Succession Planning: How to Determine and Realize the Value of Your Law Practice

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Feature_2Valuation

Financial theory and valuation practice support the fundamental principle that the equity value of a business (law practice) is the present value of future practice net cash flows discounted at a risk-adjusted rate of return. Like an office building, valuation professionals use (1) an income approach (like the rents/net operating income in the office building) and (2) a market approach (like the per square foot estimate of the value of real estate) to calculate and estimate the value of equity. But, let’s get real…

Practical Approach

Be it a partnership, proprietorship or corporation, the real asset of any law practice is the “book of business” controlled by the responsible client manager. To value a book of business and sell a law firm, we suggest this practical approach:

  1. Compare and contrast the subject book of business to the industry standard. Specifically, hours worked, billed and managed, realization rates, professional time utilization, revenue per employee/partner, referral sources, rent and other operating expenses should be compared to industry standards. The subject is either at, better or worse than the industry standard.
  2. Determine the industry standard revenue multiplier. That is, find transactions in practices that sell as some percentage of cash basis fee revenues. (Example:  0.60 x trailing 12 months revenue). The more recurring annuity type of provided services to recurring services users, the more valuable the book of business/firm and more likely a successful transition can be accomplished.
  3. Depending upon the result of the comparison in No. 1 above, adjust the multiplier up or down from the industry standard. The resulting calculation is the intangible value of the book of business/firm.
  4. Because almost all comparable market transactions are asset (as opposed to equity) sales, to determine the value of equity the “packaging adjustments” of an asset sale need to be considered. To the calculation made in No. 3, add cash, the realizable market value of receivables and unbilled work in progress less ALL liabilities of any kind at the valuation date. The resulting calculation is the equity value of the book of business/firm.

Let’s Make a Deal/Term Sheet and Definitive Agreement

Most (but not all) reported transactions are NOT cash equivalent. That is, a check for the entire calculated amount is not paid at close. Due to the very personal nature of legal services, buyers wish to minimize risk and offer contingent consideration. If the clients listed on Exhibit A to the Purchase Agreement pay fees to the buyer, then an agreed percentage of the fees are paid to the seller.

In the above example at 0.60 times revenue, if the payout period were five years, then the percentage of gross payments would be 12.0 percent (0.60/5) of collected fee cash receipts. It is common that the settlement payment is made quarterly and if a floor price deposit (see below) is paid, then that amount is credited against the amount due until the deposit balance is exhausted.

The advantage to the buyer is risk minimization. For the seller, the advantage can be deal price maximization especially if the seller is helpful in the transition to the successor firm. The seller sends a letter to the book of business clients saying that great effort was made to find a highly qualified successor and that the seller has agreed with the buyer to work on client files and assist the transition as needed. (A separate Consulting Services Agreement for “as needed” consultation at an agreed hourly rate, with margin for the buyer, is customary).

Other common deal terms are:

  1. A purchase price floor.
  2. Minimum and maximum consulting hours to fit the needs of both buyer and seller.
  3. Retention payments for key personnel.
  4. Security, collateral and guarantees, if any.
  5. Incentive payments from seller proceeds to reward and acknowledge prior and planned work effort.

Taxation of the purchase payments is an issue. Are they deductible to the buyer as ordinary income to the seller, or asset purchases not immediately deductible to the buyer but capital gain to the seller? Likely, it is some combination of both. (Tip: Early on, discuss this issue and even fill out a preliminary draft pro-forma IRS Form 8594 as part of the Letter of Intent or Term Sheet). Remember, value is value, but deal terms affect the final negotiated price. These same concepts can apply to a transfer WITHIN the firm from senior partners to partners and/or associates.

Final Thoughts

It is important to note that the book of business/firm may be more valuable in the hands of a potential buyer than it is as operated. It is possible that the book of business, the required professionals and staff relocate to existing office space and rent is actually less when allocated to the larger revenue base. Similarly, head count reduction, changes in employee benefits or policies may result in lower operating costs and greater contribution margins. All of these facts should be considered when negotiating deal terms and value.

In our experience, the best kind of deal is negotiated in the sweet spot between the fair market value of the practice operated as is by the seller and investment value to the buyer that includes the synergies, strategic benefits and cost savings to be realized by the buyer.


Michael J. Eggers, CPA/ABV, MCBA, ASA, FIBA, ABAR, works for American Business Appraisers LLP. He can be reached at mje@abasf.com.

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