What Is the Value of Your Law Firm?

There is not much literature available about how a law firm is to be valued ' or if a law firm is capable of valuation at all. A significant debate around this issue is presently underway in the United Kingdom, where deregulation of the legal profession has given rise to a lot of speculation about the future of the legal profession as we know it. The Legal Services Act, which was passed into law at the end of 2007, essentially provides that law firms may be owned by non-lawyers, and many in this context speculate that especially smaller law firms will be bought and sold just like regular businesses. After all, what makes a law firm so different from accounting practices, where buying and selling is commonplace? Since the answer to this question is relevant not only in the UK, but also for law firms in the United States, this article summarizes our approach to law firm valuation which we have tested in the contexts of law firm acquisitions and equity buy-outs.

Law Firm Valuation in Context

Valuing a publicly held company is fairly simple: At its most basic, one opens the daily newspaper, finds the appropriate stock quotation, and multiplies the stock price by the number of shares outstanding to derive the current market value of the business. Current macro-economic conditions aside, public company valuation ' rightly ' assumes that the collective market has perfect or near-perfect information, and knows exactly the present value of future cash flows that a shareholder can expect.

When one seeks to value a private industrial company, things already become much more complicated. First, there is no readily determinable market for a privately held company. Second, a privately held company does not get bought and sold every day, and thus there is much less reliable information about the company than there is in the publicly held context. Third, valuation is as much a number-crunching exercise as it is a qualitative assessment of intangible factors that
impact the business's ability to generate future cash flow: Much more depends on the company's ability to navigate its competitive environment, on the company's existing structures and systems and, most important, the skills and abilities of management to drive a strategically rational business model. While there are many common elements in how private company valuation can be approached, the plethora of books written on the subject allows the conclusion that private company valuation is as much an art as it is a science.

Professional services firms ' law firms included ' provide a special, more difficult context of private company valuation. At first blush, many approaches and bases for an ordinary private company's valuation appear at minimum difficult to apply to law firms and at the most are simply inapposite. The ability of a law firm to generate future cash flow depends much more on the ability of individual partners and on the firm as a structure to provide intangible value drivers, which is much more difficult to quantify than, for example, a private industrial company's ability to generate a return on assets.

Customized Approach to Law Firm Valuation

My firm has recently been approached to stress-test valuations undertaken by others; as a result of our work, we have developed our own customized approach to valuation that is bespoke to the legal sector. Our approach essentially involves three major steps after we have made ourselves familiar with the firm and its financials: 1) analyze external influences impacting on the firm's business; 2) analyze internal value-drivers in the context of these external influences; and 3) analyze the impact of the above on the financial value of the firm. In turn:

Analyze external influences impacting the firm's business. We typically begin with a review of the macroeconomic conditions and trends that affect the law firm. This begins with a review of the basic markets that a law firm seeks to serve and the macro conditions surrounding it. For instance, in a recent valuation of a national firm, the international context and the national competitive context within which the firm operates played much more of a factor than in the valuation of a smaller, local firm. In light of its market environment, we evaluate its current competitive position and market trends that are specific to that firm's markets and clients, as well as its overall market share (usually by work type) and penetration of its major corporate clients.

Analyze internal value drivers in context of external influences. Many law firms still do not have a clearly articulated strategic approach, and often, in particular in Continental Europe, strategy remains defined by the strong will of individual partners. The absence of a clearly articulated strategy, one that does not seem to fit, given the external environment in which the firm operates (either because it is too ambitious or not sufficiently ambitious), or one for which there is no record of having been effectively executed, will directly impact on the financial value of the firm.

In light of the firm's business strategy and competitive recipe, we review the essential aspects of the firm's intellectual capital and how the firm's intellectual capital supports effective strategy execution. I have written before about this model: A firm's intellectual capital has three essential components: human capital, relational capital, and structural capital.

