Valuation of a Law Firm and a Law Practice

Part One, last month, discussed the current state of law firm valuation, how to determine what it is that is being transferred, and a few of the methods used for valuing a law firm. Part Two will examine a possible solution to the differing valuation methods and look at issues that arise in an external transfer when someone outside of the firm is interested in buying it.

The Profit Sharing/Earn-Out Model (A Potential Solution)

The traditional method of looking back at earnings and applying a multiple over some payout period has also been dubbed the “unfunded buy-out.” Much of the legal profession has altered its view of these programs ' labeling them unworkable in their most historic form and a dangerous tax on the current earnings of mobile partners with portable books of business. Some firms have retained such plans, many with features to improve their economics. A few feel their culture and reputation are sufficient to maintain the economic expectations of successors and retirees with the arrangements in place.

Irrespective of one's view for, neutral or against such programs, there is room for improvement with two modest changes. The purpose of such programs is to recognize the value of a transferred client base and referral network. The first modification is to make the program self-funding by linking the payout to the very clients and referral sources being transferred. The second modification is to value the payout as a declining percentage of the net contribution of those clients and referral networks to the profitability of the firm.

Accordingly, the earn-out, much as with the external transfer described below, integrates itself with the future economics of the firm. Clients who stay and provide more work and more profitable work benefit both the retiree and the successors. Those clients who leave, thereby providing less work or less profitable work, diminish the amounts paid to the retirees in direct proportion to the diminished profits experienced by the firm. This outcome has a real market connection and benefits those partners who integrate into the firm with an institutional view.

Partners who do not have a client following, or have clients that the firm does not want or cannot maintain, will not benefit from such a model. Partners who practice in isolated silos and do little to develop a successor, preferring to leverage every ounce of profit during their own career, will have consumed all value at retirement.

Valuing the External Transfer

When the buyer is not associated with the seller's firm, the transfer is handled a bit differently. The buyer and seller will often know of each other, but the buyer may not fully understand the seller's practice.

The first step is to learn about the seller. This is standard business due diligence. Interview lawyers, judges, bankers, accountants and other contacts who can tell you something about the individual. Discuss the practice, the clients, pricing and billing policies.

The buyer should look to the seller to assist in the transfer of the client relationships and referral contacts. It is for this reason that so many of these deals extend over one to five years, and sometimes longer. A common procedure to facilitate such a deal is to have the acquiring lawyer(s) and the selling lawyer operate as a joint “firm” for a period of time.

Value the Business

The method to value another lawyer's business is very similar to the internal transfer method of valuing the capital of a partner. Essentially, the business is valued on the net book value cash basis balance sheet. Reasonable due diligence should be conducted as one would for any business transaction. Rarely will a firm have assets that require separate fair market adjustments. This usually occurs with real estate, antiques, artwork and the like. However, often those assets are the personal property of the seller and will not be part of the transaction. If such assets are part of the transaction, then separate appraisals may be necessarily undertaken by those valuation experts with expertise and experience with each class of asset.

Items to consider:

• Review copies of filed federal income tax returns for the past three to five years.
• Protect yourself against the quality of the work-in-progress and accounts receivable and the level of debt and accounts payable. Although you may not be buying these assets and liabilities, you could inherit the problems that are hidden within.
• Review title to all assets and a detail of assets included in the transaction.
• Review all debt agreements, equipment and office leases, maintenance contracts and subscription agreements. Look for capital leases improperly classified as operating leases. New accounting rules regarding leasing are on the way and will need to be factored into any review.
• Review all business and payroll tax returns that are required to be filed for the last three to five years.
• Review the malpractice insurance policy and applications. Verify claims history with the carrier. Determine the availability of “tail” and “prior acts” coverage.
• Review all other liability, fire and theft policies and applications.
• Interview the staff and review salaries, bonuses and benefits. Review performance evaluations, if any.
• Interview the office manager and conduct a procedures and practices audit to look for general compliance with applicable rules and regulations.
• Test for prepaid expenses, accounts payable, accrued expenses and deferred income taxes.
• Examine the trust account asset and liability, including the detail ledgers supporting the balances; confirm the balance with the bank. Require representation that the balances are accurate and confirm with clients after closing. Is the trust account properly established?
• Review annual client fee lists for several years and compare the fee detail lists to fees reported on the tax returns. Do a conflicts check.
• Review practice management procedures (file opening procedures, tickler systems, conflict check systems and the like).
• Review open matters and any pending deadlines.

