Attorneys who routinely retain appraisers to value businesses as part of their practice may believe they know what is involved when their own firms must be appraised. And those who do not regularly work with valuators might think it is simply a matter of a "plug-and-play" mathematical formula.
However, both notions are mistaken. Law firm valuations are different from — and sometimes more complicated than — typical business appraisals in some significant ways.
Legal vs. other businesses
When most businesses are sold, appraisers can reasonably assume that they will continue to generate a certain amount of revenue. For closely-held professional services firms, however, that is not necessarily the case.
Clients might prove more loyal to specific partners than the firms themselves. If an owner leaves, the clients may follow that attorney or look elsewhere for legal services. Unlike some businesses, firms generally cannot enforce non-compete agreements against attorneys who leave a practice. Also, firms can have conflicts of interest that limit their ability to maximize revenues.
Another complication? The sale of law firms is a relatively new phenomenon (and even now the American Bar Association Model Rules of Professional Conduct require satisfaction of certain conditions). Valuators have yet to adopt a common method for valuing firms, and no comprehensive data is widely available.
Circumstances and methods
Because the acquisition of one firm by another often does not involve an actual payment, valuations are not commonly obtained for prospective sales. They are more frequently sought after the death or departure of a partner, or when a partner divorces, as well as for purposes of retirement planning, estate planning and life insurance purchases.
In some cases, a firm's partnership agreement will specify the valuation method to be used. However, the language of these agreements can be surprisingly imprecise and easily give rise to disagreements.
Several valuation approaches are available, and professional valuators generally use a combination of the following, depending on the firm's unique circumstances:
- Rule of Thumb
The appraiser takes the sum of average annual revenues and multiplies it by a certain factor. Factors generally can range from 0.5 to 3.0 and above, based on the number of clients, amount of repeat business and transferability of client relationships.
The valuator deducts the firm's liabilities from the sum of all of the firm's assets to calculate a net value. Note that this approach generally is disfavored for law firms because it ignores earnings and cash flows, two major indicators of a firm's financial health.
- Discounted Cash Flow
A DCF value is based on future revenues, rather than historical performance. The appraiser projects cash flows over a period of time and applies a growth rate to estimate a terminal value at the end of that time period. The cash flows and terminal value are then discounted to their net present value.
- Comparable Sales
As noted above, data on law firm sales are difficult to find, and an appraiser likely will not be aware of any unique circumstances behind the scenes of a particular sale that would require adjustments. Still, data from sales might prove helpful as a supplement to results produced by other valuation methods.
Whatever the reason for an appraisal, firms need to exercise the same care in selecting a valuator for their own business as they would for their clients. This means finding a qualified professional with proven experience valuing firms similar to theirs.
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.