Human capital consists of two elements: the firm's professionals and its management. In the context of valuation, we review very closely the skills and abilities of all of the firm's professional complement. This includes both legal skills required to execute the work that the firm seeks to do and, as importantly, its lawyers' non-legal skills (e.g., commercial acumen, language capabilities, industry knowledge, client skills) that we feel are necessary for that particular firm's lawyers to service its desired clientele. We also spend significant effort understanding the skills and effectiveness of the managing partner, the management board, and the senior partner in the context of strategy execution. The track record of the managing partner is given much more weight than his/her legal skills or accomplishments as a practicing lawyer prior to becoming managing partner.

Relational capital consists of three elements: clients, brand, and network. We review very closely the firm's client base and will assess to what extent the firm is maximizing the potential to generate cash flow from its client base. Depending on the type of firm, we may interview some clients to further determine the strengths and weaknesses of a particular law firm. Even if we do not undertake client interviews, we will review very closely the longevity of the firm's client base, the firm's “share of wallet” and other factors that indicate the quality of the client relationship. Brand recognition ' both with clients and with talent ' is tested, as are referral sources and other required parts of the firm's networks. For instance, a private client practice will typically rely heavily on chart accountants and tax practitioners for its client base. The firm that is actively cultivating a referral base is likely to be more successful in the future than a firm that does not.

Structural capital consists of three elements: the firm's service lines, its own processes, and its culture. For instance, for a firm that primarily handles employment claims, we would expect to have processes and systems in place that allow the partners to only do that part of the work that truly requires partner involvement; we would expect that firm to have systems, i.e., technology, people, and procedures, in place to execute all other parts of the work at the lowest cost possible. While many firms make much of their own unique culture, we test aspects of behavior within the firm that make accomplishing common strategic goals easier or more difficult.

With respect to each of the above components of intellectual capital, we assess the firm's resources, investments, capabilities, and limitations. While we capture these elements in a structured and objective way, in the end we apply qualitative value judgments. Armed with these qualitative value judgments, we then seek to understand how these value drivers will affect the firm's ability to execute on strategy, and thus its ability to generate future cash flow and the firm's financial value.

Financial Valuation Based on Value Drivers

The firm's existing financial statements will provide the initial basis for the financial aspect of our valuation. Almost always, the financial statements will require adjustments. We review the balance sheet and its major components very closely, in particular for issues that affect the firm's ability to generate cash flow: large work in progress, accounts receivable and vendor balances, or significant fluctuations in these, are viewed less favorable than a convincing picture of sound working capital management. We also will sanitize the financial statements from partner perks and other issues usually found in private company financial statements. Testing projected revenues (based on detailed partner interviews and, if necessary, major client interviews) forms part of this work, among other analytical reviews and benchmark testing.

On that basis, we apply at least three traditional private company valuation methodologies: multiples of earnings, discounted cash flows, and self-financed purchase. These are considered in turn.

Multiple of Earnings

After determining earnings before interest, taxes, depreciation, and amortization (“EBITDA”), we seek to assess an appropriate multiplication factor that a willing buyer should be prepared to pay. As a starting point for determining the multiple, we typically reference comparable publicly held firms. In the legal services context, this is tricky because there are only a few publicly held legal services providers. Slater and Gordon in Australia is a well-publicized one, but has special issues: It runs a fairly commoditized personal injury claims firm; Murgitroyd, a Scottish patent firm, also seems apposite only in a limited way. However, in my opinion, other publicly held professional services firms provide an equally rational starting point (for example accounting firms, management consultancies, and recruiting firms). The qualitative analysis of value drivers as described above then serves to adjust (usually downward) the price-earnings comparable derived from the publicly held firms.

