Law Firm Valuation – How much is your Law Firm worth?

As a shareholder of a publicly traded company you basically know at all times how much your part of the company is worth. But what about law firms? How do you as a partner know how much your stake is worth? And does it matter?

Key words: Valuation, Law Firm, Substance Value, Multiplier

Image: Pexels/Anna Nekrashevich

The Market Cap Metric

Publicly traded companies are often compared in size using their market capitalization as the metric of choice. The market capitalization of a publicly traded corporation (with one share class) is as follows: Market Capitalization = N° of Shares x Current Stock Price. E.g. if a corporation issues 5 Mio shares and the current price per share is USD 45.50, the market cap of said corporation equals USD 227’500’000. However, when it comes to most law firms, things are a little more complicated.

Law Firms are Partnerships or Closely-Held Companies

With very few exceptions (e.g. Slater + Gordon; ASX:SGH) law firms are not listed on a stock exchange and do therefore not have the luxury of having a real-time valuation of their firms. There are two main reasons for this: First, many jurisdictions don’t allow for law firms to be incorporated, and if they do, usually no ‘outside investment’ is permitted. Second, law firms are closely-held companies (CHCs), meaning that in most cases a small or moderate-sized group of people (usually called equity partners) share the ownership of the firm among them.

Most of the times, there is no market for ownership stakes in CHCs. Whenever a transaction is to be made (if contractual obligations at all allow for such transactions) prices have either to be negotiated or are calculated using a predefined formula.

Measuring a Law Firm’s Value

Why would you at all need to know the value of your law firm (apart from sheer curiosity)? There are a number of reasons that could potentially trigger a valuation, such as:

- succession planning / handing over a running practice to a successor;

- distribution of an inheritance or compensatory payments after a divorce;

- tax reasons, especially in countries with wealth taxes;

- retirement or admittance of a partner, incl. lateral hires; or

- law firm mergers.

For most partners, a law firm’s valuation doesn’t really matter, as they are bound by contractual regulations that specify the amount of the buy-in as well as the amount of the payout –the usual rule being: a dollar in is a dollar out.

Nevertheless, let’s talk about law firm valuations – even if it’s mostly just for the fun of it. A widespread method for valuating non-publicly traded companies is the Discounted Cashflow method (DCF method), which relies on predictions on future cashflows that, however, can be difficult or unreliable for law firms for a variety of reasons. Valuations of Professional Service Firms such as law firms, whose only or major production factor is the labor of its professional workers (attorneys, accountants, consultants etc.) are therefore usually calculated using simplified methods.

Substance Valuation

A law firm’s value is heavily intertwined with its professionals, the lawyers that not only deliver the services, but also to a great extent oversee their own books of business and apply their unique networks – ‘assets’ that leave the firm whenever the professional walks out of the building in the evening. A law firm can therefore lose much of its value or even collapse in a very short period of time as the cases of Dewey & LeBoeuf and others have shown in the past. Some people therefore argue that law firms have no value other than its substance, such as furniture, computers, office supplies etc., because the entire workforce and goodwill (client contacts, individual reputation) rest solely with the physical person(s), who can basically leave at any time. They therefore claim that a law firm’s value equals its assets minus its liabilities. And for smaller practices that are going out of business, this metric might be the right one.

Multipliers and Mixed Methods

Other easy methods to valuate a law firm are multiplier or mixed methods. Multiplier methods rely on a certain key financial figure such as revenue or profit as well as a multiplier. In these scenarios the most difficult part is the definition of the multiplier (e.g. 2-4 when based on profits, 0.5-2 when based on revenues).

Mixed methods combine the multiplier method with the substance method by adding the values and subsequently dividing them, e.g.: Law Firm Valuation = (Substance Value + 2 x Revenue) / 3.

These valuations take into account the revenue streams or profits and therefore bet on the firm’s continuing operation. They make sense when a practice owner hands over not only his office but also his client base to a successor, usually working alongside the successor for a certain time to assure that the clients stick with the successor.

More Sophisticated Valuations

More sophisticated valuation approaches usually rely on a key financial figure (profits, cashflows, revenues) and a multiplier, too. The difference lies in the complexity of the multiplier, which can include, among others:

- a size factor: it is assumed that larger firms are more diversified and therefore have less cyclical revenue and profit streams and are less dependent on key figures (however, keep in mind Dewey & LeBoeuf etc.);

- growth factor: has the law firm been able to show continuous growth with regard to revenue and profits (especially per lawyer or per partner)? Or has the trend rather been negative?

- brand factor: how strong is a law firms brand? This includes not only the question of whether the law firm is known/recognized within a certain geographical area, but also what it is being associated with (first tier work, mass production, scandals etc.);

- client loyalty and turnover: a law firm with a loyal client base that generates repeated revenues provides more certainty and is likely to be valued at a higher price than a competitor, who struggles to keep its clients and therefore has a large client turnover;

- nature of the mandates / practice areas: some areas of the law are considered to be more steady revenue generators, such as tax or employment matters. Others, incl. M&A are more project-based and often rely on the state of the economy as a whole. It is therefore advisable to look at the revenue distribution among different practice areas, their reliance on economic cycles as well as the existence of anti-cyclical buffers (e.g. restructuring or bankruptcy practices).

- partner structure and key partners: how does the partnership look like in terms of age structure, values of books of business etc. Does the firm heavily rely on a couple of key rainmakers (cluster risk) and are there still active name partners who might leave the firm (such as Rudy Giuliani, who left his firm Bracewell Giuliani to join Greenberg Traurig, before… let’s leave politics out of this)?

- future readiness: how future-proof is the law firm? Did they invest in their IT infrastructure, are their processes automized and efficient? How is the firm doing regarding diversity and how successful is its recruiting of young talents?

Obviously, there are many more factors that could be plugged into the formula. And once the selection of the relevant factors has been made, they have to be weighed – an even more difficult task. This brief article intended to provide you with a very brief overview of easy valuation methods as well as some food for thought regarding the factors that have to be considered when a law firm is to be valued more seriously.