Value the Practice

Review the factors provided above that affect the value of earnings multiples for internal transfers. These same factors are critical for arriving at an appropriate understanding of the practice value (appropriate multiple) for an external transfer.

Valuing a practice can involve a number of methodologies. Looking at internal transfers as well as past transactions for that firm is one good way to begin to develop a valuation. Organizational documents may set forth a methodology that the owners have agreed to with respect to valuation. Remember that buy-ins are as instructive as buy-outs in determining how the owners feel about value. Look to see how that compares with any prior transactions at the firm.

A second methodology used is known as the multiple of earnings approach. This method is founded on the principle that value is predicated on what an informed and rational investor would pay for the company's future earnings. Profits must be “normalized,” that is, adjusted for those items that would reflect the company's operating characteristics going forward after a sale. Follow these steps when using the multiple of earnings approach:

Use five years of financial statements to see the sustained level of and direction of performance;

• Eliminate non-recurring revenues and expenses as well as items that are not indicative of economic performance for each year;
• Consider the appropriate mix of past years of revenue to use as going forward revenues;
• Review historical gross and net profit margins to see how direct costs and selling, general and administrative (SG&A) expenses relate to revenues to determine what direct costs and SG&A expenses to subtract from the going forward revenues;
• Calculate for each year an adjustment to normalize earnings by adding back benefits, “perks” and compensation to reported net income and subtracting a reasonable compensation package. Determine what adjustment is appropriate for the going forward analysis;
• Calculate the multiple using a methodology similar to what has been described above; and
• Multiply the normalized earnings by the multiple.

While a common methodology, the multiple of earnings approach requires skill in determining the economic income, future growth and the appropriate multiple. This method will often include most of the balance sheet as those assets and liabilities are necessary to the production of the income. Excessive net assets require an addition to the final value.

A third methodology is capitalized cash flows . This method is predicated on the present value of future cash flows (as opposed to earnings). This means that earnings are adjusted for non-cash expenses such as depreciation and amortization, and non-expense cash flows such as repayment of debt. The capitalization rate is the return a prudent investor would require, after adjusting for risk, over a five year period. We have used a balanced market index investment portfolio, adjusted for risk, for this methodology:

• Use five years of financial statements to see a sustained level of and direction of performance;
• Eliminate non-recurring revenues and expenses as well as items that are not indicative of economic performance for each year;
• Add back depreciation and amortization and subtract out repayment of debt to determine cash flows for each year;
• Calculate for each year an adjustment to normalize earnings by adding back benefits, “perks” and compensation to reported net income and subtracting a reasonable compensation package;
• Determine net cash flows for each year. Then calculate average and weighted average (determine what weights are appropriate to reflect the direction of performance) net cash flows for the five years;
• Determine the capitalization rate; and
• Calculate the practice value using the capitalization rate computed above.

The same concerns exist for capitalized cash flows as for the multiple of earnings method.

A fourth methodology is capitalized excess earnings . This method essentially is calculated as follows:

• Determine the firm's net tangible assets on an accrual basis;
• Reconstruct net income by adding back benefits, “perks” and compensation to reported net income and subtracting a reasonable compensation package;
• Calculate reconstructed net income for three to five years and average;
• Multiply net tangible assets from above by a reasonable return rate;
• Subtract the reasonable return from average reconstructed net income (the result is excess net income); and
• Capitalize the excess net income to arrive at goodwill.

This is a widely used valuation method, but requires considerable skill and judgment to do well. And in a professional practice, the concept of excess earnings is a very difficult concept to work with. See the author's article, Unreasonable Compensation for P.C. Shareholders , which is available free of charge from www.altmanweil.com.

Structuring the Deal

You have probably used all of the above methods and now have a series of value ranges. See if you have any that are significantly different from the rest. If you do, then go back and try to understand why that occurred. Generally, you will see a pattern of value that you can feel comfortable using.

