Defining Law Firm Valuation
Law firm valuation is the process of determining the economic value of a law firm. The purpose of ascribing value to a law firm is to determine its worth in the eyes of the buyer, whether that be a partner, an associate, a practice group leader or a lateral hire. It’s important because it gives a sense of whether the value of the firm meets the expectations of a potential buyer. So much of what law firms do is based on belief and reputation but the process of valuing a law firm gives it some substance. Just as we see with the valuation of other businesses, there are basic principles that can be applied to the valuation of a legal practice.
Like any business, law firms are worth what the potential buyer deems them to be worth. Buyers tend to look at a variety of factors in determining whether the price being asked for the firm has value. If the firm has work in process, how much of that is going to be collected? Will the work in process remain in house or will it be lost with the revenue divided by the remaining time of the matter and that amount subtracted from the original amount billed? How much of the work in process is for clients considered to also be good clients? Will the firm’s employees and lawyers stay on post-acquisition and if so for how long? If there are personal relationships within the firm that have kept it going, how will those relationships be preserved?
More than anything buyers of law firms want to know the risk to acquisition. The risk is in redundancies. Who is going to take over the work in process? Who will keep the clients engaged and happy? What equipment and systems exist to keep things running smoothly? Determining the value to a law firm is about determining the risk and then determining how much the buyer wants to pay for that risk.
The three primary types of valuation models that are used by buyers of law firms are – a multiple of revenues model; a multiple of earnings model; and a discounted cash flow model . A multiple of revenue or earnings takes into account what a firm has done over a period of time. If the firm is transferring a stable practice to a buyer or building up client relationships, this model is the best way to evaluate the law firm’s worth. For example, if $1 million of revenue from the firm is considered stable, the price might be three times those revenues or $3 million. This is not an absolute number, but a range. The firm would be worth between two and four million dollars. The buyer will then inspect the firm’s financial data to get the risk factors associated with this firm down (e.g. is every dollar readily collectible, does the buyer believe the revenue is stable). The range becomes narrower.
If the firm has a large amount of irregular revenues (e.g. litigation or a few large clients), that type of model will not work. So the buyer compares the earnings of the firm to its expenses (this is not the owner’s earnings but the earnings that would be available to the firm). The difference is the profit margin, which works with an EBITDA multiple. The market rate for those multiples runs from three times to ten times. Again, there’s a range, but the law firm’s owner and its staff make the numbers shift in the buyer’s eyes.
The third model is the discounted cash flow model. This looks at the future cash flows and applies the risk to those cash flows. (What if that particular litigation matter wins? If so, what will it be worth? What if it loses? If it does, how much will it cost the owner personally?)
It’s the rare law firm that is a pure services business and does not have some corresponding value in equipment, computers, leases, and insurance. In those cases, a liquidated value or book value makes sense – what do the assets have on the open market?
Most Popular Law Firm Valuation Methods
There are three standard methods for valuing any business, including a law firm: an income-based approach, a market-based approach, and an asset-based approach.
With the income-based approach, we consider the expected future income of a law firm. Under this approach, we convert those future cash flow streams to their current value by applying an appropriate discount rate—similar to the way we might value a stock on the stock market. Careful consideration is given to the risks inherent in a particular firm’s chance of success. Valuing a law firm under the income-based approach also requires consideration of nonrecurring items, such as losses or gain on the sale of assets, bad debts, extraordinary legal fees, and/or extraordinary write-offs, which may distort actual operations. The income-based approach is the most common way to value law firms.
Under the market-based approach to law firm valuation, we look at the selling prices of other firms of similar type, size, and quality in order to determine the price that a prudent, willing buyer might be expected to pay for your law firm. This is much the same as you do when you sell a car or a house by researching sales of similar cars or homes—in this case, other law firms.
Under an asset-based approach to law firm valuation, we take the value of the assets owned by the law firm (including tangible assets such as accounts receivable and furniture/furnishings/computers, and intangible assets such as goodwill and intellectual property) and subtract the liabilities owed by the law firm.
Law Firm Valuation and Rules of Thumb
Commonly, we will hear the terms "average" and "rule of thumb" used more or less interchangeably to describe a simple method or formula for estimating a value or range for a law firm. Whether describing an annual revenue multiple, average collections per partner or an effective utilization rate for lawyers, these rules of thumb can be descriptive but are rarely complete or even sensible in isolation of the relevant circumstances. For most attorneys, these rules of thumb do not accurately capture the final number for their law firm. Nonetheless, we would be remiss to disregard using these figures when they can be a useful starting point for a valuation.
A few common rules of thumb are:
• Multiple of annual gross revenues/collections: 1.5-2 times annual gross revenues or collections
• Multiple of annual net income: 3-5 times annual net income
• Multiple of annual WIP: 1 times annual WIP balance for a 2-3 year period
• Per lawyer valuation method: $200,000-$500,000 in revenue per lawyer
• Average hourly billing utilization of 80-85%
These rules of thumb may be useful in many circumstances. However, the real issue arises when a law firm is described as being a "top 20 personal injury firm" or a "top 10 suburban general practice" firm. Are these noise or are they reasonably accurate? For example, if a 15-lawyer "top 20 personal injury firm" sells and has a 5-year average of $6M revenue and a 5-year average of 2.5M profit, does that mean that it will sell for a total of $12M or 2X its profit? Does the low multiple, compared to the typical multiple of 3-5X, represent a ‘bargain," or was the firm value high to begin with, making it difficult to find a buyer or "right" valuation method? Maybe the top 20 personal injury firms are not all worth 2-3X earnings than their smaller counterparts.