Discounted Cash Flows

Under the discounted cash flows method, one seeks to discount back to present value the firm's future net cash flows. Conceptually, the discounted cash flows method is the most sound, but it has practical limitations: The risk-adjusted discount rate requires a plethora of assumptions that are difficult to establish in a volatile market environment. While the risk-free rate is easy enough to determine, both industry risk and company-originated risk provide challenges. Understanding what return a willing investor might expect also is easier in a steady market than in a volatile one. In the current market environment, we structure several return scenarios and then stress-test these to determine a rational value under this method. Most will be surprised that the risk ' and thus the expected return ' will be much higher than in a publicly held company context ' and this is especially true where the law firm is a “motel” for lawyers instead of an integrated business with a collective proposition.

Self-finance Method

While this method seems somewhat backward at first, it provides a good reality test of whether the other methods yield a rational result: We seek to determine the maximum value that the business could sustain if it had to pay for its own shares. On the basis of future cash flow, we determine the maximum amount that could be available for debt service. Based on available financing, the maximum loan amount available (plus down-payment) at then-current interest rates and terms determines the value of the firm. The value drivers analyzed above inform the firm's ability to generate the cash necessary for debt service and also the interest rate and terms that a financier would be willing to offer.

There are other valuation methodologies that are applied from time to time, yet the above tend to be the most rational in the law firm context. We disagree with those parts of the literature that seek to value law firms on the basis of net book value or multiples of revenue.

On the basis of the above valuation methodologies, discounts and premiums apply as they ordinarily would in any private company valuation.

The key issue is that the above method only works for integrated law firms. At a minimum, a firm would have to have developed a cohesive business model that values the objectives of the firm, above and beyond the contributions of individual partners; it is quite difficult to find this cohesive business model in firms that are “motels” for lawyers. However, the above approach to valuation allows us to use our market knowledge to look deeply behind the numbers. This way, we understand what has to happen for the numbers presented by the firm to be sustained, to be expanded, and also how additional capital will increase future cash flows and thus support long-term value generation.

Michael Roch, a member of this newsletter's Board of Editors, is a senior member of KermaPartners, an international management consulting firm that exclusively focuses on advising professional services businesses worldwide from its offices in New York, Toronto, and London. For more information visit www.KermaPartners.com. ' 2008 KermaPartners

There is not much literature available about how a law firm is to be valued ' or if a law firm is capable of valuation at all. A significant debate around this issue is presently underway in the United Kingdom, where deregulation of the legal profession has given rise to a lot of speculation about the future of the legal profession as we know it. The Legal Services Act, which was passed into law at the end of 2007, essentially provides that law firms may be owned by non-lawyers, and many in this context speculate that especially smaller law firms will be bought and sold just like regular businesses. After all, what makes a law firm so different from accounting practices, where buying and selling is commonplace? Since the answer to this question is relevant not only in the UK, but also for law firms in the United States, this article summarizes our approach to law firm valuation which we have tested in the contexts of law firm acquisitions and equity buy-outs.

Law Firm Valuation in Context

Valuing a publicly held company is fairly simple: At its most basic, one opens the daily newspaper, finds the appropriate stock quotation, and multiplies the stock price by the number of shares outstanding to derive the current market value of the business. Current macro-economic conditions aside, public company valuation ' rightly ' assumes that the collective market has perfect or near-perfect information, and knows exactly the present value of future cash flows that a shareholder can expect.

When one seeks to value a private industrial company, things already become much more complicated. First, there is no readily determinable market for a privately held company. Second, a privately held company does not get bought and sold every day, and thus there is much less reliable information about the company than there is in the publicly held context. Third, valuation is as much a number-crunching exercise as it is a qualitative assessment of intangible factors that
impact the business's ability to generate future cash flow: Much more depends on the company's ability to navigate its competitive environment, on the company's existing structures and systems and, most important, the skills and abilities of management to drive a strategically rational business model. While there are many common elements in how private company valuation can be approached, the plethora of books written on the subject allows the conclusion that private company valuation is as much an art as it is a science.

