Valuing a Legal Practice
By SAM COUPLAND, DIRECTOR, FMRC LEGAL
If any business is to be valuable it must be profitable, organised and able to achieve
replicable results through quality systems. In many respects law firms are not that different.
There are however some aspects of law firms that make the valuation process unique.
The value of a legal practice usually involves both the net tangible assets and goodwill (if it
exists).
1. Net Tangible Assets
The first step in any valuation is to work out what is being bought and what is being sold.
This requires analysing the balance sheet to calculate the net tangible assets (i.e. tangible
assets less tangible liabilities). Intangible items such as goodwill are calculated separately.
1.1 Calculating Net Tangible Assets
A legal practice is rarely sold on a ‘walk in, walk out’ basis. Usually the vendor retains some
of the assets and liabilities. Calculating net tangible assets is a balance sheet issue and is best
demonstrated below:
Balance Sheet
(as reported)
Adjustment
Balance Sheet
(adjusted)
Note
Assets
Cash
WIP
Debtors
Equipment
Goodwill
Total Assests
1,000
120,000
45,000
50,000
150,000
366,000
-1,000
-100,000
-45,000
10,000
-150,000
0
20,000
0
60,000
0
80,000
a.
b.
c.
d.
e
Liabilities
Creditors
Loans
Employee entitlements
Total Liabilities
Net Assets
20,000
25,000
15,000
60,000
306,000
-20,000
-25,000
0
0
0
15,000
15,000
65,000
f.
g.
h.
In this example the balance sheet shows Net Assets of $306,000. If the firm were being
valued for sale, a number of adjustments would need to be made to reflect the true position of
what is being sold. These following adjustments give rise to a net tangible asset value of
$65,000.
a. Cash: the vendor will keep all cash. To fund the firm the purchaser may have to make
an initial capital contribution.
b. WIP: where possible it makes sense that as much work-in-progress (WIP) as possible
is billed prior to sale date. The resultant debtors are then collected by the vendor.
There may be special situations such as conveyancing matters which cannot be
invoiced while the matter is still running(see below for guidance). Purchasing WIP
may have tax consequences.
c. Debtors: the vendor should collect all outstanding debtors.
d. Equipment: the balance sheet will show the written down value of equipment. This
may need to be adjusted to reflect the replacement value.
e. Goodwill: this will be valued separately.
f. Creditors: the vendor should be responsible for all outstanding creditors.
g. Loans: the vendor usually pays out all outstanding loans.
h. Employee entitlements: if employees are remaining with the practice, the purchaser
will usually assume all employee entitlements.
1.2 Valuing WIP of conveyancing files
Valuing the WIP of conveyancing can be difficult. One option is to split the total value of all
active matters at sale date evenly down the middle. This produces a reasonably accurate
estimate of WIP as the matters will be at varying stages of completion. Where little
professional time has been spent on a new file this will usually be offset by an almost
complete file in which substantial professional time has been spent. An example of this
'swings and roundabouts' approach is:
Number of active files at sale date
Average professional fee per file
Total value of conveyancing files
25
$1,200
$30,000
In this example, the WIP will be $15,000 for each of the purchaser and the vendor.
1.3 What about a strongroom full of deed packets?
Many vendors view their deed packets as an asset that can be sold. The difficulty is working
out a value due to the uncertainty over:

