Adventure of Strategy

Business valuations have always been regarded as a bit of a black art. Nowhere is this more true than in a professional service firm, where the primary assets reside between the ears of the people working in the firm. Law firms have additional complications such as strict Law Society rules and issues of client trust and confidentiality. Nevertheless, there are occasions on which it is necessary to value a legal practice.

Business valuation is also an extremely complex topic and different appraisers routinely come up with different values, based on the same data from the same firm. An exhaustive treatment of the subject is far beyond the scope of a short article, which can hope only to discuss a few of the issues most relevant to valuing law firms in particular. Imminent changes to legislation in the United Kingdom following the 2004 Clementi Review, that will make external ownership of law firms possible, makes this discussion extremely topical.

WHY VALUE THE FIRM?

The first question that needs to be answered is why the valuation is necessary. There are many possible reasons, including:

-During a merger or acquisition of the firm or a portion of a firm with or by another.
-During the sale of the firm to another entity, for instance upon retirement of the owner
-For tax, succession planning estate planning or divorce purposes
-Upon withdrawal of a partner where the partnership agreement is not explicit about the financial arrangements (especially where the withdrawal is without the withdrawing partner's agreement.)

Each different situation creates its own set of dynamics, which influences the valuation technique and the way in which it is applied.

WHAT IS BEING SOLD?

What exactly is the asset being transferred, when a law firm is sold? To answer this question, one has to understand what a firm means to both buyer and seller. At the two extremes:

-The firm is simply a means of generating owner compensation and it has no value beyond the cash-basis capital account.

-The firm is an investment that can grow in value, can be bought and sold, and has immense goodwill value beyond the cash-basis capital account.

Valuing a firm according to the first extreme would lead to a valuation strictly on a net book value (NBV) basis, with little or no consideration of future earnings. In other words: the net assets of the firm less the net liabilities of the firm.

Under the second scenario that looks at the firm as a going concern, there is considerable value in the firm's ability to generate future earnings precisely because of its brand, client relationships, systems in place and other intangible value drivers. Under these circumstances, a model that takes account of future earnings would be appropriate. Buying a legal business as a going concern also has many savings over starting from scratch. The time involved in going through the gamut of statutory registrations, finding office space, designing and ordering stationery, finding staff and a multitude of other tasks all have an opportunity cost. Vendor relationships, business contacts, systems and procedures and client books all take time to develop, too, so have an intrinsic value from that perspective. These are all embedded in the overall valuation and not usually calculated separately - they are simply mentioned to illustrate an additional benefit of buying a business as a going concern rather than starting from scratch.

TANGIBLE V INTANGIBLE ASSETS

In the legal profession, it is commonly held that goodwill has little or no value because it relates directly to client relationships that, as a matter of public interest and of practicality, cannot be bought or sold in a way that customer relationships of a business are. This view results from a narrow view of goodwill, however. Naturally, it is a matter of public interest that clients should be free to select and change legal representatives as they see fit, but that is not to say that they will. There is logically considerably more value in a firm that is able to retain profitable clients over long periods of time, than a firm that has high client turnover, irrespective of current earnings.

The question is how to conduct the valuation and reach a figure that is fair and acceptable to both buyer and seller, given the statutory and ethical restrictions, the high mobility of key fee earners and the intangible nature of the assets.

The Net Assets. This contains the tangible assets including the debtors book, work in progress (WIP,) furniture and equipment, leaseholds and other investments in place, less debt, outstanding rental and lease obligations and other liabilities. Valuing these is simply a matter of arithmetic, with some judgment required for adjustments. For instance, the book value of some of the tangible assets may exceed what they will realize if sold (if the firm is not being sold as a "going concern") and some of the receivables may prove uncollectible, especially if the calculation includes work in progress as well as the debtors book. Minus liabilities, of course.

The Practice. The practice embodies the ability to generate revenues now and in the future. It comprises the people, the reputation, the systems, the client relationships and the knowledge embedded in the firm.

VALUING INTANGIBLE ASSETS

Valuing the practice is more complex and subjective. A comprehensive treatise on each is beyond the scope of this article, but briefly the generic approaches are as follows:

Income Approaches

-Discounted Future Economic Income Method, also sometimes called discounted cash flow (DCF)
-Capitalized Future Economic Income Method

These approaches are based on the forecasted future revenue streams that the business is expected to generate. At its most basic, this would be an extrapolation of previous years revenues, adjusted as necessary to reflect changes in the business or the market that could cause these to increase or decrease. Although as a basic principle one should separate payment from valuation, the final amount agreed might also be influenced by whether the is price fixed and payable up front (high risk for buyer, low risk for seller) or is it dependent on future income forecasts being met (lower risk for buyer but may result in a higher multiple?)

Market Approaches

-Guideline Publicly Traded Company Model Method
-Guideline Merged and Acquired Company Method

This approach is only directly relevant to publicly listed entities and indirectly relevant (by virtue of the proxies that may be deduced) for unlisted businesses that resemble them. Given that there are very few listed companies that resemble any but the largest and most commercialized firms (in which case comparisons to companies such as merchant banks may yield value,) this is not the most suitable approach for valuing law firms.

Asset Based Approaches

-Capitalized Excess Earnings Method
-Asset Accumulation Method

Asset based approaches do have merit in valuing law firms, especially the capitalized excess earnings method. (Professional service firms typically do not focus on asset accumulation given that most earnings are distributed to shareholders each year.)