You have used a mixture of historical information and adjustments to project the future economic performance of the practice. But what if you are wrong? What if the clients do not stay with the practice? Consider a structure that pays prospectively. If you are buying a future stream of income, then pay based on the future income. It's riskier to the seller, which may mean a higher multiple for the valuation, but at least it is self-funding. Since the seller is needed to assist in the transfer, this could be structured as an earn-out. The best result is that you pay even more because the combination of the seller's efforts and yours result in even more business during the transition years.

A good practice is to provide for post-closing price adjustments. Sellers generally do not like them, while buyers like them to protect against downside risk. In professional service firms, adjustments based on client transfer are a bit trickier. Good provisions contain the following elements:

• Adjust for material discrepancies only;
• Provide for bi-directional adjustments, so that up and down adjustments are possible; and
• Limit adjustments to a reasonable post-closing time period.

The Seller's Perspective

The seller of a law practice is primarily interested in assuring that his/her clients will be provided with quality legal services, that payment is received, and that personal liability is protected.

There is risk to the seller if the buying lawyer is not competent to handle certain areas of the practice being acquired. Clients may not continue their relationship with the new lawyer. Payments may not be made.

Therefore, a selling lawyer must undertake due diligence that includes:

• Verification of purchasing lawyer's expertise and credentials;
• Verification of purchasing lawyer's reputation, including a check of malpractice claims with the purchasing lawyer's insurance carrier;
• Assessment of purchasing lawyer's philosophical approach to clients and practice (will there likely be an effective relationship between seller's clients/referrals and the purchasing lawyer?); and
• Determination of availability of “tail” insurance coverage.

Credentialing

A word on credentialing for both buyers and sellers. Credentialing is a process whereby you confirm with the issuing organization the existence and good standing of a bond, certification, degree or license. It is preferable to obtain certified copies of the documents for your records. Some will say this is overly burdensome and overly intrusive. And problems with valid credentials are rare. But when credentialing problems occur, they can be quite troublesome.

James D. Cotterman is a principal of Altman Weil, Inc., a legal management consultancy headquartered in Newtown Square (suburban Philadelphia), PA. A member of this newsletter's Board of Editors, he may be contacted at 407-381-2426 or e-mail [email protected]. Copyright ' 2014, Altman Weil, Inc., Newtown Square, PA, USA. All rights for further publication or reproduction reserved.

Part One, last month, discussed the current state of law firm valuation, how to determine what it is that is being transferred, and a few of the methods used for valuing a law firm. Part Two will examine a possible solution to the differing valuation methods and look at issues that arise in an external transfer when someone outside of the firm is interested in buying it.

The Profit Sharing/Earn-Out Model (A Potential Solution)

The traditional method of looking back at earnings and applying a multiple over some payout period has also been dubbed the “unfunded buy-out.” Much of the legal profession has altered its view of these programs ' labeling them unworkable in their most historic form and a dangerous tax on the current earnings of mobile partners with portable books of business. Some firms have retained such plans, many with features to improve their economics. A few feel their culture and reputation are sufficient to maintain the economic expectations of successors and retirees with the arrangements in place.

Irrespective of one's view for, neutral or against such programs, there is room for improvement with two modest changes. The purpose of such programs is to recognize the value of a transferred client base and referral network. The first modification is to make the program self-funding by linking the payout to the very clients and referral sources being transferred. The second modification is to value the payout as a declining percentage of the net contribution of those clients and referral networks to the profitability of the firm.

Accordingly, the earn-out, much as with the external transfer described below, integrates itself with the future economics of the firm. Clients who stay and provide more work and more profitable work benefit both the retiree and the successors. Those clients who leave, thereby providing less work or less profitable work, diminish the amounts paid to the retirees in direct proportion to the diminished profits experienced by the firm. This outcome has a real market connection and benefits those partners who integrate into the firm with an institutional view.

Partners who do not have a client following, or have clients that the firm does not want or cannot maintain, will not benefit from such a model. Partners who practice in isolated silos and do little to develop a successor, preferring to leverage every ounce of profit during their own career, will have consumed all value at retirement.

Valuing the External Transfer

When the buyer is not associated with the seller's firm, the transfer is handled a bit differently. The buyer and seller will often know of each other, but the buyer may not fully understand the seller's practice.

The first step is to learn about the seller. This is standard business due diligence. Interview lawyers, judges, bankers, accountants and other contacts who can tell you something about the individual. Discuss the practice, the clients, pricing and billing policies.