Professional services firms ' law firms included ' provide a special, more difficult context of private company valuation. At first blush, many approaches and bases for an ordinary private company's valuation appear at minimum difficult to apply to law firms and at the most are simply inapposite. The ability of a law firm to generate future cash flow depends much more on the ability of individual partners and on the firm as a structure to provide intangible value drivers, which is much more difficult to quantify than, for example, a private industrial company's ability to generate a return on assets.

Customized Approach to Law Firm Valuation

My firm has recently been approached to stress-test valuations undertaken by others; as a result of our work, we have developed our own customized approach to valuation that is bespoke to the legal sector. Our approach essentially involves three major steps after we have made ourselves familiar with the firm and its financials: 1) analyze external influences impacting on the firm's business; 2) analyze internal value-drivers in the context of these external influences; and 3) analyze the impact of the above on the financial value of the firm. In turn:

Analyze external influences impacting the firm's business. We typically begin with a review of the macroeconomic conditions and trends that affect the law firm. This begins with a review of the basic markets that a law firm seeks to serve and the macro conditions surrounding it. For instance, in a recent valuation of a national firm, the international context and the national competitive context within which the firm operates played much more of a factor than in the valuation of a smaller, local firm. In light of its market environment, we evaluate its current competitive position and market trends that are specific to that firm's markets and clients, as well as its overall market share (usually by work type) and penetration of its major corporate clients.

Analyze internal value drivers in context of external influences. Many law firms still do not have a clearly articulated strategic approach, and often, in particular in Continental Europe, strategy remains defined by the strong will of individual partners. The absence of a clearly articulated strategy, one that does not seem to fit, given the external environment in which the firm operates (either because it is too ambitious or not sufficiently ambitious), or one for which there is no record of having been effectively executed, will directly impact on the financial value of the firm.

In light of the firm's business strategy and competitive recipe, we review the essential aspects of the firm's intellectual capital and how the firm's intellectual capital supports effective strategy execution. I have written before about this model: A firm's intellectual capital has three essential components: human capital, relational capital, and structural capital.

Human capital consists of two elements: the firm's professionals and its management. In the context of valuation, we review very closely the skills and abilities of all of the firm's professional complement. This includes both legal skills required to execute the work that the firm seeks to do and, as importantly, its lawyers' non-legal skills (e.g., commercial acumen, language capabilities, industry knowledge, client skills) that we feel are necessary for that particular firm's lawyers to service its desired clientele. We also spend significant effort understanding the skills and effectiveness of the managing partner, the management board, and the senior partner in the context of strategy execution. The track record of the managing partner is given much more weight than his/her legal skills or accomplishments as a practicing lawyer prior to becoming managing partner.

Relational capital consists of three elements: clients, brand, and network. We review very closely the firm's client base and will assess to what extent the firm is maximizing the potential to generate cash flow from its client base. Depending on the type of firm, we may interview some clients to further determine the strengths and weaknesses of a particular law firm. Even if we do not undertake client interviews, we will review very closely the longevity of the firm's client base, the firm's “share of wallet” and other factors that indicate the quality of the client relationship. Brand recognition ' both with clients and with talent ' is tested, as are referral sources and other required parts of the firm's networks. For instance, a private client practice will typically rely heavily on chart accountants and tax practitioners for its client base. The firm that is actively cultivating a referral base is likely to be more successful in the future than a firm that does not.

Structural capital consists of three elements: the firm's service lines, its own processes, and its culture. For instance, for a firm that primarily handles employment claims, we would expect to have processes and systems in place that allow the partners to only do that part of the work that truly requires partner involvement; we would expect that firm to have systems, i.e., technology, people, and procedures, in place to execute all other parts of the work at the lowest cost possible. While many firms make much of their own unique culture, we test aspects of behavior within the firm that make accomplishing common strategic goals easier or more difficult.

With respect to each of the above components of intellectual capital, we assess the firm's resources, investments, capabilities, and limitations. While we capture these elements in a structured and objective way, in the end we apply qualitative value judgments. Armed with these qualitative value judgments, we then seek to understand how these value drivers will affect the firm's ability to execute on strategy, and thus its ability to generate future cash flow and the firm's financial value.

