Valuation of a Law Practice

This article builds on the well-articulated valuation principles outlined in the articles appearing in the June 2009 and October 2009 issues of Accounting and Financial Planning for Law Firms. In June, Michael Roch explored a customized approach to law firm valuation based on a thorough evaluation of external influences, internal value drivers and their combined impact on the financial value of the specific law firm valuation target. (See, “What Is the Value of Your Law Firm?,” Michael Roch, Accounting and Financial Planning for Law Firms, Volume 22, Number 6, June 2009.) In October, Edward D. Heben expanded on the reasons to undertake a valuation analysis of a law practice, with emphasis on the limitations in doing so. (See, “What's Your Practice Worth?,” Edward D. Heben, Accounting and Financial Planning for Law Firms, Volume 22, Number 10, Oct. 2009.)

Both Mr. Roch and Mr. Heben have hit the mark with their comments and observations. My firm has emphasized valuation services for over two decades, with a particular recognition for our work with professional service firm valuation, and more particularly in valuing law firms and ownership interests in law firms for a broad array of purposes ranging from dissolution of marriage, estate tax, shareholder disputes, and more recently in engagements to assist law firm ownership to protect and enhance value.

The Value Proposition

The balance of this article explores two key attributes that drive the value proposition of any law practice: decisions made regarding compensation of the owner-employees of the practice, and the area, or areas, of law that the practice pursues. The decisions made with respect to compensation of owner-employees of any closely held business or professional practice directly impact the valuation of the enterprise, which is most often captured in some multiple of the remaining economic benefit stream available to the owners of the enterprise.

Much of the analysis and effort undertaken when valuing a business or professional practice focuses on what constitutes reasonable compensation for the owner-employee group, as that determination is critical to the normalization process applied to the enterprise's financial statements. (For a more detailed discussion of owner-employee compensation, including an extensive review of U.S. Tax Court case law on compensation determinations, refer to the article titled “What Is Reasonable Compensation?,” co-authored by Ronald L. Seigneur and Kevin Yeanoplos, available at www.cpavalue.com.)

“Normalization” is a term used by business appraisers whereby the historical and projected financial activity of the enterprise is restated to what would be considered “normal” to an arm's-length investor. As applied to the specific issue of owner-employee compensation, the normalization adjustment is intended to restate the enterprise's financial activity to what would need to be paid to replace and replicate the services provided to the entity by the owner-employees. Small, privately held professional practices frequently determine the payment of compensation or disguised compensation for alternative reasons, such as tax minimization, or simply because the owner-employee has the ability to pay him- or herself whatever he or she wants or needs for personal lifestyle needs.

The key to this aspect of the overall valuation process is that by recasting the financial performance to “normalize” the required economic burdens for compensation and other controllable expenses, the appraiser is able to determine a measure of the economic benefit stream that would be available to an investor in the enterprise. It is this normalized economic benefit stream that drives the value proposition for what someone would be willing to pay for the rights to that entity as an investment. Using either an income or a market method, or some combination thereof, as has been wonderfully outlined in Mr. Heben's article, it is this economic benefit stream to which an appropriate market multiple or income-based discount rate is applied to derive the resulting indications of value for the subject interest.

For example, using a methodology commonly known as the excess earnings method, it is determined, after adjustment for all other factors, that an attorney is consistently capable of earning $400,000 per year, as compared with his or her peers, who are working equally hard and who earn, say, $325,000 per year. There would be $75,000 of excess earnings under this method. This $75,000 excess can be capitalized at an appropriate rate to capture the risk inherent in the excess earnings to derive an indication of the value associated with the practitioner's ability to earn more than his or her peers. Using an assumed 30% rate, the excess earnings would be valued at $250,000 ($75,000 divided by 30%). This overly simplistic example merely shows how critical the reasonable compensation determination can be, as if the peer group comparative was, say, $340,000, thereby yielding only $60,000 of excess earnings, the resulting value would be $200,000 instead of $250,000, or a $50,000 difference on this attribute alone.

Goodwill Value

This example opens the door for the second aspect of this article. The $250,000 or $200,000 of value determined above is a measure of the goodwill value associated with the subject practice and the ability of the practitioner to consistently earn more than his or her peers with the same amount of relative effort. Obviously, if a practice was being sold, purchased or evaluated for other purposes, such as a dissolution of marriage, there would be other assets typically included in the transaction, such as fixed assets, accounts receivable, work in process and the like. But for now, let's stay focused on the value of the goodwill element of this particular practitioner, and let's assume it is deemed to be $250,000.

The next critical aspect is to determine whether this $250,000 value constitutes practitioner or enterprise goodwill, as in some instances it can make a world of difference. To get to the bottom of this, we must evaluate what attributes allow the subject practitioner to generate the excess economic benefits. Is it driven by the talent and reputation of the individual, or is it a function of the institution with which the practitioner is aligned? Often it is a bit of both, where a talented attorney is a member of a well-regarded law firm. Many aspects, including the specific area of law, the economy, and the overall competitive landscape can enter into this evaluation; but regardless, business appraisers are routinely called upon to first determine the existence of goodwill, and then determine the appropriate allocation of the goodwill between the professional and the enterprise.

Obviously, there are many more aspects and elements that must be thoroughly considered when valuing a law practice, including the proper standard of value, the level of control (or lack thereof) that the practitioner has over decisions such as compensation, the economic environment and competitive landscape, and beyond. While accounting practices like that of this author have been routinely bought and sold for many years, yielding a wealth of information on practice values, law firms have had significant restrictions on sales and ownership transfers, so the valuation challenge for law firms and law practices is even more complex. (ABA Model Rule 1.17, or some derivative thereof, has been adopted in most U.S. jurisdictions, allowing for the outright sale of a law practice, but transactional data remains very sketchy at best, as compared with other professional practices, such as medical, dental, accounting and others.) With the high rate of divorce in our society, along with the era of baby-boomer retirements and transitions, together with the ever-increasing pace of law firm mergers and acquisitions, the need for competent valuation of law firms and interests therein is critical. This article highlights just a few of the nuances that must be properly considered to derive a supportable and logical valuation conclusion for any specific application.