Editor’s note: This is the first part of a three-part series on the valuation of a law firm. This part examines key operational and financial considerations. Part 2 will focus on key valuation considerations, and the final part will discuss key professional responsibility considerations. The series is based on a CLE paper Kramer and White presented at LAJ’s 2017 “Last Chance” CLE program. It was edited for Louisiana Advocates.
Valuation practitioners face a variety of issues when determining the value of law firms. Appraisers are typically asked to value a law firm on behalf of existing partners of the law firm who are interested in purchasing a transitioning or retiring partner’s interest in the firm, including through predetermined buy-sell agreements.
Law firm partners have often invested decades of time and effort providing services to clients, building a firm, fostering future client opportunities, and establishing a reputation in the marketplace.
Valuation practitioners must carefully consider the facts and circumstances in the valuation of each law firm, including factors that may not apply to the valuation of other firms, such as personal goodwill. This article provides an overview of key operational, financial, and valuation considerations of which practitioners should be aware in assessing the value of a law firm.
Key operational considerations
When valuing a law firm, appraisers should carefully consider the nature of the firm’s operations, including its practice areas, leadership team, clientele, and other areas. Consideration of these factors will help the appraiser develop an understanding of the law firm’s business and the areas that may have a significant impact on the firm’s value.
An essential operational factor that a valuation practitioner should consider is whether the subject law firm is primarily a plaintiff or defense firm.
Plaintiff law firms represent parties injured as the result of another’s actions and may sometimes pursue class action or mass action lawsuits. Plaintiff firms often take on relatively high degrees of risk by bearing the financial costs of litigation in exchange for a portion of a final verdict or settlement.
Cases that plaintiff firms pursue may take many years to resolve, are subject to appeal, and may involve considerable expense. Thus, a plaintiff firm’s working capital requirements may be significant, as the law firm must self-finance day-to-day operations, such as rent and salaries, even though the firm may not collect revenue from cases for an extended period.
Defense firms, on the other hand, often represent clients in exchange for a retainer and compensation on an ongoing hourly basis. These firms tend to have lower risk profiles with all financial risk borne by the client.
Thus, a valuation practitioner must carefully consider the nature of the cases the law firm pursues and the extent to which the law firm bears the risk of litigation outcomes in providing legal services to its clients.
Another operational factor an appraiser must analyze is the law firm’s practice areas. Certain law firms, such as personal injury firms, tend to specialize in certain practice areas in which the firm’s attorneys have developed extensive legal knowledge.
Plaintiff attorneys may specialize in areas such as asbestos/mesothelioma cases, catastrophic personal injury, or mass tort product liability. Corporate law firms may specialize in practice areas such as corporate securities, intellectual property, mergers and acquisitions, private equity, venture, capital, real estate, or environmental law.
Analyzing the law firm’s practice areas allows the appraiser to understand any potential risks associated with those practice areas. For example, a law firm based in Texas that generates a majority of its revenue from clients in the energy industry may experience sharp declines in revenue during periods of low overall commodity pricing.
Valuation practitioners should also understand the knowledge and experience of the law firm’s senior practitioners. The appraiser should consider how long senior members have practiced law, as well as the number of years spent practicing in any specialty areas. And the appraiser should understand each partner’s contributions to the firm from operational and business development standpoints, as different partners may have significantly different roles and focuses within the firm.
Additionally, appraisers should understand the nature of clients’ relationships with each partner, including whether clients are personally loyal to a particular partner or to the law firm as a whole. Assessment of these factors allows the appraiser to identify any key-person risk associated with the firm, including whether a particular partner may compete against the firm in the future.
Understanding the governance of the law firm is another area an appraiser should consider. Appraisers should understand the terms and requirements of any governing documents of the firm, including, for example, buy-sell agreements, partnership agreements, and employment agreements.
Typically, a partnership agreement provides the appraiser with an understanding of the law firm’s governance and management. Buy-sell agreements may specify the requirements and mechanisms for determining an individual or series of payments due to a particular individual, or a particular formula for the transaction of partnership units. These formulas can be based on financial multiples (e.g., 1x revenue), the resolution of a major case, or even a guaranteed payment.
The appraiser should also consider the impact of any prior transactions in the law firm’s partnership units, including whether those transactions were consummated at arm’s length.