In the Capitalization of Excess Earnings method (also called the "Income Approach") the valuation specialist first estimates the appropriate income level for the practice, looking forward (for a single normalized or adjustment-stabilized period.) Then this income is divided by the investor's required rate of return (the "direct capitalization rate.") The value lies in the earnings in excess of the earnings generated over what the firm requires to operate (or its net operating income.) This would need to include a reasonable adjustment for partner earnings, which is usually either what partners have earned traditionally or what a reasonable market related salary would be.

This is a particularly useful model when the firm is considering sale of the practice as a going concern to an external entity, because it spotlights the additional value that the external ownership has to yield in order to make it worthwhile.

For instance, let us assume that a firm's revenues are $100 million per annum and net operating profit before tax is $40 million per annum. Let us assume that the valuation yields a multiplier of 1.2 on revenues, or $120 million. Let us assume now that the investor requires a direct capitalization rate of 20%. Let us also assume that the partners will be reluctant to reduce their earnings under the new ownership.

20% of $120 million yields $24 million, which suggests that the firm will need to increase its revenues by 24% following the sale, in order to provide the new owners with the return that they require and cover the net operating costs of the firm, including (former) partner drawings. Or, alternatively, reduce costs by $24 million. (R100 million revenues would need to increase by 24% to yield the R124 million required to cover the same R100 million net operating costs PLUS the 20% return on the R120 million that the new owner paid for the firm.)

This is exactly the situation that Edward Nathan (a premier South African law firm) and Nedcor (a major South African bank) found themselves in, where the return that Nedcor was looking for on its investment placed severe pressure on profits available for distribution to the senior fee-earners, to the extent that it was becoming difficult to match what those fee earners might have earned elsewhere. External ownership of the firm needs to create enough additional value to match the economics of an owner managed firm of similar stature PLUS yield an adequate return on investment (ROI) for the external owner. That's a very big ask indeed!

In the above example, it meant that while Edward Nathan sold itself to Nedcor to 1999 for ZAR400 million (about US$65 million at the time,) when the golden handcuffs expired five years later the directors were able to buy themselves back for only ZAR50 million (about US$9 million) which was very little more than book value. Future cash flows , the directors held, would be from the sweat of their own brows and they could generate cashflows in other firms, or by walking across the road en masse and starting a brand new firm. Their clients were embedded with individuals, not the firm. In the light of possibilities following the Clementi Review in the United Kingdom, this case study is one of value both to English law firms contemplating selling themselves, or those entities considering buying a law firm.

Relief from Royalty

This method has not been used much with professional service firms but is the basis for a recent study on the value of the brands of the top London firms that was undertaken recently by an organization called Intangible Business, based in London. It does show promise in that it focuses on the implicit royalties that the firm would need to pay to somebody else if they did not own their brand, but is relieved from doing so because they do. The royalty rates are derived from qualitative research in the market, media coverage and other sources and the discounts applied are derived from an estimated weighted cost of capital.

ADJUSTMENTS

No matter which valuation method (or combination thereof) one chooses to value a law firm, there is a myriad of non-financial factors that must be taken into account that in the end will affect the value of a firm:

-Willing buyer/seller. Irrespective of what the numbers yield, there needs to be a willing buyer and a willing seller at a defined price.

-Whether the seller/s and/or other key fee earners and staff will continue to practice in the firm ("golden handcuffs")

-Issues uncovered during the due diligence that suggest that the revenue forecasts are overestimated or underestimated (eg unstated liabilities, pending legal action, unidentified conflicts, doubtful client relationships, client turnover, WIP that is unlikely to be translated into invoices, etc on the downside; impending large engagements and other positive issues on the upside)

-Reconstruction of net income to add back benefits and "perks" that owners have been enjoying "under the radar," and substituting the real compensation packages that are agreed.

-Whether the shareholding will be a majority or minority holding. Unless control is secured contractually, a minority shareholding is usually less valuable than a majority holding.

-Relevance of the practice's palette of services to the changing market. Are the firm's services cutting edge and up to date, or are they largely uncompetitive services where profitability is declining because of reduced demand and/or increased client price-sensitivity? What is the profile likely to be in a couple of years? (This, too, one probably would try to build into the model by adjusting revenues downward to reflect decrease demand.)

A FINAL WORD

Using traditional valuation techniques as a starting point, one can value law firms as is possible for any other business, once the assumptions have been accurately detailed and once the factors that make the business of law as a unique industry have been identified and have been dealt with. (Getting consensus on the assumptions, however, is often no easy task. Sidestepping this stage of the process will lead to a valuation that is something like estimating "how long is a piece of string," though.)

This article appeared first in the February 2006 edition of "Without Prejudice," a South African corporate law journal.

REFERENCES:

Byrne, M., 2005. Firm Offers - The Clementi Review has opened the door for law firms to float but what are the dangers? The Lawyer.com 18 May 2005.
Cotterman, J.D., 2000. Valuation of a Law Practice. American Bar Association, Jan/Feb 2000
Intangiblebusiness.com, 2005. The UK's Most Valuable Law Firm Brands 2005. www.intangiblebusiness.com
Reilly, R.R. and Schweihs, R.P., 1999. Valuing Intangible Assets. McGraw Hill