Valuing a law firm you are considering buying

Potential law firm acquisitions tend to come with a host of questions, the most vital of which is probably, how much should I pay? As you may expect, the answer is far from straightforward. This is because when one law firm acquires another, it is buying both the business and its practice.

In this context, the “business” relates to the obligations and assets that the law firm owns or is liable for. The main factors to consider include:

• Gross Income
• Profitability and Work-In Progress
• Turnover, the adage goes, is good for vanity, profits are good for sanity
• Areas of work undertaken in the practice
• Age of the practice
• Location
• Professional Indemnity Insurance Premiums – is there a history of claims? Is the person responsible for these claims still working in the practice?
• Does the practice work out of leasehold or freehold premises? If freehold, is this owned by the principal/partners or does the practice pay a rental for these premises? If it does not pay a rental, this distorts the true net profit of the practice.

Generally, the business of a law firm is valued on the net book value of its cash balance sheet. Even if you factor in the need to establish values of outdated equipment that stand to be replaced within the next few years, or client fees that are billed but are unlikely to be paid, acquiring firms should be able to value such obligations and assets with little difficulty.

In the context of valuing the “practice” of another law firm, this allows the business to create and earn its revenue. It includes the knowledge possessed by the firm’s principals/partners, alongside their networks, referral sources, professional contacts and other individuals who help the firm generate revenue both in the past and in the future. It also includes the firm’s goodwill, which allows it to generate business from professional contacts and referral sources.

Valuation methods

• Asset-based valuations

Some acquiring firms use asset-based calculations to value a practice. The focus on assets and liabilities means the valuation is guided by the business of the firm rather than its practice, as described above, and does not take into consideration the firm’s earnings or cash-flow. For this reason, asset-based valuations are not commonly used.

• Previous transaction valuations

Although basing the valuation of a law firm on what similar practices sold for would be an effective and efficient way to value a firm, problems arise because the terms and prices of these transactions are rarely made public. Even if prices were publicly available, potential acquiring firms would still remain in the dark, at least in part, because there are bound to be unique circumstances that will not be known publicly that could cause the law firm to be valued differently.

• Cash-flow valuations

This method is formulated on the future projected financial performance of the firm being acquired. In particular, it creates a valuation by estimating the firm’s future cash-flows, which tends to be based on the previous five years’ of financial statements, and the expected rate of return principals/partners would reasonably expect to receive on those cash-flows.

• Multiple earnings valuations

Here, a law firm valuation is calculated by averaging (typically) the previous five years’ of gross fee revenues. Then a factor between 0.5 and 3.0 is applied, depending on several considerations surrounding the expected capacity for those revenues to remain the same or grow in the future.

These considerations can include everything from the firm’s location, its profitability and affluence of its client base, whether its clients provide repeat business, to whether the potential acquiring firm can properly transition those clients into its firm. The more likely an acquiring firm can maintain or exceed the level of the potential firm’s average gross revenues when it becomes part of the acquiring firm, the greater the multiple.

There are few things more monumental for law firms than acquiring or merging with another practice. Such an undertaking necessitates a thorough investigation, particularly around the valuation and the price a potential acquiring firm will pay. Using the information described above, potential acquiring firms will hopefully be in a better position to understand from the beginning the work that is required in determining the value of a law firm they are considering buying.

If you have a query about the value of a firm you are considering buying, please do get in touch.