent-free for a while.
- Current Investment – Delaying critical upgrades and investments, especially in IT and office fit-out can easily maximize profit in any period on a profit and loss statement. Buyers of old IT platforms should exercise caution because a significant and expensive update may soon be necessary.
Methods to value a law firm
There are different valuation techniques, and an appraiser will probably use a mix of the following techniques to calculate the worth of your company, depending on the specifics and the purpose of the valuation. The following are the most common law firm valuation methods:
- Asset-based approach – Under this approach, the appraiser will determine a law firm’s worth based on its assets’ value. Basically, the firm is valued by taking the fair market value of its total assets minus any liabilities. The assets can include all the valuable resources that a firm possesses, including property, cash in the bank, equipment, machinery, furniture, and software. Thus, the asset-based approach is the most reliable and accurate law firm valuation method.
- Cost Approach – The cost approach is the second most common approach used to value a law firm. Under this method, identifying the cost to create an exact replica of a firm’s current structure will give you a fair and accurate estimate of its value. Typically, calculating all the costs associated with setting up a law firm allows the appraiser to come up with an approximate value. This may include development costs, marketing costs, building costs, software purchase costs, and so on. However, the cost approach requires a great deal of research and time to calculate the estimates.
- Market approach – In this approach, the values of similar companies operating in a similar market are compared to determine a proper value for the firm. The market value of each firm can be determined by using such metrics as comparable firms, market share, net profit margins and a host of other internal and external factors. As a result, the fair value of the law firm can be determined by using the most appropriate metrics and figures with corresponding company-specific information.
- Rule of thumb – A frequent technique for determining a company’s value is the rule-of-thumb approach. The law firm valuation rule of thumb is a straightforward process that doubles the gross revenue from one year by a specific number. The multiplier range commonly used in the legal industry is 0.5 to 3.0. Several elements, including the following, determine whether the multiplier is at the high or low end of the range:
- Legal practice area
- Number of customers
- Number of returning customers
- Geographical area
- Discounted cash flow – Instead of relying on a legal firm’s past performance, the discounted cash flow method does so. The technique entails projecting a company’s future cash flows, frequently using financial statements from the previous five years as a basis, and then using a growth rate to approximately project a terminal value at the conclusion of a predetermined time. The terminal value and cash flows are next discounted to their net present value. The method essentially calculates the expected rate of return on future cash flows.
How to maximize your law firm valuation?
Now that you have given your all to finally grow the law firm, the best you would like is to have the best valuation when selling. Enhancing your company’s financial health before beginning a valuation process is one method to be sure of this, especially if you plan to sell it, as this will make it more appealing to potential purchasers. Consider the suggestions made by your staff and clients. Are there any areas where you could make improvements to raise the value of your business?
One important strategy for raising your legal practice’s value is implementing new technologies to improve and streamline operations. Using new software to automate particular operations can significantly streamline the work and use the extra time for more productive work.
Need help in valuing your law firm?
When valuing a business, it is important to take into account all facts and figures and look at all sides of the equation. Law firms are no different from any other business. Therefore, the same principles apply. In order to facilitate decision-making, strategizing, and making the best move for your law firm, a realistic and accurate valuation is necessary. Thus, Eqvista helps you to streamline the process by providing a transparent, real-time, and data-driven approach. At Eqvista, years of experience and expertise are at your disposal to navigate through the process of valuing a law firm with confidence.