What’s it worth?

I’m often instructed to value legal practices, whether that is part of advising on a merger/acquisition, restructuring, partnership dispute or retirement. Valuations have become increasingly important during the past couple of years, particularly as we have seen major changes within the ownership and trading structure of law firms. As we move forward into the post Legal Services Act era, and as external ownership of/investment in law firms is permitted, the valuation issues will become ever more important.

The valuation of law firms is not an exact science. The actual value can only be determined by negotiations between an informed/willing buyer and an informed/willing seller. In the absence of formally marketing for sale, professional practices tend to be valued using one of three valuation methods:

  1. applying a multiple to maintainable fee income
  2. applying a multiple to maintainable net profits or earnings
  3. valuing the net recoverable assets of the practice and determining whether to add an element for goodwill.

The valuation tends to be no lower than the value of the net recoverable assets of the practice. If the practice is to cease trading, the valuation would be based on the break-up value of the net assets. On a break-up basis, the net recoverable amount of assets would be lower than that on a continuing basis due to the firm having:

  • assets such as equipment, fixtures and library that would be sold for their net realisable values rather than net book values in fixed assets;
  • assets that do not realise full value once the business is broken up such as work in progress, unpaid bills and unbilled disbursements; and
  • liabilities for winding up the business such as accounting costs, legal costs, regulatory and redundancy costs and potentially for involving intervention agents.

Using multiples

The valuation multiple used will reflect the valuation of goodwill in the business. Goodwill is the benefit and advantage of the good name, reputation, and connection of a business. Goodwill will be the excess over the value of the net tangible assets.  In order for there to be such an excess, the expected annual maintainable profits from the business must be greater than a reasonable financial return from the investment in those assets.

The recent downturn in the economy, and the legal sector in particular, has adversely impacted the valuation of legal practices. Other issues impacting the legal sector at present, including the Legal Services Act and legal aid reform, have reduced the multiples used in valuations. In practice, the number of law firm amalgamations has declined during the recent recession, although there is now increasing interest in law firm mergers driven by changes to the market.  Most of the amalgamations that have taken place have reflected mergers rather than acquisitions, with no cash changing hands.  It has therefore become more difficult to value legal practices in the current climate. It is not commonplace at present for a premium, or goodwill, to be paid when acquiring a practice.

In the years immediately prior to the recent recession, acquisitions of law firms that were based on fee income used multiples varying from 1 to 1.5 and profit multiples tended to fall within a range of 3 to 4. The average net profit percentage of law firms has fallen over recent years, for the reasons noted in the paragraph above, and so the multiple to apply to fee income for most firms has also fallen.

Once the profit multiple has been decided, it is then necessary to determine which profits to apply that multiple to. This is often achieved by taking an average of the profits earned for the previous three years, however, this would not be appropriate where there is a definite trend upwards or downwards.  In that case, it would be more appropriate to extend the trend or use the most recent results as a guide to future performance. 

It may be necessary to make adjustments to the actual profits shown in the accounting records and the accounts of a business to reflect a ‘maintainable’ level. The typical adjustments that are often required are:

  • to incorporate a notional partner salary to reflect the cost of employing a fee earner to carry out the fee earning duties of the partner;
  • to incorporate a notional rent charge if properties are owned by a connected party and are not shown in the profit and loss account at market rates;
  • to remove any exceptional non-recurring items in the profit and loss account; and
  • to smooth out the effect of any changes in accounting policies.

Valuing the net recoverable assets

It may not necessarily follow that the value of the net assets is that shown in the accounting records, or the accounts of the business as prepared under UK Generally Accepted Accounting Principles (“UK GAAP”). For example, work in progress valued in accordance with Urgent Issues Task Force Abstract Number 40 does not necessarily reflect the recoverable sales value of work performed to the balance sheet date of the accounts, particularly for contingent work types. 

In order to determine the net recoverable amount of assets, attention would also need to be given to other areas of the balance sheet, including the recoverability of unpaid bills and unbilled disbursements.  This would usually be evidenced by the ageing profile, since the older the items are, the less likely they are to be collectable. However, in certain work types such as Personal Injury, it is common for the work to take place over a longer period, in excess of a year in many instances, and therefore comparatively older unbilled disbursements may still be considered collectable.

Provisions may also be required that are not within the accounting records of the practice, to ensure that the valuation is in accordance with the true financial position of the business at that point in time, whether or not certain expenses incurred have actually been paid.

This, and most other factors involved in the valuation process is extremely subjective and it always pays to have experienced valuation advisers involved in the process.

Andy Poole, Legal Sector Partner

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