I recently received the following query about the value of legal practices:
“Some have suggested that they should use ‘1/3rd of gross profit for the preceding 12 months’ (or the average of the preceding 24 or 36 months) as a sale price. Is there any merit to this formula?”
My response was:
"There is some merit to this formula or rule of thumb. However, some practices are worth more and some are worth less.
"Factors (not exhaustive) to consider:
1. The formula you mention should be for goodwill and usually equipment combined.
2. In addition is the value of WIP, outlaid disbursements and debtors
3. No two practices are the same and the value depends on the proportion of work by type of law. Some work types are worth more than others.
4. CBD, suburbs and regions will vary
5. Transition assistance from outgoing principal is relevant
6. Sometimes goodwill is traded off against an attractive consultancy agreement
7. Extent of advertising and promotion expenditure required to generate fee revenue"
I will elaborate on some of the above but first I will add two points that I did not mention in my response:
Gross profit should be replaced by fee revenue. Often the most important determinant of value is fee revenue. Fee revenue should be fees received rather than fees billed. The reference to gross profit presumably means gross revenue less disbursements paid. This is usually close to fee revenue.
The value of any business is a function of future expectations. Therefore whether the last 12 months of revenue should be examined or the average of the last three years depends on which provides the better picture of future revenue.
What would a rule of thumb include and exclude?
The main assets of a legal practice are goodwill, plant and equipment, work in progress (including outlaid disbursements) and debtors. If you are trying to derive a handy rule of thumb then you need to decide which of these assets are included and excluded.
In my response I stated that it should include goodwill and plant and equipment - sometimes also fixtures and fittings. The rule of thumb fails to produce a sensible result in cases where the value of work in progress (WIP) is high. This would be the case in litigation-type practices, especially those handling no win no fee personal injury matters.
Type of work
The value of legal practices becomes complicated when you realise that their profitability, level of work in progress and future prospects vary depending on the type of work they are handling.
For example, a family law practice varies significantly from a conveyancing practice. Some areas of work are more in demand by purchasers than others. I’m sure you would agree that a practice doing 80% conveyancing and 20% estates would not have the same value or rule of thumb as a practice doing 20% conveyancing and 80% estates.
The difference between CBD, suburbs and regions is relevant, not because one location is better than another, but because it is often a sign about personal goodwill versus business goodwill.
CBD practices usually tend to have a higher degree of personal goodwill. Suburban and regional practices are not free from personal goodwill but they have a higher degree of business goodwill. This comes from the fact that they tend to provide services to a geographic area. Sometimes this is called locational goodwill.
If a practice is heavy in personal goodwill it does not mean that it has no goodwill value. Rather, it means that the method of transition from vendor to purchaser must be executed according to a plan. Such a practice is more likely to have goodwill payments transfered after the event of the sale.
There is an increasing tendency for firms in certain categories of work to boost revenue through advertising, especially online advertising. If there were two practices that generated the same level of revenue but one had consistently higher advertising expenditure, which of the two would have a higher business value? In most but not all cases, the practice with the lower advertising expenditure would have a higher business value.
Best use of rule of thumb
A rule of thumb is not the best way to assess the value of a practice. It can be used as a cross-checking device or a type of reality check. A far better approach is to consider the investment required and evaluate what the possibilities are as a result of making the investment. This will vary a lot from one individual to another and from one firm to another.
(c) 2017 Peter Frankl Pty Ltd