By com ksicinskig sva Gregory J. Ksicinski
, CPA/ABV, MST, SVA Certified Public Accountants S.C.
March 16, 2011 – Valuing a business is difficult. Valuing a closely held professional practice is more difficult. Valuing a closely held law practice presents additional and unique challenges. Whether a sole practitioner is looking to move out of the area or retire or a young lawyer is looking to buy in to a multi-lawyer practice, there are numerous issues that both the buyer and seller need to be aware of. This article touches on just a couple of the issues of concern.
One of the primary challenges in determining the value of a law practice is understanding what is actually being transferred from the seller to the buyer. In looking at a law practice, there are really only two things that are transferrable – the business assets and the practice itself. In a typical law-practice sale, the “hard” assets – furniture and equipment – are part of the transfer but not a significant part of a sale and are somewhat easily valued. Some other assets – including accounts receivable, unbilled fees and costs, and long-term leases – have different issues, but these assets also are somewhat easily valued. The complex issue in the valuation of a law practice is consideration of the value of the practice itself – the clients and the income stream associated with those clients.
Valuation of transferred assets
Hard asset valuation. The valuation of the transfer of a law practice can be viewed from two separate perspectives. First, the value could be viewed as being only that associated with the assets actually being transferred. This view assumes that the law practice is not much more than a personal income stream generated by the efforts of the individual lawyer. The result of this valuation approach is that the buyer pays only the cash basis capital account of the seller and receives the rights to the hard assets. The seller remains entitled to the accounts receivable and likely to the unbilled fees. The buyer gets the right to earn an income stream based on his or her future personal efforts. In theory, the seller has already been rewarded for the practice value through the income stream that he or she has received over the years.
Practice or enterprise goodwill valuation. The hard asset valuation approach, however, presents a very narrow view of the value of the law practice. It ignores the fact that there is some unique value associated with a going business – a going-concern value. The buyer steps in to a business that has trained staff, an established office, vendor and banking relationships, and some office systems and procedures. These factors – often referred to as practice or enterprise goodwill – have value beyond the cash-basis capital account and need to be recognized in some manner. Valuation methods have been developed for measuring some of the factors mentioned (such as the value of having a trained staff) but, in large part, these are subjective measurements based on judgments considering the time and efforts required to establish the business.
Valuation of income stream
The second and more complicated approach to the valuation of a law practice is to consider the value of the income stream in determining the selling price. This is the more typical approach to valuing a business enterprise and looks at a multiple of the earnings stream. Use of this approach requires determining the real earnings stream and the multiple.
Determine “normalized” earnings. Determining the “normalized” earnings stream of the practice may involve adjusting the earnings for unusual one-time items, such as an unusually large case that occurred in a year or a one-time repair in the office. Adjustments also should be considered for certain perks that the business may provide, such as country club dues, continuing education-related travel, or a company car. The earnings stream should represent the amount that can consistently be anticipated to be earned by the buyer if the practice is run with a true business-like approach – maximizing income to the owner(s).
Determine the “multiple.” The determination of the multiple is the other factor considered in a practice valuation. This multiple should reflect the risks associated with the earnings stream. There are numerous approaches to determining the final multiple but all of them involve consideration of risk. Some of the factors to consider include the name and location of the practice, the type of practice (for example, general or transactional), sources of clients and referrals, the stability of the clients, the concentration of revenues, and the relative profitability of the practice compared to others in the area. The individual seller’s characteristics also must be considered. Does the seller have some unique knowledge, skills, or reputation that attracts and retains clients? All of these factors must be considered in determining the appropriate multiple.
Buyers and sellers should avoid the trap of applying a particular multiple simply because “that is what was used in the past.” The multiple is unique to the practice and all risk factors must be considered.
This analysis is only a very small part of the items considered in a practice sale. Others include payment terms (including possible earnouts), purchase price allocations, and tax allocations. In any practice sale, be sure to consult a qualified advisor early in the process to be sure that all items are fully considered.
Editor’s note: Thinking about retiring? Join the author when he presents “Ways of Valuing Your Law Practice” at the Transition to Retirement from Law Practice seminar, March 24, at the State Bar Center. As one of several program sessions, the author will demonstrate specific methods of valuing law firms of solo practitioners, small firm practice, group practice, and large firm practice, and will take questions from the audience. The Senior Lawyers’ Division and State Bar of Wisconsin PINNACLE™ are sponsoring this full-day seminar and 8.0 CLE credits and 1.0 EPR credits have been applied for. Visit Transition to Retirement from Law Practice for more information and to register.
About the author
Gregory J. Ksicinski, CPA/ABV, MST, is a principal in SVA Certified Public Accountants S.C., Brookfield. Reach him at com ksicinskig sva sva ksicinskig com or visit www.sva.com.