The buyer should look to the seller to assist in the transfer of the client relationships and referral contacts. It is for this reason that so many of these deals extend over one to five years, and sometimes longer. A common procedure to facilitate such a deal is to have the acquiring lawyer(s) and the selling lawyer operate as a joint “firm” for a period of time.

Value the Business

The method to value another lawyer's business is very similar to the internal transfer method of valuing the capital of a partner. Essentially, the business is valued on the net book value cash basis balance sheet. Reasonable due diligence should be conducted as one would for any business transaction. Rarely will a firm have assets that require separate fair market adjustments. This usually occurs with real estate, antiques, artwork and the like. However, often those assets are the personal property of the seller and will not be part of the transaction. If such assets are part of the transaction, then separate appraisals may be necessarily undertaken by those valuation experts with expertise and experience with each class of asset.

Items to consider:

• Review copies of filed federal income tax returns for the past three to five years.
• Protect yourself against the quality of the work-in-progress and accounts receivable and the level of debt and accounts payable. Although you may not be buying these assets and liabilities, you could inherit the problems that are hidden within.
• Review title to all assets and a detail of assets included in the transaction.
• Review all debt agreements, equipment and office leases, maintenance contracts and subscription agreements. Look for capital leases improperly classified as operating leases. New accounting rules regarding leasing are on the way and will need to be factored into any review.
• Review all business and payroll tax returns that are required to be filed for the last three to five years.
• Review the malpractice insurance policy and applications. Verify claims history with the carrier. Determine the availability of “tail” and “prior acts” coverage.
• Review all other liability, fire and theft policies and applications.
• Interview the staff and review salaries, bonuses and benefits. Review performance evaluations, if any.
• Interview the office manager and conduct a procedures and practices audit to look for general compliance with applicable rules and regulations.
• Test for prepaid expenses, accounts payable, accrued expenses and deferred income taxes.
• Examine the trust account asset and liability, including the detail ledgers supporting the balances; confirm the balance with the bank. Require representation that the balances are accurate and confirm with clients after closing. Is the trust account properly established?
• Review annual client fee lists for several years and compare the fee detail lists to fees reported on the tax returns. Do a conflicts check.
• Review practice management procedures (file opening procedures, tickler systems, conflict check systems and the like).
• Review open matters and any pending deadlines.

Value the Practice

Review the factors provided above that affect the value of earnings multiples for internal transfers. These same factors are critical for arriving at an appropriate understanding of the practice value (appropriate multiple) for an external transfer.

Valuing a practice can involve a number of methodologies. Looking at internal transfers as well as past transactions for that firm is one good way to begin to develop a valuation. Organizational documents may set forth a methodology that the owners have agreed to with respect to valuation. Remember that buy-ins are as instructive as buy-outs in determining how the owners feel about value. Look to see how that compares with any prior transactions at the firm.

A second methodology used is known as the multiple of earnings approach. This method is founded on the principle that value is predicated on what an informed and rational investor would pay for the company's future earnings. Profits must be “normalized,” that is, adjusted for those items that would reflect the company's operating characteristics going forward after a sale. Follow these steps when using the multiple of earnings approach:

Use five years of financial statements to see the sustained level of and direction of performance;

• Eliminate non-recurring revenues and expenses as well as items that are not indicative of economic performance for each year;
• Consider the appropriate mix of past years of revenue to use as going forward revenues;
• Review historical gross and net profit margins to see how direct costs and selling, general and administrative (SG&A) expenses relate to revenues to determine what direct costs and SG&A expenses to subtract from the going forward revenues;
• Calculate for each year an adjustment to normalize earnings by adding back benefits, “perks” and compensation to reported net income and subtracting a reasonable compensation package. Determine what adjustment is appropriate for the going forward analysis;
• Calculate the multiple using a methodology similar to what has been described above; and
• Multiply the normalized earnings by the multiple.

While a common methodology, the multiple of earnings approach requires skill in determining the economic income, future growth and the appropriate multiple. This method will often include most of the balance sheet as those assets and liabilities are necessary to the production of the income. Excessive net assets require an addition to the final value.