Financial Valuation Based on Value Drivers

The firm's existing financial statements will provide the initial basis for the financial aspect of our valuation. Almost always, the financial statements will require adjustments. We review the balance sheet and its major components very closely, in particular for issues that affect the firm's ability to generate cash flow: large work in progress, accounts receivable and vendor balances, or significant fluctuations in these, are viewed less favorable than a convincing picture of sound working capital management. We also will sanitize the financial statements from partner perks and other issues usually found in private company financial statements. Testing projected revenues (based on detailed partner interviews and, if necessary, major client interviews) forms part of this work, among other analytical reviews and benchmark testing.

On that basis, we apply at least three traditional private company valuation methodologies: multiples of earnings, discounted cash flows, and self-financed purchase. These are considered in turn.

Multiple of Earnings

After determining earnings before interest, taxes, depreciation, and amortization (“EBITDA”), we seek to assess an appropriate multiplication factor that a willing buyer should be prepared to pay. As a starting point for determining the multiple, we typically reference comparable publicly held firms. In the legal services context, this is tricky because there are only a few publicly held legal services providers. Slater and Gordon in Australia is a well-publicized one, but has special issues: It runs a fairly commoditized personal injury claims firm; Murgitroyd, a Scottish patent firm, also seems apposite only in a limited way. However, in my opinion, other publicly held professional services firms provide an equally rational starting point (for example accounting firms, management consultancies, and recruiting firms). The qualitative analysis of value drivers as described above then serves to adjust (usually downward) the price-earnings comparable derived from the publicly held firms.

Discounted Cash Flows

Under the discounted cash flows method, one seeks to discount back to present value the firm's future net cash flows. Conceptually, the discounted cash flows method is the most sound, but it has practical limitations: The risk-adjusted discount rate requires a plethora of assumptions that are difficult to establish in a volatile market environment. While the risk-free rate is easy enough to determine, both industry risk and company-originated risk provide challenges. Understanding what return a willing investor might expect also is easier in a steady market than in a volatile one. In the current market environment, we structure several return scenarios and then stress-test these to determine a rational value under this method. Most will be surprised that the risk ' and thus the expected return ' will be much higher than in a publicly held company context ' and this is especially true where the law firm is a “motel” for lawyers instead of an integrated business with a collective proposition.

Self-finance Method

While this method seems somewhat backward at first, it provides a good reality test of whether the other methods yield a rational result: We seek to determine the maximum value that the business could sustain if it had to pay for its own shares. On the basis of future cash flow, we determine the maximum amount that could be available for debt service. Based on available financing, the maximum loan amount available (plus down-payment) at then-current interest rates and terms determines the value of the firm. The value drivers analyzed above inform the firm's ability to generate the cash necessary for debt service and also the interest rate and terms that a financier would be willing to offer.

There are other valuation methodologies that are applied from time to time, yet the above tend to be the most rational in the law firm context. We disagree with those parts of the literature that seek to value law firms on the basis of net book value or multiples of revenue.

On the basis of the above valuation methodologies, discounts and premiums apply as they ordinarily would in any private company valuation.

The key issue is that the above method only works for integrated law firms. At a minimum, a firm would have to have developed a cohesive business model that values the objectives of the firm, above and beyond the contributions of individual partners; it is quite difficult to find this cohesive business model in firms that are “motels” for lawyers. However, the above approach to valuation allows us to use our market knowledge to look deeply behind the numbers. This way, we understand what has to happen for the numbers presented by the firm to be sustained, to be expanded, and also how additional capital will increase future cash flows and thus support long-term value generation.

Michael Roch, a member of this newsletter's Board of Editors, is a senior member of KermaPartners, an international management consulting firm that exclusively focuses on advising professional services businesses worldwide from its offices in New York, Toronto, and London. For more information visit www.KermaPartners.com. ' 2008 KermaPartners