What is the value of your law firm?

Once fully implemented, the Legal Services Act 2007 will fundamentally deregulate the legal services market in the UK. Among many other reforms, it provides that law firms (firms) may be owned by non-lawyers. In this context, much has been written about firms incorporating and taking on external investment or being sold to so-called ‘consolidators’ who seek to acquire smaller firms and integrate them into their larger business model.

As a result, quite a few firms have been asking: ‘How much would we be worth if we were to sell out?’ While far too much wishful thinking is taking place in that direction, in particular in smaller firms, it is worth thinking about how a firm could and should be valued in the event of a financial investment or a strategic acquisition taking place. This article summarises our approach to firm valuation, which we have tested in both acquisition contexts and in an equity buy-out context.

Law firm valuation in context

Valuing a publicly held company is fairly simple: at its most basic, one opens the daily newspaper, finds the appropriate stock quotation and multiplies the stock price by the number of shares outstanding to derive at the current market value of the business. Current macro-economic conditions aside, public company valuation (rightly) assumes that the collective market has perfect or near-perfect information and knows exactly the present value of future cash flows that a shareholder can expect.

When one seeks to value a private industrial company, things already become much more complicated. First, there is no readily determinable market for a privately-held company. Second, a privately-held company does not get bought and sold every day, and thus there is much less reliable information about the company than there is in the publicly-held context. Third, valuation is as much a number-crunching exercise as it is a qualitative assessment of intangible factors that affects a business’s ability to generate future cash flow: much more depends on the company’s ability to navigate its competitive environment, on the company’s existing structures and systems and, most important, the skills and abilities of management to drive a strategically rational business model. While there are many common elements in how private company valuation can be approached, the plethora of books written on the subject allows the conclusion that private company valuation is as much an art as it is a science.

Professional-services firms – law firms included – provide a special, more difficult context of private company valuation. At first brush, many approaches and bases for an ordinary private company’s valuation appear, at minimum, difficult to apply to firms and, at the most, are simply inapposite.

The ability of a firm to generate future cash flow depends much more on the ability of individual partners and on the firm as a structure to provide intangible value drivers that is much more difficult to quantify than, for example, a private industrial company’s ability to generate a return on assets.

Customised approach to law firm valuation

We have recently been approached to stress test valuations undertaken by others. As a result of our work, we have developed our own customised approach to valuation that is bespoke to the legal sector. Our approach essentially involves three major steps after we have made ourselves familiar with the firm and its financials: (a) analyse external influences affecting the firm’s business; (b) analyse internal value drivers in the context of these external influences; and, (c) analyse the impact of the above on the financial value of the firm.

Analyse external influences affecting the firm’s business

We typically begin with a review of the macroeconomic conditions and trends that affect the firm. This begins with a review of the basic markets that a firm seeks to serve and the macro conditions surrounding it. For instance, in a recent valuation of a national firm, the international context and the national competitive context within which the firm operates played much more of a factor than in the valuation of a smaller local firm. In light of its market environment, we evaluate its current competitive position and market trends that are specific to that law firm’s markets and clients, as well as its overall market share (usually by work type) and penetration of its major corporate clients.

Analyse internal value drivers in the context of external influences

Many firms still don’t have a clearly articulated strategic approach, and often, in particular in continental Europe, strategy remains defined by the strong will of individual partners. The absence of a clearly articulated strategy, one that does not seem to fit given the external environment in which the firm operates (either because it is too ambitious or not sufficiently ambitious), or one for which there is no record of having been effectively executed, will directly impact on the financial value of the firm.

In light of the firm’s business strategy and competitive recipe, we review the essential aspects of the firm’s intellectual capital and how the firm’s intellectual capital supports effective strategy execution. A firm’s intellectual capital has three essential components: human capital, relational capital and structural capital.

Human capital consists of two elements: the firm’s professionals and its management. In the context of valuation, we closely review the skills and abilities all of the firm’s professional complement. This includes both the legal skills required to execute the work that the firm seeks to do and (as importantly) its lawyers’ non-legal skills that we feel are necessary for that particular firm’s lawyers to service its desired clientele (for example, commercial acumen, language capabilities, industry knowledge and client skills). We also spend significant effort understanding the skills and effectiveness of the managing partner, the management board and the senior partner in the context of strategy execution. The track record of the managing partner is given much more weight than his/her legal skills or accomplishments as a practicing lawyer prior to becoming managing partner.

