Whether you are selling your law firm due to retirement or buying a firm to allow you to expand and grow, valuation is often the key point for consideration and this can be a very complex task.
The actual value can only be determined by marketing the business for sale and then negotiating between a willing buyer and a willing seller. In the absence of such procedures, law firms are normally valued using one of three methods:
- Applying a multiple to maintainable fee income
- Applying a multiple to maintainable net profits or earnings
- Valuing the net recoverable assets of the practice and determining whether to add an element of goodwill
Typically, law firms are valued at no lower than the value of the net recoverable assets. If a firm is ceasing operations, the valuation would be based on the break-up value of the net assets, which is lower than the value on a continuing basis due to factors such as: work in progress, unpaid bills, and unbilled disbursements that may not realise their full value once the firm has broken up, as well as costs associated with winding up a business.
Valuation of your law firm using multiples
Goodwill plays a significant role in valuing a law firm and is influenced by the business’s name, reputation and connections. It represents the excess in the value of the business over the value of its net tangible assets. To obtain an excess, the estimated annual maintainable profits from the business must be greater than a financial return from the investment in the net tangible assets.
Valuations based on maintainable fee income
Multiples based on a maintainable fee income have been rarely used in the last few years and are only really used when a firm has large amounts of recurring work and fees. Often brokers may quote multiples of fees as a valuation basis, but in reality, when you are buying a firm, it is the right to the future profits of the firm that you are acquiring, and so multiples of profit are the usual real valuation basis in law firm transactions.
Valuations based on net profit or earnings multiples
The multiple used is a valuation based on net profit or earnings multiples will differ based on factors including the business’s size and age, the reason for the transaction, work type and who the acquirer is.
Once the profit multiple has been decided, it is necessary to determine which profits to apply it to. This is often achieved by taking a weighted average of the profits earned for the previous three years, with more weight being put on recent years. Adjustments are often necessary to reflect ‘maintainable’ earnings.
Applying the multiple to the maintainable earnings gives you the Enterprise Value of your firm. However, most deals are completed on a cash-free, debt-free and normalised working capital basis. To determine the Equity Value, adjustments are made to add cash and cash-like items and deduct any debt and debt-like items, and account for normalised working capital.
Valuing the net recoverable assets
Valuing net recoverable assets requires careful consideration. The value shown in the accounting records may not accurately reflect the true value, especially for contingent work types. Aging profiles can indicate the recoverability of unpaid bills and unbilled disbursements, with older items being less likely to be collectable. However, certain work types, such as Personal Injury, cases may have longer durations and therefore comparatively older unbilled disbursements may still be considered collectable.
How do I value my law firm?
There are many intricacies in every firm which will affect its valuation, and the subjective nature of these intricacies shows that one person’s valuation of a business may vary from another. It’s therefore important that you seek professional advice when trying to value any firm or decide on potential future strategies.
This article was written by ALFMA member Armstrong Watson. ALFMA members can be contacted here.