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

Whether the packets will convert into a probate file
if they do, when this will happen
What the likely professional fee will be, and
What the cost to service the probate will be.
The table below sets out an example of this dilemma:
Number of deed packets
Percentage that may become a probate file
within the next 5 years
Average professional fees for a probate file
Firm profit margin (after principals salaries)
1,000
10%
$5,000
15%
Based on this, the best profit outcome from purchasing the deed packets would be $75,000
over a five year period, or $15,000 per year. There is little point paying dollar for dollar in
profit, so the actual saleable value of deed packets (if you can determine it) is likely to be
relatively low.
2. Goodwill
The second component of law firm valuation is goodwill. For goodwill to exist, the practice
must generate profit beyond a commercial salary to the principals.
As a financial exercise the calculation of goodwill involves the following broad steps:
i. Average profit
ii. Less notional salary to
equity principals
$400,000
($300,000)
iii. Equals 'Super Profit'
iv. Capitalisation
rate
v. Total value of goodwill
$100,000
1.75x
$175,000
Note
This may be the weighted average profit over
the past three years. Any payments to the
equity principals need to be added back.
The notional salary is the salary the
principals could earn as employees in another
firm. In this example I have assumed 2 equity
principals and a notional salary of $150,000
each.
The super profit is the profit the practice
generates in excess of notional salaries. If
there is no super profit, then commercial
goodwill does not exist.
See below for details.
Super profit multiplied by the capitalisation
rate
The capitalisation rate is largely a function of how much someone is willing to pay given an
assessment of the risks and rewards of the practice. In the legal profession capitalisation rates
usually range between 1.0 times and 3.0 times.
Rule of thumb capitalisation rates (such as using 2.5x) are dangerous as they do not take into
account the unique nature of each practice. In determining an appropriate capitalisation rate
you should consider the factors set out below.
2.1 Profitability of the practice
Any business should return a salary to all working owners. Saleable profit is the amount of
income generated after salaries and expenses, including reasonable market salaries for all
working principals.
Firms are moe valuable where there is a history of consistent profits. They are mote valuable
still if profits are being generated by the operations of the firm as a whole rather than by any
one individual. These circumstances minimise risk for any purchaser.
Consider two firms that return the same profits to the principals. One is a high end litigation
practice that relies heavily on a senior partner for client development and fee generation. The
second is a property practice with a number of developer clients who are serviced by a team
of lawyers and paralegals. All other things being equal the property practice should attract a
higher valuation.
2.2 Free cash flow
A constant challenge for firms is improving the speed with which activity, or work in
progress, becomes cash. When it comes to valuing a practice a commercially astute purchaser
will want to examine how quickly a firm converts work-in-progress into debtors and debtors
into cash.
When it comes to goodwill, firms with low levels of WIP and debtors will attract a greater
value than firms carrying large amounts of inventory. WIP and debtors should be valued
separately from the goodwill as part of the net tangible asset calculation, so large amounts of
WIP and debtors (if sold) would have the capacity to increase overall sale price.
2.3 Investment payback term
The investment payback term (IPT) is the maximum period a purchaser would accept before
receiving a total return of funds invested. It involves, in part, an assessment of the risk
involved in purchasing the firm.
In many respects this is a balancing act. The payback term should not be too short or too
long. A practice that is subject to significant risk may be profitable with desirable cash flow
but the inherent risk will give rise to a shorter IPT (say one year). A less risky business may
have a payback term of three, five or more years. Although contradictory on face value, the
logic is that the lesser the risk associated with a practice the greater the likelihood of any
purchaser adopting a longer term view and the greater the valuation, regardless of profit
levels. This is of particular importance for external sales.
When determining an IPT you should consider factors such as:
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

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Brand awareness
recurrent nature of client base
level of reliance on current principals for fees and clients
areas of law practiced, and
competition.
2.4 Client concentration
The personal nature of the law means that clients often identify more with a lawyer than a
firm. Branding and promotion of individual partners and employed lawyers has distinct
marketing advantages but it devalues a practice relative to a circumstance where work is
attracted by the brand of the firm and evenly distributed.
Law firm’s with effective delegation and good leverage usually attract a greater value.
Conversely, if a rainmaker who takes pride in personally serving his clients is selling his
share of equity and won’t be involved in the practice beyond sale one could reasonably
expect a lesser value
2.5 Recent investment in operations
Profit in any period can easily be maximised on a profit and loss account by deferring
necessary upgrades and investments particularly in IT and office fit out. Purchasers should be
wary of aging IT platforms as the likelihood of a major and costly upgrade could be around
the corner. Similarly, beware that scheduled office fit outs or improvements haven’t been
deferred to take place immediately after sale.
A review of the depreciation schedules usually indicates the investment program. Similarly
any valuation should consider a comparative review (using comparative financial
benchmarks) of lease expenses for computers, software and any deprecation amount
appearing in three consecutive profit and loss accounts.
2.6 Vendors role post-sale
Depending on the circumstances the intentions of the vendor post-sale may impact on the
valuation. Practising restraints imposed upon the vendor under a restraint of trade clause to be
included in the agreement for sale of business, may bear significantly upon the value of the
goodwill.
Some purchasers would like to retain exiting principals on a consultancy basis to ensure an
orderly transition of clients and management. Other purchasers may place more value on
exiting the principal from the business at the time of sale. Obviously there are no concrete
rules here, but it is an important consideration.
3. Tying it together
From the examples in this article, the total value of the practice is the sum of the net tangible
assets and goodwill:
Net tangible assets
Goodwill
Total value
$65,000
$175,000
$240,000
Practices seeking an eventual sale should focus on:
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

Developing a track record of annually increasing profitability
ensuring as much legal work as possible is systemised and process driven and where
possible delegated to employed fee earners
having robust management accounts as well as an up-to-date and accurate client data
base, and
developing repeat clients who can be readily transferred to a nominated successor or
new owner of the practice.
Sam Coupland is a Director of FMRCLegal, a specialised consultancy providing financial
benchmark research, training and management advice to law firms.