Relational capital consists of three elements: clients, brand and network. We closely review the firm’s client base and will assess to what extent the firm is maximising the potential to generate cash flow from its client base. Depending on the type of firm, we may interview some clients to further determine the strengths and weaknesses of a particular firm. Even if we don’t undertake client interviews, we will closely review the longevity of the firm’s client base, the firm’s ‘share of wallet’ and other factors that indicate the quality of the client relationship. Brand recognition – both with clients and with talent – is tested, as is testing referral sources and other required parts of the firm’s networks. For instance, a private client practice will typically rely heavily on chart accountants and tax practitioners for its client base. The firm that is actively cultivating a referral base is likely to be more successful in the future than a firm that does not.

Structural capital consists of three elements: the firm’s service lines, its own processes and its culture. For instance, for a firm that primarily handles employment claims, we would expect to have processes and systems in place that allow the partners to do only that part of the work that truly requires partner involvement. We would expect that firm to have systems in place (for instance, technology, people and procedures) to execute all other parts of the work at the lowest cost possible. While many firms make much of their own unique culture, we test aspects of behaviour within the firm that make accomplishing common strategic goals easier or more difficult.

With respect to each of the above components of intellectual capital, we assess the firm’s resources, investments, capabilities and limitations. While we capture these elements in a structured and objective way, in the end we apply qualitative value judgments. Armed with these qualitative value judgments, we seek to understand how these value drivers will affect the firm’s ability to execute on strategy, thus its ability to generate future cash flow and finally the firm’s financial value.

Financial valuation based on value drivers

The firm’s existing financial statements will provide the initial basis for the financial aspect of our valuation. Almost always, the financial statements will require adjustments. We review the balance sheet and its major components very closely, in particular for issues that affect the firm’s ability to generate cash flow: large work in progress, accounts receivable and vendor balances, or significant fluctuations in these, are viewed less favourably than a convincing picture of sound working capital management. We will also sanitise the financial statements from partner perks and other issues usually found in private company financial statements. Testing projected revenues (based on detailed partner interviews and, if necessary, with major clients) forms part of this work, among other analytical reviews and benchmark testing.

On that basis, we apply at least three traditional private-company valuation methodologies: multiples of earnings, discounted cash flows and self-financed purchase. These are considered below.

Multiples of earnings

After determining earnings before interest, depreciation, income and amortisation (EBIDTA), we seek to assess an appropriate multiplication factor that a willing buyer should be prepared to pay. As a starting point for determining the multiple, we typically reference comparable publicly-held firms. In the legal services context this is tricky because there are only a few publicly-held legal services providers. Slater and Gordon in Australia is a well-publicised one, but has special issues: it runs a fairly commoditised personal injury claims firm. Murgitroyd, a Scottish patent firm, also seems apposite only in a limited way. However, other publicly-held professional-services firms provide an equally rational starting point (for example accounting firms, management consultancies and recruiting firms). The qualitative analysis of value drivers as described above then serves to adjust (usually downward) the price-earnings comparable derived from the publicly held firms.

Discounted cash flows

Under the discounted cash flows method, one seeks to discount back to present value the firm’s future net cash flows. Conceptually, the discounted cash flows method is the most sound, but it has practical limitations: the risk-adjusted discount rate requires a plethora of assumptions that are difficult to establish in a volatile market environment. While the risk-free rate is easy enough to determine, both industry risk and company-originated risk provide challenges. Understanding what return a willing investor might expect is easier in a steady market than in a volatile one. In the current market environment, we structure several return scenarios and then stress-test these to determine a rational value under this method. Most will be surprised that the risk – and thus the expected return – will be much higher than in a publicly-held company context. This is especially true where the law firm is a ‘motel’ for lawyers instead of an integrated business with a collective proposition.

Self-finance method

While this method seems somewhat backward at first, it provides a good reality test of whether the other methods yield a rational result. We seek to determine the maximum value that the business could sustain if it had to pay for its own shares. On the basis of future cash flow, we determine the maximum amount that could be available for debt service. Based on available financing, the maximum loan amount available (plus down-payment) at then-current interest rates and terms determines the value of the firm. The value drivers analysed above inform the firm’s ability to generate the cash necessary for debt service, and also the interest rate and terms that a financier would be willing to offer.

In summary

There are other valuation methodologies that are applied from time-to-time, but the above tends to be the most rational in the law firm context. We disagree with those parts of the literature that seek to value law firms on the basis of net book value or multiples of revenue.

On the basis of the above valuation methodologies, discounts and premiums apply as they ordinarily would in any private company valuation.

Ordinary valuations (often undertaken by accountants) look primarily at the numbers. The above approach allows us to use our market knowledge to look deeply behind the numbers. This way, we understand what has to happen for the numbers presented by the firm to be sustained, to be expanded and also how additional capital will increase future cash flows and thus support long-term value generation.

Michael Roch is a senior adviser at Kerma Partners and a member of the editorial board. He can be contacted at michael.roch@kermapartners.com