By Michael Stewart, Corporate Finance Assistant Manager
One of the biggest questions when you are looking to buy or sell a law firm is ‘what is it worth?’ Whether you are selling due to retirement or buying a firm to allow you to expand and grow, valuation is often the key point for consideration. As the Law Society’s preferred partner for accountancy and corporate finance services, the legal sector team at Armstrong Watson is well-versed in valuing law firms of all types and sizes, across the UK.
The valuation of a law firm is not an exact science. The actual value can only be determined by marketing the business for sale and then negotiating between a willing buyer and a willing seller. In the absence of such procedures, law firms are normally valued using one of three methods:
Usually, firms tend to be valued at no lower than the value of the net recoverable assets. However, if the business 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 assets would be lower than on a continuing basis, due to:
The valuation multiple will reflect the valuation of goodwill in the business. Goodwill is mainly driven by having a good name, reputation and connection of a business. The calculation of goodwill will be the excess in the valuation of the business over the value of the net tangible assets in the business. To obtain an excess, the estimated annual maintainable profits from the business must be greater than a financial return from the investment in the net tangible assets.
In the last two years or so, firms have generally enjoyed particularly large increases in profits and good cash flow, despite a very early slowdown caused by the Covid-19 lockdown. During that period, demand for legal services has been high and firms have been more concerned with recruitment and retention in order to meet that demand.
The main issues for law firms right now are the impact of a potential UK recession/slowdown reducing transaction volumes, poor cash flow resulting from increased lock up (particularly if Court redress is required), and increasing interest rates making it more costly to borrow to invest. However, thanks to this latter point, law firms that hold large amounts of client money are benefiting from the increased returns on such balances.
Multiples based on a maintainable fee income have been rarely used in the last few years and are only really used when a firm has large amounts of recurring work and fees. Often brokers may quote multiples of fees as a valuation basis, but in reality, when you are buying a firm it is the right to the future profits of the firm that you are acquiring, and so multiples of profit are the usual real valuation basis in law firm transactions.
When it comes to a valuation based on net profits or earnings multiples, the multiple will differ based on a range of factors such as the business’s size and age, the reason for the transaction, work type, and who the acquirer is. For smaller businesses looking to exit with no succession plan, where all of the goodwill is vested in individuals, multiples may be as low as zero. For larger businesses in stable/mixed work areas with easier succession, multiples tend to range between 2 and 4. For those that are being acquired by the newly floated firms, multiples have been in the range of 4-7*, more commonly around 5-6. Private equity-backed acquisitions have seen multiples in a larger range but commonly have fallen in a range of 4-5. (*As of July 2023).
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 a weighted average of the profits earned for the previous three years, with more weight being put on recent years. It is often necessary to adjust the actual profits from the accounting records to reflect ‘maintainable’ earnings. The adjustments will vary from firm to firm; however, some typical adjustments are:
Applying the multiple to the maintainable earnings will get you to the Enterprise Value (EV) of your firm. However, the majority of deals are completed on a cash-free, debt-free and normalised working capital basis, so you would need to adjust the EV to add cash and cash-like items and deduct any debt and debt-like items, and then adjust for normalised working capital to get you to the Equity Value.
It may not necessarily follow that the value of the net assets, shown in the accounting records or the accounts of the business as prepared under UK Generally Accepted Accounting Practice (UK GAAP), is the reported value. For example, work in progress (WIP) valued, in accordance with Financial Reporting Standard 102 section 23 (FRS 102), 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 following UK GAAP, contingent work in progress is most commonly valued at nil or at a cost value rather than the anticipated recoverable value if the contingency was removed. This is important, as in firms that specialise in contingent work types, off-balance sheet WIP can result in the net recoverable assets being higher than the value calculated using a multiple valuation method, meaning net recoverable assets will be the most appropriate valuation method.
In order to determine the net recoverable amount of assets, attention would also need to be given to 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.
Overall, there are lots of intricacies in every firm which will affect the valuation and the subjective nature of these intricacies shows that one person’s valuation of a business may vary from another. It’s therefore important that you seek professional advice when trying to value any firm or decide on potential future strategies.