Month: July 2022

By Katherine A. Puffer, CPA/ABV, CPCU, MBA

Even if you’re not in the market to sell your law firm, there are several reasons to value your firm such as a possible firm merger, securing loan financing, the addition of new partners, and other business and personal matters such as your succession/exit strategy. It is not only important to know the value of your firm, but also the process analysts take to come to an estimated value. Several valuation approaches are used, and depending on your firm’s circumstances, valuation analysts may use a combination of the income, asset, and market approaches to estimate the value of the firm. 

The Valuation Process: 

To begin, the asset approach presumes that the value of the firm is best determined by the sum of the value of all the firm’s tangible assets subtracted by the liabilities, leaving the net value of its tangible assets (“net tangible assets”). Many firms maintain financial records using cash-based accounting, thus for valuation purposes, their cash-based financials are adjusted to accrual-based financials. For example, accounts receivable, work-in-progress and accounts payable are added to the cash basis balance sheet to arrive at an accrual basis balance sheet. The next step in an asset-based valuation is to adjust the accounting asset values to their market value. For example, fixed assets such as computer equipment are adjusted to their estimated market value (likely close to zero). Asset-based valuations generally do not contain “goodwill” which is the value of a firm over and above the value of its net tangible assets. As a result, the asset approach is generally used to estimate value of real estate entities, holding companies and unprofitable firms. For profitable firms, it provides a minimum value for analysts to consider. 

The income approach values a firm based on cash that can be distributed to partners (“free cash flow”, “cash flow”). Free cash flow is not net income and for growing companies it is generally less than net income. Free cash flow takes into consideration the amount of income that must be held in the firm to fund accounts receivable, work-in-progress, purchases of equipment and other capital needs. For S corporations and LLC’s, distributions to owners to pay taxes are also deducted from net income to arrive at free cash flow. There are a number of methodologies that the valuation analyst can use under the income approach. The methodology chosen depends on whether future free cash flow is expected to grow steadily, vary from year to year or can be estimated based on prior year’s results. After future free cash flow is estimated or forecasted, it is discounted back to the valuation date based on the valuation analyst’s assessment of the risk of achieving future cash flows. For example, a lack of a firm succession plan adds to the risk of achieving future cash flows, increases the discount rate and results in decreased estimated value. Conversely, the existence of a repeating income stream generally reduces risk and the discount rate, resulting in increased estimated value. The final step in the income approach is to subtract firm debt. The income approach arguably provides the most theoretically accurate estimated value for a firm as it is based on the actual firm characteristics and results. ² 

However, the accuracy of this approach is dependent on estimates of future free cash flow and the discount rate. 

Finally, the market approach involves researching the sales of other law firms and utilizing information on the sale of firms with operating and financial characteristics similar to the subject firm to arrive at an estimated value. At a minimum, seven to ten comparable sales are needed to utilize this approach. Information provided on the sale of law practices and the nature of the practices involved is sometimes too incomplete to provide a basis for calculating a value indication. 

Other Considerations: 

Many law practices have buy-sell agreements in place to avoid fighting over value in the event that a buy-out must occur. Many of these agreements contain formulas that have nothing to do with the economic reality of the situation. This frequently causes fights among the owners. In certain jurisdictions, these types of agreements will not be considered indicative of value for a marital dissolution case. 

In a law practice, there tends to be much more dependence on the professional than in other types of businesses. During the valuation process, the attributes of the professional(s) must be considered. Unusual skills, long work hours, a large referral base, and other similar factors will certainly affect the valuation, whether it ends up as a part of reasonable compensation or built into the discount or capitalization rate. 

Probably one of the most difficult assets to value on the balance sheet of a law practice is work in progress. Unless the firm keeps really good records, this can be pretty tricky. This is particularly true for a contingent fee law firm.¹ 

When a professional practice is being valued for transaction or litigation purposes, it may be important to identify professional and practice goodwill separately and to discuss the likelihood that a portion of the professional goodwill can be transferred in a transaction. 

Consistently high earnings do not necessarily indicate a high practice value for a number of reasons. If earnings are highly volatile, as they can be for a law firm with large contingent-fee cases, value tends to be lower based on the risk of achieving future estimated cash flows. A professional with an outstanding reputation may attract many referrals, but the resulting high earnings in the practice reflect professional goodwill, not practice goodwill. A professional may work much longer than normal hours, but the resulting high earnings may not increase the value of the practice.² 

While, rules of thumb (formulaic: expressed in multiples of revenue or earnings) may provide insight on the value of a professional practice, it is usually only appropriate to use them for reasonableness tests of other valuation approaches. 

 

¹ Understanding Business Valuation, Fourth Edition, Gary R. Trugman, Copyright 2012
² Financial Valuation, Second Edition, James R. Hitcher, Copyright 2006