One matter which is often given limited attention in merger discussions and documents is the valuation of Work in Progress (by which I include all unbilled work variously classed in statutory accounts as Accrued Income, Amounts due on Contracts or Work in Progress).
This is a little surprising since so many mergers and acquisitions of smaller law firms are based on Net Asset Value and for most firms the largest item in the Balance Sheet is Work in Progress. It is not unusual for us to see the value of Work in Progress on a firm’s IT system to be several times the value shown in the Accounts-legitimately so!
In theory it is simple. The WIP value is shown in the Accounts and approved by HMRC so it must be right. At least it must be right for the purpose of computing tax liability, and even then there are judgement calls in the valuation. Since nobody wants to pay more tax than necessary, we should expect the judgements to be at the lower end of the range. Our accounts may well under value the true commercial value of our WIP. But when we are selling our business we want the value to be at the top of the legitimate range.
The computation should be straightforward. When we sell on a time basis, we record the time, multiplied by our charge out rate, the system produces the answer on a matter list or work in progress report
So how wide is the range of possible valuations?
The range of valuations can be far wider than you may expect-the commercial valuation may be several times the value for tax purposes. Firstly accounting standards require accrued income to be valued whenever there is a contractual right to the income-but not necessarily valued if that point has not been reached. This does not mean that the file is worthless, merely that it has not reached the point for statutory valuation.
Why can this be?
The biggest issue is often Contingent or Conditional Fee Arrangements. This is clearly a factor in Personal Injury/Clinical Negligence when most work is done on this basis, but it also applies in areas such as Residential Conveyancing, where in any case, many firms do not record time at all.
It could be that the system value is not correct, but not necessarily. There are fixed fees-where the system records and values time but if this over runs it needs to be written down. Similarly experience shows clients often negotiate fees down leading to an under recovery of the recorded time so the system could overvalue WIP. Conversely time capture may not pick up enhancements such as success fees, client contributions or value elements on probate. The system could actually undervalue the WIP. This does not mean that over and under valuations can even themselves out.
The sums involved can be material. With WIP being the biggest element in the Net Asset Value these valuations can make a major impact on the value actually achieved for the sale of the business. It is however a truism that the value of Work in Progress is only ever an estimate of the true value which is only really established at the point where the matter is billed and collected.
This is where the payment terms of the merger transaction become important. In theory it may be in the seller’s best interest to wait until matters are completed and collect their value at that point. Fine in theory but most sellers do not want to wait, they want their money upfront and do not want to rely on the buyer to compute and remit the realised value. If that’s the case and much of the consideration is paid upfront it is worth spending the time to establish detailed valuation formats and rules specify how the work in progress is to be valued (possibly by work type) for the purposes of the merger.
All of this can take time and effort at a point where time is scarce to avoid creating accidental winners and losers in an acquisition. In the case of the true merger the issue is doubly important as both parties would need to be clear about the value of the assets that they are bringing to the combined enterprise. Double the possibility for error
It can be tempting to treat the WIP valuation is a technical side issue but it can be costly to do so. There is value in taking the time to take all the relevant factors into account professional advice can pay for itself several times over.