A Fresh Look At Law Firm Valuation
The legal industry has consolidated slowly over the years, but this process will be accelerated by the impacts of the current crisis, its economic effects, and the operational changes it drives. Some practice areas will flourish, and others will be negatively impacted. Some firms will need to bolster infrastructure (technology, remote working), requiring investment, while others will have excess infrastructure (office space, back office) that can accommodate growth.
Adopting the right strategy and taking decisive actions at this time are key to optimizing the future of the firm and protecting the interests of its clients and its people. Not only does the current crisis warrant such attention, but it provides a case for change that would not be politically viable during normal economic conditions. Additionally, there are now very few firms in the fortunate position to be able to rely on organic growth to ensure a successful future.
Most firms will evaluate how to restructure their business, particularly in the light of future financial perspectives. Partners of firms will also be evaluating their own individual status and professional goals. Considerations by firms will include:
- Acquisition Strategies – enhancing competitive advantage by luring laterals or acquiring competitors (referenced in “Planning for Recovery: 7 Strategies for Opportunistic Law Firms” authored by N. Jarrett-Kerr) or merging with another firm
- Succession Strategies – maintaining the financial health and strength of the firm through the transfer of ownership to younger partners and/or retirement of founding partners
- Consolidation Strategies – selling the firm to take advantage of the brand and investment resources of the bigger firm as well as a means of realizing goodwill and to allow older partners to depart (assuming the firm is in reasonable shape)
Such changes will involve valuation issues, be it the valuation of firms or shares in them. While traditional methodologies of valuation may be used as comparative benchmarks, they do not necessarily focus on the real value involved in any transaction.
- Capitalization rate/multiple of earnings: it is difficult to justify these methodologies due to the absence of a real market/market information on deals between law firms and the differing circumstances of each transaction. Why, as is often touted, should the value be between 1-3 years of profits and, even if it is, how do you arrive at the value within that range?
- Discounted economic income or discounted cash flow: it is similarly difficult to determine a discount rate to apply to future earnings/cash flow. Any increase of the cost of capital based on risk (the “risk premium”) is prone to be subjective.
To illustrate this conundrum, consider a few situations.
In an acquisition the acquirer will pay for net assets as well as any goodwill since the seller will relinquish control and management of its business, even though its partners may continue to participate in the acquiring firm. The value of goodwill, if any, will depend on the added value an acquirer foresees.
An acquirer is unlikely to want to pay much just for an increase in size of business represented by the summation of its revenues with those of the seller (i.e. 2+1=3) unless that results in a significant increase in profit per equity partner. The latter may arise for several reasons:
- leverage is increased and the increase in the number of equity partners is disproportionately less than the increase in projected income
- reduction in infrastructure and support costs (i.e. economies of scale)
- profit margins of the seller are significantly higher than those of the acquirer and its profit per equity partner exceeds the perceived market compensation for their peers
Note that any value judgements here are based on projections of the acquiring firm’s position post-acquisition and not on the economic income projections of the seller or a multiple of its earnings.
Acquirers are more likely to pay for value in the form of incremental revenue flows and/or the cost avoided by having to develop business (i.e. acquiring a new practice area, a new geographic region or a new client base). This arises where there is a strong synergy between the business of the acquirer and the seller, manifested by
- enhanced service offerings for the captive client base
- accelerated ability to compete in new markets
- complementary capabilities and intellectual capital
The value of goodwill could be significant and again does not necessarily bear a direct relation to the previous or projected earnings of the seller. A seller may argue that their business was developed over years and significant investments were made but, if that is not perceived to generate any value to the acquirer, there is no use in applying traditional valuation methods to determine sales value.
Clearly the degree of certainty that incremental revenues/avoided costs will be realized impacts the value attributed to them. Factors that will influence the outcomes include
- retention of seller’s client base and the predictability of future revenue from it
- maintenance of key partners/attorneys and referral sources of seller
- characteristics of seller:
- brand reputation and profile
- nature of relationships (institutional or transactional)
- susceptibility of business to economic/market changes
- diversification of clients and practice portfolio
- level and durability of institutional knowledge and intellectual property
In summary, there are multiple factors at play in determining the value of a firm. Tangible assets are quantifiable but the value of intangible assets, or goodwill, will depend more on the projected post-acquisition dynamic than merely on the ability of a seller to generate earnings in its own right.
In the case of a genuine merger, where two or more firms are contributing their resources and net assets to a new merged firm for mutual benefit, the concept is different. Generally speaking, each firm, and its equity partners, will assume responsibility for the realization of pre-merger assets and payment of liabilities and any resolution of pending items will be the subject of the merger agreement. The same applies to settlements with partners who will not join the merged entity.
The initial allocation of shares/equity participation and the partner compensation system of the new merged firm will regulate profit sharing. Together they should represent fairly the relative value contributed by the parties at the time of the merger and in the future, as well as protecting against dilution. Financial projections of the new merged firm and simulation of participations will be a key part of this process. In essence, the “goodwill” pre-merger is being translated into future profits to be distributed equitably amongst partners.
Restructuring of Partnership
Usually there are rules or methodologies in place to govern incoming and outgoing partners, the transfer of their shares and profit sharing. In any case, in contrast to acquisition by an outside party, the partners are familiar with the business and any added value to continuing partners will be based less on synergies and more on the retention of clients and referral sources, as well as the profits “liberated” by retiring partners.
As shown, valuation is not a simple mathematical exercise and values will vary in accordance with the type of transaction, the characteristics/profile of all interested parties and the value perceived by those acquiring an interest in a firm. Traditional valuation methods, such as multiple of earnings or discounted cash flows, can be used as benchmarks or as a reference point for sellers to establish an asking price for a firm or their shares, but they have limitations. A customized approach analyzing the different elements involved is necessary.
Those in acquisition mode will be searching for value at the most economic price possible. However, they will be avidly calculating the value that any acquisition target can bring to the firm.
A seller, with the luxury of time, can always optimize its own business and organization to enhance its value but, finding a buyer that would find most value in its attributes should be a priority. Offering the buyer greater certainty of increased economic income by, for example, agreeing to a period during which certain key partners remain and clients are transitioned, adds even further value.
A planned transition of ownership also adds value in an internal restructuring. Unless there are extenuating circumstances or disputes, a phase-out of retiring partners, over a period of time, should diminish any disruption of the client base and management of the firm as well as lessen the immediate financial burden on continuing or incoming partners.
In summary, entrepreneurial firms should forget how things were traditionally done in the legal sector or in their firm and should consider how a radical restructuring strategy might benefit the firm, its clients and its people and what smart plans can be deployed to evaluate how value can be optimized.