Bar News - December 16, 2011
Business Law & Business Litigation: Valuing Ownership Shares of a First Generation Law Firm
By: Arthur G. Greene and William E. Howell
Editorís Note: The first part of this article appeared in the September issue of Bar News.
This article addresses the factors involved in valuing a law firm for purposes of admitting new partners and retiring senior partners. Regardless of the entity structure (Partnership, Professional Association or Professional Limited Liability Company), law firms face issues of how to value interests in the firm for purposes of internal transfers (which weíll assume to be Partnership interests in this article). While general business valuation techniques are relevant, the personal service aspect of a law business presents complicating factors. Valuing ownership interests in a law firm is unique and far different than valuing interests in a manufacturing company or a retail operation.
Some firms do not require payment for acquiring an ownership interest and are referred to as "free in, free out." In other words, new partners are not required to pay for the purchase of an ownership interest and retiring partners do not receive payment for selling their share of the equity. In those cases, retiring partners receive a return of capital and any other retirement-type benefits are usually limited to funded pension plans.
However, most law firms require new partners to pay for shares and retiring partners receive value for selling their ownership interest in the firm. Many firms are motivated by the desire to reward the founders and/or the current partners for the "sweat equity" involved in developing, growing or maintaining a successful firm. In other cases, the firms simply want the new partners to feel invested in the firm and may set a modest price that is more symbolic than actually representing a valuation.
In attempting to create a realistic valuation, it is important to start with an understanding of what is being sold. Likely to be included are hard assets, work-in-process, receivables and goodwill (value of clients retained going forward), with a reduction for any debt. The value of the firmís client base is both the most important aspect and the most difficult to evaluate. The client retention possibility will depend on the nature of the practice and the extent to which they consider themselves firm clients, as opposed to clients of individual lawyers. In a sense, what is being sold is a network of contacts that represent nothing more than an opportunity to retain or acquire clients.
When we look at the legal profession, we see three methods used for valuing law firms: Arbitrary Valuation Process.
For lack of a better approach, many small firms simply set an arbitrary price when transferring an interest in the firm between partners. Sometimes the amount to be charged is set out in the partnership agreement and other times it is set on an ad hoc basis when transactions occur. Although common, such an approach is not recommended. It lacks credibility and does not position the firm well for the long term.
Some firms develop a common sense formula to value the firm that focuses on financial data, without applying sophisticated business valuation techniques. A standard formula would include:
Formulas usually ignore good will, although that is not always the case.
- The value of the real estate (if any)
- The fair market value (or book value) of any furnishings, equipment or other personal property
- A percentage (perhaps 80 percent) of the receivables less than a certain age (say 120 days), after eliminating clearly uncollectible receivables from the list
- A percentage (perhaps 70 percent) of the work-in-process, after eliminating old work-in-process that is unlikely to be billed
- Less any debt
The formula amount is then divided by the number of shares or points outstanding to get a value for each share or point, for purposes of valuing any transfer.
Business Valuation Techniques
To apply a business valuation technique, letís start with the fundamental principles for valuing a companyís earnings or cash flow. In such a process, the value of an ownership interest is considered to be a function of the factors listed below.
In the context of law firm succession, letís consider:
- The expected stream of benefits, typically in the form of cash flow
- The timing of receipt of the benefits
- The risk that actual benefits will deviate from the expected amounts and time frames
The firm needs to perform a similar analysis. The firm is comprised of the current partners and there should be an analysis that determines that the firmís value is enhanced by adding the new Partner. The enhanced value may come from reduced risk by retaining talented professionals and also an increased likelihood for the achievement of buy-outs as Partners retire.
- Benefit stream Ė The purchase of an interest in a law firm should result in an expected benefit stream, which can be in the forms of higher compensation, higher bonuses, profit distributions, and so forth. The purchasing partner needs to compare his or her expected financial relationship with the firm relative to his or her market compensation. The difference between the expected financial relationship as a Partner and market compensation can be construed as the "benefit stream."
The expected benefit stream can be considered to be payments in any and all forms in excess of fair market compensation for the work performed by the Partner. Market compensation for a lawyer is not necessarily a single amount, though. A range may be worth considering, as many surveys will have results based on average, median, quartiles, deciles, and perhaps other metrics. The over-simplified use of average or median amounts may or may not be appropriate.
Compensation relative to market is a critical factor in the analysis and requires the careful exercise of professional judgment. Examples of factors to consider include subjective and objective measures regarding:
The valuation process is based on an analysis of the firm and needs to include consideration of the aforementioned factors. Several valuation methods can be useful for determining the value of a firm based on its earnings or cash flow. Theoretically, they should all yield the same result.
- Internal firm factors - business development, client relationships, active participation in marketing activities, staff utilization, billable hours, firm compensation structure, and so forth
- External benchmarks Ė compensation surveys and perhaps anecdotal information on what other firms are doing
- Timing of receipt of the benefits Ė The value is dependent on the timing for receipt of the benefits. Given that the capital requirements of a law firm are rather low, the cash basis profit may generally be available for distribution.
- Risk of deviation Ė Future benefits are typically discounted by a factor to reflect the risk of receiving a return relative to alternative investments that may be available to a buyer of an ownership interest. Rates of return for mature closely held companies can vary broadly, based on an assessment of perceived risk factors. Estimates in the range of 17 percent to 35 percent would not be unusual. For professional service firms, the risks may be within the range or possibly above the higher end of the range. Risk is higher when the profits generated by the firm (i.e., after considering market compensation) are directly attributable to the personal relationships between the law firm Partners and their respective clients.
The aggregate value of the firmís intangible assets (i.e., workforce in place, customer relationships, going concern value and so forth) is estimated by the extent to which the value determined from earnings or cash flow exceeds the net tangible assets.
To establish a policy for buy-ins and buy-outs, there would be additional considerations although we deemed them to be beyond the scope of this article. Without being all inclusive, such factors that may warrant consideration include the standard of value, the premise of value, professional and personal goodwill, existence of either excess assets or a capital deficiency, applicability of discounts and/or premiums regarding rights and restrictions pertaining to the subject interest, state law and so forth.
Predictable profitability (after market compensation) across a broad cross-section of professional legal services (i.e., risk reduction) can significantly improve the transferable value of an ownership interest in a practice.
Valuing the shares of a law firm is not a math problem. In fact, the determinative factor will likely be whether the benefit to an associate moving into the partnership ranks will be perceived as justifying the purchase price. How much more will the associate earn as an equity partner? Finding the right dollar amount is the challenge. Valuing ownership interests in a law firm is more an art than a science.
|Arthur G. Greene
Arthur G. Greene Consulting, LLC provides consulting services to law firms, with focus on the needs of small and mid-sized firms. He can be reached at firstname.lastname@example.org.
|William E. Howell
Bill Howell, ASA, CPA/ABV/CFF provides business valuation services to closely held and family owned businesses. More information is available at www.williamehowell-llc.com and he can be reached at email@example.com.