A third methodology is capitalized cash flows . This method is predicated on the present value of future cash flows (as opposed to earnings). This means that earnings are adjusted for non-cash expenses such as depreciation and amortization, and non-expense cash flows such as repayment of debt. The capitalization rate is the return a prudent investor would require, after adjusting for risk, over a five year period. We have used a balanced market index investment portfolio, adjusted for risk, for this methodology:

• Use five years of financial statements to see a sustained level of and direction of performance;
• Eliminate non-recurring revenues and expenses as well as items that are not indicative of economic performance for each year;
• Add back depreciation and amortization and subtract out repayment of debt to determine cash flows for each year;
• Calculate for each year an adjustment to normalize earnings by adding back benefits, “perks” and compensation to reported net income and subtracting a reasonable compensation package;
• Determine net cash flows for each year. Then calculate average and weighted average (determine what weights are appropriate to reflect the direction of performance) net cash flows for the five years;
• Determine the capitalization rate; and
• Calculate the practice value using the capitalization rate computed above.

The same concerns exist for capitalized cash flows as for the multiple of earnings method.

A fourth methodology is capitalized excess earnings . This method essentially is calculated as follows:

• Determine the firm's net tangible assets on an accrual basis;
• Reconstruct net income by adding back benefits, “perks” and compensation to reported net income and subtracting a reasonable compensation package;
• Calculate reconstructed net income for three to five years and average;
• Multiply net tangible assets from above by a reasonable return rate;
• Subtract the reasonable return from average reconstructed net income (the result is excess net income); and
• Capitalize the excess net income to arrive at goodwill.

This is a widely used valuation method, but requires considerable skill and judgment to do well. And in a professional practice, the concept of excess earnings is a very difficult concept to work with. See the author's article, Unreasonable Compensation for P.C. Shareholders , which is available free of charge from www.altmanweil.com.

Structuring the Deal

You have probably used all of the above methods and now have a series of value ranges. See if you have any that are significantly different from the rest. If you do, then go back and try to understand why that occurred. Generally, you will see a pattern of value that you can feel comfortable using.

You have used a mixture of historical information and adjustments to project the future economic performance of the practice. But what if you are wrong? What if the clients do not stay with the practice? Consider a structure that pays prospectively. If you are buying a future stream of income, then pay based on the future income. It's riskier to the seller, which may mean a higher multiple for the valuation, but at least it is self-funding. Since the seller is needed to assist in the transfer, this could be structured as an earn-out. The best result is that you pay even more because the combination of the seller's efforts and yours result in even more business during the transition years.

A good practice is to provide for post-closing price adjustments. Sellers generally do not like them, while buyers like them to protect against downside risk. In professional service firms, adjustments based on client transfer are a bit trickier. Good provisions contain the following elements:

• Adjust for material discrepancies only;
• Provide for bi-directional adjustments, so that up and down adjustments are possible; and
• Limit adjustments to a reasonable post-closing time period.

The Seller's Perspective

The seller of a law practice is primarily interested in assuring that his/her clients will be provided with quality legal services, that payment is received, and that personal liability is protected.

There is risk to the seller if the buying lawyer is not competent to handle certain areas of the practice being acquired. Clients may not continue their relationship with the new lawyer. Payments may not be made.

Therefore, a selling lawyer must undertake due diligence that includes:

• Verification of purchasing lawyer's expertise and credentials;
• Verification of purchasing lawyer's reputation, including a check of malpractice claims with the purchasing lawyer's insurance carrier;
• Assessment of purchasing lawyer's philosophical approach to clients and practice (will there likely be an effective relationship between seller's clients/referrals and the purchasing lawyer?); and
• Determination of availability of “tail” insurance coverage.

Credentialing

A word on credentialing for both buyers and sellers. Credentialing is a process whereby you confirm with the issuing organization the existence and good standing of a bond, certification, degree or license. It is preferable to obtain certified copies of the documents for your records. Some will say this is overly burdensome and overly intrusive. And problems with valid credentials are rare. But when credentialing problems occur, they can be quite troublesome.

James D. Cotterman is a principal of Altman Weil, Inc., a legal management consultancy headquartered in Newtown Square (suburban Philadelphia), PA. A member of this newsletter's Board of Editors, he may be contacted at 407-381-2426 or e-mail [email protected]. Copyright ' 2014, Altman Weil, Inc., Newtown Square, PA, USA. All rights for further publication or reproduction reserved.