In addition, the appraiser should develop an understanding of the law firm’s clientele since different law firms may have clients with substantially different risk appetites and financial resources. Both plaintiff and defense firms may have significant concentration in their client base if several clients provide a substantial portion of the law firm’s billings.
The nature and concentration of the law firm’s client base may help the appraiser determine any risks associated with the firm’s clients in consideration of the overall value of the firm, as well as the firm’s working capital requirements and how the firm’s operations are funded.
Understanding the firm’s competitors is another important area for an appraiser to analyze. The appraiser should consider the reputation of the subject law firm in its key practice areas and the legal industry as a whole, and whether the subject firm has significantly greater perceived expertise than its competitors.
Additionally, valuation practitioners should consider the subject law firm’s competitive advantages in the legal marketplace, such as greater expertise in certain practice areas.
Key financial considerations
A law firm’s financial condition is also a key element of its value. Appraisers often start by analyzing the law firm’s current and historical balance sheet to understand how each account affects the firm’s ability to generate cash.
A plaintiff firm’s cash balance, for instance, may fluctuate significantly over time depending upon the firm’s overall case-win rate, and the timing and status of critical cases may influence whether the law firm has collected or disbursed cash at a given time. Law firms may also retain significant prepaid expenses, such as those related to prepaid marketing expenses for direct advertising. Law firms may finance these prepaid marketing expenses and other working capital assets through short-or long-term debt, especially when the collection of revenue is irregular.
While plaintiff firms may have significant prepaid marketing expenses at a given time, defense firms often have lower levels of prepaid expenses due to the nature of the firm’s operations.
A law firm’s working capital needs may vary significantly over time depending upon the status of key cases.
In a plaintiff firm, the collection of a final settlement agreement may significantly alleviate the firm’s working capital needs, while undertaking a class action suit with no initial retainer or ongoing payments may strain the law firm’s financial resources. Thus, these firms frequently need to take on short- or long-term debt to finance ongoing case costs and other operating expenses, including rent and employees’ salaries.
In some cases, law firms may raise mezzanine debt with the debt balances collateralized by a portion of the firm’s caseload; of course, such debt may accrue relatively high interest rates and service charges.
Appraisers should consider whether the law firm must make ongoing payments for salaries and other operating expenses, even in the absence of collections from clients, in determining an appropriate working capital level for the firm.
When analyzing a law firm’s balance sheet, appraisers should also consider the nature of the accounting policies employed by the law firm, including any significant differences in policy between the subject law firm and any comparable firms. For example, consider that law firms may employ different accounting policies in recording certain assets or liabilities on their balance sheets, such as recognizing billed and unbilled receivables.
Valuation practitioners should also consider the law firm’s historical performance from an income statement perspective. A plaintiff firm’s revenue may fluctuate significantly depending upon the firm’s overall case-win rate in a given year, particularly with regard to key cases. A defense firm’s revenue, however, is more heavily impacted by the overall caseload undertaken in a particular year.
The amount of advertising or activities devoted to a particular practice area as well as the overall amount of activity in the practice area or industry may influence a law firm’s revenue. For example, law firms specializing in serving clients operating in the oil and gas industry may have seen an increase in revenue during 2012 and 2013 when crude oil prices rose.
Law firms often maintain a relatively large proportion of fixed expenses, such as salaries and rent, which may cause operating margins to fluctuate during the year depending upon the firm’s caseload in a given period. The firm’s overall headcount typically drives operating expenses, while capital expenditures (which are often relatively low) primarily involve purchases of furniture, fixtures, as well as computers and other information technology equipment and software.
A law firm’s operating margin may also fluctuate depending upon the amount of time spent on certain cases, on a particular practice area, or even on a key case.
Within a year, a law firm’s distributions may vary significantly. For example, consider a law firm that makes distributions to partners on a quarterly basis to coincide with the partners’ debt service payments related to the purchase of interests in the law firm. Or consider a firm that times distributions to coincide with quarterly tax obligations versus one that does not. Such timing differences can affect the value of the law firm, especially when the firm must finance distributions through additional debt.
Above all, appraisers must consider the law firm’s expected future performance in determining the value of an interest in the firm. As such, the appraiser must consider whether a law firm’s past is indicative of its future performance and, if not, in which areas a law firm’s practice will evolve.
