So what is my firm worth?

firm worth

So what is my firm worth?


10 years ago this was a question a law firm would never have asked, as it was universally recognised that there was no value in a law firm. However, today it is the first question that partners in many firms ask themselves whenever the conversation about ‘selling’ arises. So has the world really changed, or is it just a different perception driven by the world in which firms now operate?


The first question is how do you value a law firm.  Some so-called experts will value it based upon turnover.  However, unlike an accountancy firm, law firms tend to have very little recurring work, and also the client relationships tend to be with the individual fee earners as opposed to with the firm itself, and therefore clients will often follow the fee earner if he or she decides to move on. Therefore, a multiplier of turnover is in my opinion the wrong approach to coming up with a valuation.


A more appropriate way would be to value the firm based upon profitability, as ultimately any value comes from the profits the firm generates rather than the assets it owns.


But which profit should you use? The profit has to be that generated before the costs of financing the firm or utilising the assets in it are deducted, since law firms will choose to finance their practices in different ways, so by stripping back to the basic profits you are able to assess a firm’s true profitability. We call this ‘true’ profit earnings before interest, tax, depreciation and amortisation (more commonly referred to as EBITDA).


As most owners of a law firm will extract profits via drawings if they are trading as a partnership or a sole trader or mainly as dividends if they are trading as a company, it is necessary to then deduct a notional salary for each partner or director to reflect the cost of employing someone to do the “day job”.  This should be a commercial salary, reflective of the market in which the firm operates, or if appropriate taking the highest paid fee earner salary for the firm and adding on 10% or 15% to reflect a premium.


This gives the underlying profitability.  However, as with most service-based businesses, one year’s profit is not always reflective of the true underlying performance.  Often an average will be taken over the last two or three years, or perhaps if it can be justified, a combination of the last two years and a forecast for the following year.  There is a good argument to use a forecast figure, as if there is value in a business it is about what the future profits of the business are going to be as opposed to how the business performed in the past. 


In some cases the earnings will be weighted more towards current performance as opposed to that of say three years ago to give a better indication of performance.  This really does depend on what is going on in the business and, more importantly,  the direction the business is heading. 


At this point it is then necessary to use a profit multiplier to arrive at a value. In theory, the multiple should broadly equate to the number of years the vendor is prepared to wait in order to get a return. The multiplier is affected by numerous factors, ranging from those within the business and therefore under its control to those external factors over which it has no control.  


Valuation is often referred to as an art not a science, as if you ask two experts to value a law firm invariably you will get two different answers, and both will probably have different views on a suitable multiple, and will be able to justify in their minds why they have come to those views.


This is why with any valuation you have to always come back to the basic rule of valuation, which is the price agreed between a willing buyer and a willing seller.  Whilst it is useful to prepare a valuation to assess what your firm might be worth, ultimately it is only really worth what someone is prepared to pay for it.  


It is a shame that this basic principle is forgotten by some firms, who heartily believe that they have some value and therefore miss the opportunity to be acquired, as they are holding out for that ‘pot of gold’ that is not really there.


In the 25 years of working with law firms, I can count on two hands the number of deals that I have been involved in where value, i.e. goodwill, has been paid.  Where it has happened, the circumstance dictated that the firms being acquired had something that the buyer really wanted, and therefore was prepared to pay a premium.


This perception of value can leave law firms with a very blinkered view, which is a shame, as value can be created in other ways.  There is usually more than one way to shape a deal, which can be of benefit to both parties.


Value can be as simple as the seller avoiding having to take out run off cover on their professional indemnity insurance.  In some cases, the cost of this can be as much as 3.5 times the last premium paid. By the buyer becoming successor practice the seller can save significant costs. In addition, avoiding closure costs such as staff redundancies can also be of value.  Of course, it would be nice to receive a big cheque for the firm, but in some circumstances if a sale means you avoiding having to write a big cheque then this is also very attractive.  


Value can also be created by being paid the true value for the work in progress that a firm has.  Depending on the type of practice, getting the true value of WIP in say a personal injury or clinical negligence firm can be significant, as often a substantial amount of this asset has not been recognised in the firm’s accounts yet, so it is yielding value to the seller. 


The problem with wanting value is that the tax treatment for the buyer and seller are different.  For a seller, receiving a capital sum usually means that a low rate of tax can be paid on it.  However, for the buyer, paying a capital sum will often result in no tax relief being obtained on the amount paid, which makes it more expensive for them. The buyer would prefer to structure a deal that gives them tax relief on any payments.  It therefore sometimes requires an element of compromise.


If it is not possible to obtain capital value, then an enhanced income over a period of time is an alternative way of obtaining value for the practice. This can be beneficial for both parties, as it keeps the seller in the business and committed to ensuring the firm continues at the same level of performance, whilst for the buyer allows them to obtain a return on their investment.


So to answer the question, does my law firm have a value, the answer is probably yes, but it is highly unlikely for most firms that it is the pot of gold that is going to give you a very wealthy retirement.  The skill is understanding what elements of your firm are going to be attractive to a potential buyer and knowing how to exploit this in the right way.  You then need to structure the deal in a way that works for both parties.  This can often require thinking ‘ outside the box’, as there is no blueprint for a sale of a practice.  In the 25 years that I have worked with law firms, every deal I have worked on has an element that is slightly different, but different is good and different often results in value being obtained for both the buyer and seller, albeit perhaps not in the traditional way of thinking. 

Patricia Kinahan, Hazlewoods

Do contact us if you would like more information on this subject, or to talk about any aspect of law firm finance or strategic planning.


Hazlewoods team of 27 specialises in strategic, financial and taxation matters across the legal sector. Collectively we have amassed over 185 years’ service in advising law firms of all shapes and sizes. Hazlewoods is well known for its compliance services but also advising on many strategic matters such as mergers and acquisitions, valuations of practices and improving performance (both profitability and cash flow) for practice.  With over 185 years of experience in the team, we have seen everything!

Get in Touch with Hazlewoods

For help with you or your firms’ needs,
please get in touch by filling in the form below.

Request a Callback