To value a firm, the key component for price setting is comparability. While comparability can vary, net income multiples provide some of the most consistent and reliable methods available. Other methods, such as multiples of gross revenues or WIP, depend more on the practice and the clients.
Factors Impacting Law Firm Valuation
Consideration of the factors that impact the value of a law firm is essential to the determination of value. While many of these factors which are qualitative in nature may be difficult to quantify, some of the quantitative factors are particularly easy to measure and/or understand.
As both buyers and sellers of law firms take into account these various factors, there is often a willingness to adjust the financial terms of the potential transaction based on an understanding of how these factors impact value and how much money is at risk for each party in order to close the deal.
Many variables factor into the valuation of a law firm. Certainly, the level of experience of the Owner(s) will impact the value of a firm. In general, an Owner with fewer years of experience with the Firm, a smaller book of clients and exposure to fewer markets will generally see a smaller return in a sale. Buyers, of course, can view this as an opportunity to post a better return for a smaller investment. Buyers often seek to determine precisely how much the value of a firm is attributable to the actual practice and how much is attributable to a superstar lawyer.
Other factors that may impact value include size and growth rate of the Firm, both in terms of revenues and also in terms of its staff. Size can be measured in terms of actual headcount, but revenue per partner is perhaps a more direct measure of size. The breadth and depth of the Client Base will impact value. Oftentimes much value can be extracted from a firm based on the value of its Client Base and the potential for being of service to those clients.
The reputation of the Owner or the Firm and its involvement in the community will have a positive impact on value in most cases. Other considerations include uniqueness of the Firm’s practice and whether or not the Firm has positioned itself for the future in an area that is expected to grow in value and return.
Benefits and Limitations of Rules of Thumb
The pros and cons of using rules of thumb for valuing law firms are mixed. On the one hand, rules of thumb are simple and easy to use. Also, they can provide a good starting point in your determination of the value of your firm. Statements of value based on rules of thumb do tend to be quite vague, however, and require lots of explanation and qualification. A rule of thumb is usually in the format of "x times your revenue," or "y times your profit," where x and y are general estimates of a multiple for a particular type of legal practice.
A good rule of thumb for a law firm’s value, then, might be three (3) times the revenue. Therefore, if the revenue is $500,000, then a reasonable estimate might be $1,500,000. This sounds like a good rule of thumb, and it is sometimes used; although applying it to a law firm to get a valuation may be misleading . The reason is that revenue is not profit, and while revenue can be compared with revenue to make some general observations, comparing profit with profit is much more useful in determining law firm value.
So why is the rule of thumb "x times the revenue" so often used? The reason is that law firm revenue is quite public, while law firm profit is not. Therefore, if a rule of thumb is to have any utility, the estimate of the corresponding type of revenue is used. The use of a rule of thumb will provide a range of values, but the range will be wide if the quality of the revenue is not considered. The rule of thumb system allows the user to be comforted by the fact that the estimated value of their law firm is in the same ballpark as others in their industry, even though the user’s law firm may be very different from the other firms.
On the other hand, rules of thumbs can provide a good starting point in your determination of the value of your firm, but they have a much wider margin of error than a well-constrained estimate.
Examples of Law Firm Valuations
We have worked with many law firms that were contemplating an internal sale. Two particularly noteworthy examples are represented below.
Example One
For several years, our client in a high-growth practice area had discussed selling the practice to one of its associates. Unfortunately, the associate left before an internal sale was consummated. During the process, however, we had prepared a valuation of the practice and used the results, in part, as the basis for a compensation system the firm now uses for its lawyers.
Example Two
The valuation of several of our client’s practices was necessary to complete a merger with several other practices. In this case, the valuation process resulted in the same conclusions we have reached for other practices, but the support was specifically related to one large practice group instead of an entire firm.
Conclusion: Selecting a Valuation Method
Finding the best approach for valuing a law firm is not always simple, but it is possible. Accordingly, all the rules of thumb mentioned above present clues as to how a law firm or part of a law firm should be valued and perhaps even leave you with enough certainty to make an informed decision without further ado. However, often you are left with some uncertainty and more questions than answers.
If you have combined the rules of thumb in your mind and verbally communicated them with business transactions advisors and your accountant, then there is a good chance you have found the rough neighborhood of the right valuation approach . If you are still left scratching your head, then you should consider obtaining professional advice, which will provide great clarity, help avoid pitfalls, and give you greater comfort that you are making the right decision.
As my sage professor in the valuation field at New York University said over and over again – "The best approach will depend on the circumstance." And the circumstance in law firm valuation is dynamic, so your approach needs to be flexible and change as new information and market transactions come to light.