As any other business, a law firm can have market value to the remaining partners. Determining its actual value can help a firm to make informed decisions involving transition planning.
Valuing a law firm can seem complicated, but mainly, it comes down to three elements:
Book Value of Equity
Platform Value (going concern value)
Value of any transitioned business
1. Book Value of Equity
Book Value of Equity is the easiest of these to calculate and most firms can get to this number without too much difficulty. To calculate, a law firm needs:
– An updated A law firm needs an updated balance sheet as of the valuation date
– Current accounts receivable
– Unbilled Sub-ledgers
Most small and mid-sized law firms maintain their books on a cash or modified cash basis. Revenues are recognized when received, and expenses are recognized when paid. Income and expense accruals beyond the current year pension liability are rare.
Book Value of Equity is a simple calculation the includes subtracting total liabilities from total assets.
Most firms reflect this difference in each member’s capital account. Given the tax structure of the typical small and mid-sized law firm, all income is allocated each year and flows through to the individual members.
The equity section of a typical law firm balance sheet includes any fixed capital contributions and the undistributed earnings (income less draws and payments on behalf of partners) of the members. Accounts receivable and unbilled fees are typically not included unless a firm prepares an accrual basis financial statement.
Many firms have provisions governing dissolution, withdrawal, disability, retirement, and death in their operating agreements. In our experience, the most common approaches to handling unallocated book value at retirement include:
- None (no buy in /no buyout);
- Stated amount (agreed value among the partners);
- Based on retirement year equity; or
- Based on a measure of originations or profit.
Regardless of the method, allocating book value is the easiest to understand.
2. Platform Value (going concern value)
Assigning a value to a law firm as a going concern can include tangible and intangible assets. Admittedly, valuing a law firm is not likely to follow traditional business valuation approaches, and will probably lack any fair market value comparable. Paying retiring partners for anything beyond book value and shares of future client receipts is rare, but in some instances, we believe there is a legitimate case for paying for the value of a going concern.
Comparing the costs to start a new firm, which includes cash outlays and lost time, to the cost of buying retiring partners interests is an initial starting point. One challenge can include the reality that the existing platform is inefficient and lacking in competitive advantage. In these instances, it is necessary to include modernization costs and difficulties into the analysis.
The items that can add going concern value include:
- Any client master service or panel agreements that can potentially survive a transition;
- Marketing automation system contacts, workflows, blogs, resources, infographics and any other unique client or contact engagement data;
- Website and SEO rankings;
- Billing and financial histories;
- Document management infrastructure, document histories, and document creation templates and utilities;
- Efficient accounting and billing systems;
- Trained staff;
- Branding and name recognition;
- Reputational advantages with clients and judiciary;
- Office leases;
- Difference between the book value of equipment and the cost of buying new equipment;
- Established trade credit and banking relationships;
- Repeatable processes and procedures; and
- Ability to buy increase errors and omissions insurance.
While this list is not all-inclusive, it does indicate several potential advantages for evaluation. Firms who have built an efficient platform can offer junior partners compelling reasons for paying retiring partners for going concern value. Firms who do not score well in these areas have a difficult time convincing junior partners to assign a value premium to the going concern.
Assigning a value to a going concern requires a careful analysis and comparison with the benefits and costs of starting a new firm. Developing a 3-year profitability model that compares the results of maintaining the current platform to those associated with starting a new law firm.
As mentioned previously, paying a retiring partner for going concern value is not an exact science. Each situation will differ and depend on the clarity of advantages.
3. Value of Transitioned Client Accounts
Paying retiring partners for clients that a firm retains is handled in several ways, but in small and mid-sized firms, we prefer individual agreements between retiring partners and those benefiting from the transitioned client relationships.
For example, if a retiring partner facilitates a client transfer to a junior partner, the junior partner would absorb the cost any compensation paid to the retiring partner for any transferred clients. If more than one partner benefits from a retiring partner’s clients, each partner will participate in defraying the cost of the retiring partner’s compensation in proportion to the benefit they receive.
Firms that have client and matter profitability readily available have an advantage and can negotiate sustainable agreements retiring partners.
We recommend paying retiring partners over a period of years (3-5), depending upon the role of the retiring partner and the transition period. We recommend compensating based on each client’s contributed profit before transition costs. The level of payout that retiring partners receive can vary based on profitability. Many law firms do not run client level profitability and paying based on gross fees is common. Paying based on gross fees can create an unprofitable situation if the payouts are more than the profitability of the transitioned work.
A firm can set guidelines on how much a partner receives on a percentage basis and the duration of the payouts, but each retiring partner agreement can differ.
Other approaches to paying retiring partners include:
- historical compensation based formulas,
- arbitrary stipends, no benefit,
- founder’s bonuses,
- and other guaranteed payments.
Additionally, most small and mid-sized firm partners receive performance-based compensation throughout their careers, and many firms do believe that additional post-retirement compensation is justified. In these instances, partners are likely only to receive their capital account balances.
Transitioning clients requires planning and active participation on the part of a retiring partner. Creating the right incentives can increase the likelihood of perpetuating the firm.
A progressive approach to developing and executing a transition plan requires a sustained focus, which is often difficult for administrators and lawyers who must manage daily business demands and be pressing client service issues. Outside support, working in conjunction with in-house resources, ensures that the planning process remains focused and deliberate.