What is your law firm worth? A guide to valuing your practice
Even though this is a question we are often asked, giving a precise answer can be difficult because valuing a law firm is not an exact science. This is because there are many factors to consider. Typically, you could expect to receive a figure for goodwill, furniture, fixtures and fittings, equipment and library with the sale of Work in Progress paid over and above any sale price on an “as and when” basis.
A law firm’s actual value can only really be determined via negotiations between an informed and willing seller and an informed and willing buyer. But professional practices tend to be valued using one of the following three valuation methods:
- Applying a multiple to sustainable fee income
- Applying a multiple to sustainable earnings or net profits
- Valuing net recoverable assets and deciding whether to add a goodwill element
If the practice is to cease trading, the valuation will be based on the break-up value of the net recoverable assets and will be lower than that of a trading practice. This is because the trading practice will have:
- Assets, such as equipment, fixtures and library that can be sold for their net realisable values as opposed to the net book values in fixed assets
- Assets such as unpaid bills and unbilled disbursements that do not realise full value once the business has been broken up
- Liabilities such as legal costs, accounting costs, regulatory and redundancy costs for winding up the practice.
Goodwill is the advantage and benefit of the good name, business connections and reputation of the practice, and is the excess over the value of net tangible assets. For there to be such an excess, the expected annual sustainable profits from the practice must be higher than a reasonable fiscal return from investing in those assets.
This method determines value by looking at the average sustainable earnings and applying a multiple to it. This often considers the last three years’ profit, EBITDA: Earnings Before Interest, Tax, Depreciation and Amortisation, which apply a weighting to the most recent figures. We then look at adjusting for any unusual factors, and then make adjustments for partners’ dividends/drawings.
The term “successor practice” determines which insurer covers claims against firms following a takeover or merger. Law firms considering merging or acquiring another practice can become inadvertently caught by the Successor Practice Rules which can create unfair and unwieldy results and lead to significant liability for claims of the ‘prior practice’, or the failure of the firm because they could not secure renewal insurance.
However, if the acquiring party purposefully becomes a successor practice, it removes the need to purchase professional indemnity insurance run-off cover.
Run-off insurance cover
Most law firm owners will be familiar with professional indemnity insurance, and run-off cover merely extends this. It generally works on a ‘claims made’ basis and covers any work undertaken in the past being insured against future legal action, so long as the work was completed within the covered dates and the policy remains active. Run off cover applies to a period of time after a practice has ceased trading when damages claims are still possible.
- Staff transferred from the old firm to the new one are protected by TUPE Regulations. This will help acquiring firms because, where staff are retained, there is no need to pay redundancy costs.
- Office premises leases can be assigned – this transfers an existing lease to another person or business and solves the issue old firms may have of time left to run on the lease.
- The acquiring firm will take over the running costs of the practice
Valuations have become increasingly important over the last few years, in particular there have been major changes within the trading structure and ownership of law firms. Moving forward, as external ownership of law firms and investment in law firms are extended, valuations will carry even greater weight.