January 10, 2008
Going Concern Value of a Law Firm
The previous host for morepartnerincome, Tom Collins, has strong feelings about the importance of recognizing the monetary value of law firm ownership. He believes that incoming partners should purchase their share of ownership and that retiring partners or their estate should be fairly compensated for the value of the partner’s shares. I asked him for a post on the subject and here it is:
For the purpose of this post, I put aside consideration for any regulations, laws or rules of professional conduct that restrict the sale or purchase of a law firm. The issue addressed here is the value of the law firm as a going concern.
This is a different number than the value of the business in the eyes of a purchaser with a strategic objective. For example, another law firm that wants to establish a presence in your geographic area may be willing to pay a greater price than the going concern value. At a minimum, they would be willing to add to the going concern value the investment and lost opportunity cost of starting their own branch.
The going concern value is the worth of the business operated in its current fashion following its current business strategy. In academic terms, it is the present value of its future cash flows. From a practical standpoint, a common approach is to value the business at five times its estimated pretax profit less any interest bearing debt. There are some things that would turn most buyers off without an appropriate discount. One of those things is any unfunded obligation such as that many firms have in place for retiring partners. Where they exist, a prudent buyer would deduct the cost of funding those obligations.
The problem in applying any of this to a law firm is that law firm partners do not separate salaries (earned income) from investment income related to their role as owners. Those two components must be separated to compute the going concern value. The portion of compensation that represents a competitive salary is a business operating cost. The value of the law firm as a going concern is derived from the law firm’s ability to pay its partners a return on their risk and investment as owners of the business. If a law firm is not expected to produce more than a competitive salary for its partners, then it has no value as a going concern.
Why is any of this important? Law firms are sustainable as an institution only if they are adequately funded. Yet, the pressure in most midrange law firms is to distribute all available funds to partners. That reluctance to leave anything on the table runs counter to the need for the law firm to be adequately funded for growth and to safely navigate the normal ups and downs of any business. Their reluctance to reinvest earnings in the business is unlikely to change until law firms provide a way for those partners to extract their share of the value of the law firm upon leaving the firm. They deserve not only a return of their investment capital but their share of the increase in the value of the firm during their tenure as an owner. Most midrange law firms also do not require incoming partners to invest adequately for their share of ownership. Law firms typically have no sense of what incoming partners should be required to invest for their share based on the value of ownership. The firm has no way to demonstrate to that new partner that making that investment is a sound one. At the other end of the career timetable, firms struggle with the treatment of departing or retiring partners. These types of problems are routinely solved in other closely held businesses. Owners agree to a valuation method and that method is used to admit new owners and to buy out selling owners.
There are several approaches a law firm could take to separate the salary and investment component. One method is to arbitrarily set the salary component of partners at some multiple of associate salaries and treat everything else as investment income. Another is to actually set salary levels individually. For example, use a variation of the lockstep method to set the salary level of the firm’s partners. Earnings in excess of that or short falls in earnings would be treated as investment income and losses to be distributed in proportion to ownership. All of the above still results in inaccuracies. Perhaps the simplest and most workable approach is to make the assumption that the law firm is being operated soundly and that 80 percent of fee revenues goes toward paying all operating cost and salaries including the salary component of the partners or owners. The remaining 20 percent of revenues represents investment income, income earned on the risk and investment of the owners. Thus, for the purpose of entering or exiting partners, the going concern value of the business will be considered one times the annual fee revenue (5 times 20%) less any interest bearing debt and less the computed present value of any unfunded liability.
For an incoming new partner, I would suggest that the firm use the current estimated annualized fee revenue for the firm when making the partnership offer. For a retiring or exiting partner, the number should be based on an average. The value might be based on the fee revenue of the immediate prior fiscal year not to exceed 120 percent or be less than 80 percent of the average fee revenue for the immediate prior three years. The 120 percent and 80 percent rule would provide some protection against a one-time fee revenue spike or dip.
The kicker, of course, is that if the law firm isn’t being operated soundly, incoming partners will be unwilling to make the investment and exiting partners will surely leave to go elsewhere.
There is no perfect approach, but that has not stopped the rest of the business world from solving the same sticky issues.
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