United States: Law Firm Group Newsletter – Summer 2014

Last Updated: September 17 2014
Article by Joel Herman and Steve Lewis

PUTTING A PRICE ON YOUR LAW FIRM

Joel Herman, CPA

Many situations can trigger the need for a law firm's appraisal, including insurance coverage, a partner's death or divorce, capital buy-ins of new partners, firm dissolution and mergers. There are specific ways that law firms create, or diminish, value. This blog discusses some of these "value drivers" and how the three most common business valuation methods are applied. But, as a Sidebar notes in regard to one divorce case, valuators often disagree about the same professional practice interest.

If you have never had your law firm appraised, it could only be a matter of time. Many situations can trigger the need for an appraisal, including insurance coverage, a partner's death or divorce, capital buy-ins of new partners, firm dissolution and mergers.

If you are contemplating a merger, sale or acquisition, a professional valuator should perform the appraisal to help ensure accuracy. But even when you leave valuation in an expert's hands, it is useful to understand how law firms create, or diminish, value.

Unique Factors

Valuation methods used for small businesses, such as multiple of earnings or discounted future cash flows, also apply to law practices. However, law firms must consider some unique factors. For example, the ABA's Code of Ethics generally prohibits law firms from buying and selling client lists. Although most states have adopted ABA Standing Committee on Ethics and Professional Responsibility Model Rule 1.17, which enables firms to sell client files and the associated goodwill firms generate, a few have not. Other "value drivers" that apply specifically to law firms include:

Financial Performance Stable, sustainable, growing revenue streams and lean operating expenses are ideal. Appraisers evaluate balance sheet strength, including the transferability of work in progress (WIP) and collectability of receivables. Large firms may be more valuable, because they offer one-stop legal expertise and can spread fixed overhead expenses over a larger revenue base.

Type of Work Does the firm provide services that match the needs of its local market? General practices may sell for less than specialty firms, such as patent or environmental law practices. If a firm handles only contingency fee cases, which generate varying annual revenues, valuing its future income streams can be challenging.

Reputation Firms add value with a strong brand, unique work and attorneys who are regarded as experts in their field. Firms also can boost value by speaking at conferences, publishing articles in professional journals and participating in community service.

Concentration Risks Value is diminished when one attorney or client generates a significant portion of the firm's business. Significant could be defined as low as 10%. The loss of this rainmaker or major client could cause financial distress.

Staff A firm's assembled workforce of paralegal, IT, marketing and secretarial professionals is important, too. In addition to the quality and depth of your staff, valuators consider your employees' average years of experience and retention rates.

Valuation Methods

In general, there are three business valuation methods. Here is how they might apply to your law firm:

  1. Cost A valuator adjusts your balance sheet to current market values. Your most valuable tangible assets include receivables (such as unbilled work in process and client costs), computer equipment and furniture, and real estate. Favorable or unfavorable lease terms can also affect value. Your firm's net tangible value is the difference between your hard assets and liabilities.
  2. Market If your firm is being appraised for sale, private transaction databases can be used to derive a range of pricing multiples of earnings or gross revenues. Where your firm falls within that range depends on its value drivers.
  3. Income This approach determines value based on discounted net cash flow or capitalization of earnings. More valuable firms have higher expected cash flows and lower discount rates.

Goodwill Hunting

Goodwill is likely to be your firm's most valuable asset — and the most difficult to measure. Appraisers typically value goodwill by subtracting the net tangible value derived from the cost approach from the values derived under the market or income approaches.

Goodwill can be further split into two components: Business and professional. Business goodwill is associated with the firm as an operating entity and includes such items as client lists, name recognition and an assembled workforce. Personal goodwill cannot be separated from individual lawyers, except over time with carefully planned transitions of client relationships. Employment contracts, non-compete agreements and earnouts can facilitate the transfer of personal goodwill in the event of a merger.

A Valuation Specialist

Whether your firm is contemplating a merger or have other reasons to obtain an appraisal, be sure to work with an expert who has experience valuing law firms. Valuators must employ standard appraisal methods, as well as consider ABA rules and other unique value drivers.

TWO-TRACK MIND: MULTIPLE PARTNERSHIP MODELS & THEIR BENEFITS TO FIRMS AND LAWYERS ALIKE

Steve Lewis, CPA

Firms that hire and retain only partnership-track associates may be turning away profitable legal talent. Many skilled lawyers do not want the long hours and ownership responsibilities of equity partnership — and, for those who do, the organizational structure that once supported this goal has become less viable in the 21st century. This article explains why a two-tier system — of equity and non-equity partners — may be the solution.

Historically, the legal profession has been one of the most demanding, requiring long hours and high performance levels — particularly for those who hope to become a partner in a private firm. So it is not surprising that many of today's lawyers are "opting out," eschewing the partnership track for a better work/life balance.

If your firm hires only partnership-track associates and adheres to the old "up or out" rule whereby associates who do not make the grade are expected to leave, you may be turning away profitable legal talent. A two-tier system — of equity and non-equity partners — may be the solution.

Popular for a Reason

The two-tier concept has spread like wildfire in the past decade. According to the American Bar Association, more than 60% of larger firms now offer equity and non-equity partnerships. Several industry shifts have made this system attractive:

Smaller Pies With fewer equity partners, each individual can take a bigger slice. As law firms get squeezed by rising costs, intense competition and budget-minded clients, limiting the number of profit-sharers may keep current equity partners satisfied and engaged.

Lateral Movers Hiring midcareer lawyers is increasingly common. But despite having high expectations for such lateral movers, firms are often wary of offering untried attorneys full equity partnership.

Changing Values Many younger attorneys are rejecting the idea that their job is their life and refusing the late nights, frequent travel and mental pressure generally associated with equity partnership tracks. Similarly, some lawyers simply want to practice law, not generate new business or assume management responsibilities.

Oversupply It is no secret that there are more law-school grads than plum, partnership-track positions. Not every lawyer is owner material, but many are, nevertheless, capable of making significant legal and financial contributions.

A Better Offer

Some firms have reacted to such cultural changes by creating "permanent associate" programs, placing non-partnership-track attorneys in satellite offices with lower-profile, less-challenging work. Unfortunately, this can create a demoralizing "second class citizen" environment that discourages them from producing their best work.

Non-equity partnerships offer an alternative for attracting and retaining talent. Lawyers in this tier enjoy the title of "partner" but typically are compensated with a combination of salary and performance bonuses, not profit shares. In fact, one of the advantages of adding non-equity partners is the flexibility to determine the best means of their compensation.

Non-equity partners do not make capital contributions to the firm or assume personal liability for debts. But they may be granted limited voting rights and participate in partner meetings where strategic decisions are made.

Qualified Candidates

Such positions should not be used to dispose of underperforming lawyers who traditionally would be asked to move on. Instead, reserve them for individuals such as:

  • High-billing senior associates who desire a 9-to-5 workday;
  • Older equity partners whose business development activities have slowed;
  • Experienced lawyers with valuable niche knowledge, but no desire to be an owner; and
  • Unproven lateral hires.

Some of these attorneys may eventually become equity partners. But it is important to make your non-equity track a respected and professionally challenging alternative to equity partnership so that good lawyers will remain loyal to your firm.

Eye on the Prize

For most ambitious young attorneys in private practice, equity partnership remains the ultimate prize. But the organizational structure that once supported this goal has become less viable in the 21st century. Although some research has suggested that single-tier firms enjoy higher per-partner profits, most firms that want to remain competitive need to explore alternatives to the traditional equity partnership model.

Transitioning to a two-tier partnership system can be complicated.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Joel Herman
Steve Lewis
 
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