The valuation process of any business is typically described as difficult and, for some, even intimidating.
Despite its reputation for difficulty, understanding the valuation process is a non-negotiable for making strategic decisions about your law firm, including positioning yourself for a successful exit.
In this step-by-step guide, we’ll get into all the particulars of the valuation process – from the major factors affecting a firm’s valuation to the 10-step process you must undergo to achieve an accurate valuation. Now, let’s get the ball rolling!
Need a quick summary? We’ve collated all the essential steps to value a law firm:
1. Review Financial Statements
2. Evaluate Revenue Streams
3. Consider Client Base
4. Analyze Market Position
5. Assess Assets
6. Calculate Net Profit
7. Examine Liabilities
8. Apply Valuation Method
9. Factor in Growth Potential
10. Get Professional Appraisal
A simple way to obtain a law firm’s valuation is through the rule of thumb. The calculation is as simple as multiplying a firm’s annual revenue by a multiplier of 0.5 to 3.0 – a value often used in the legal sector.
So, if you’re selling a law firm that generated a revenue of $1 million last year and was evaluated with a multiplier of 2.4, the estimated worth of the firm is $2.4 million.
You might say, that’s a vast range – what number do I use? The truth is that it varies on several factors. One of the major ones is the demand for a law firm’s services. Generally, the higher the demand, the higher the multiplier.
Other determinants of a law firm’s valuation include the number of clients and geographical location.
There are 5 main factors that impact a law firm’s valuation. Let’s discuss each one further:
Any law firm that shines financially indeed shimmers in terms of its valuation. When an external entity assesses the value of a law firm, this is often the first criterion they look at.
When assessing financial performance, evaluators look at metrics such as revenue growth and profit margins. At the same time, it gives an idea of how consistently profitable a law firm is, which can increase its valuation.
The higher the demand for a particular practice area, the higher the expected valuation. According to the JD Supra, these specializations within the legal sector are deemed to have significant demand:
A law firm with a vast client base can command a high valuation. However, it isn’t just about how many clients they have – it’s also about their loyalty. If the firm has maintained a long-term relationship with these clients, that’s a green flag for many buyers.
Multiple revenue streams are also seen as positive, increasing a firm’s valuation. Diverse revenue sources show that a firm can mitigate risks by not solely depending on a single service or sector – showcasing its financial resilience.
Don’t discount intangible assets such as a law firm’s reputation and brand recognition. These speak volumes about trust and reliability. However, they are valuable as these assets do not grow overnight; they require excellent service, significantly contributing to a law firm’s valuation.
When a law firm holds a valuable edge against its competitors, it will likely be considered valuable. When conducting competitor analysis, these are the seven factors that are often analyzed:
Valuing a law firm is often believed to be a lengthy and complex process. We’ll simplify it into 10 straightforward steps:
Is the law firm in good financial standing? Only numbers can answer the question. The following financial statements will tell you more about a firm’s financial strength than any other document.
Financial Statement
Description
Income Statement
Shows a firm’s profitability within a specific time frame
Balance Sheet
Provides a glimpse into a firm’s assets, liabilities, and equity
Statement of Cash Flows
Highlights the sources and uses of cash
Next, you have to assess the firm’s revenue streams. Are they solely reliant on a specific service to generate income, or do they have multiple revenue streams? Having several income streams is an excellent way to stay financially resilient and strengthen a firm’s market impact.
By having a diverse revenue portfolio, law firms can explore opportunities for expansion within existing services or into new areas. Therefore, these income streams make up a significant part of a firm’s valuation.
Another way to value a law firm is to assess its client base. While many valuation methods focus on the financial aspect, Harvard Business Review states that implementing customer-based company valuation (CBCV) can also help assess a firm’s value.
Together with financial data, these models are also taken into consideration:
Model
Description
Customer Acquisition
Forecasts the inflow of new clients.
Customer Retention
Forecasts the duration of time a client stays engaged.
Purchase
Forecasts the frequency of client transactions within a firm.
Basket-Size
Forecasts the amount a client spends per transaction.
A crucial step in finding your firm’s worth is analyzing its position in the market. Here’s how you can perform this analysis:
When determining a law firm’s true value, including its assets in the calculation process is essential. We can break these down into 2 types: tangible and intangible.
The former refers to physical assets, while the latter covers non-physical assets that add to the firm’s overall value. Let’s classify each asset:
Tangible
Intangible
Real estate
Brand reputation
Office furniture and equipment
Human capital – the skills and expertise of attorneys
Cash reserves
Client base
Office furniture and legal library
Intellectual property
Tech infrastructure
Marketing assets, including firm name or logo
You must never leave the net profit out of the equation, especially when evaluating a firm’s value. Net profit is calculated using a simple formula:
Net Profit = Total Revenue - Total Expenses
The net profit is a financial metric that provides insights into a firm’s profitability. The higher it is, the better.
It’s not all about the profit. If a law firm has numerous debts and liabilities, then this could affect its valuation.
Liabilities can be short-term (current) or long-term (non-current liabilities). The following are examples of each:
Current Liabilities
Non-Current Liabilities
Wages Payable
Deferred Tax Liabilities
Interest Payable
Long-Term Lease Obligations
Dividends Payable
Bonds Payable
There are multiple valuation methods to choose from. Hence, selecting the one best suited for your business involves considering various factors.
The two most commonly used methods are the Multiples of Earnings and the Discounted Cash Flow (DCF) analysis. Let’s compare them below.
Characteristic
Multiples of Earnings
Discounted Cash Flow
Focus
Focuses on current earnings as a basis for valuation.
Emphasizes the present value of future cash flows
Time Horizon
Short-term
Long-term
Complexity
Simple and straightforward to use.
Requires more financial forecasting than the multiples of earnings method
Suitability
Well-suited for stable law firms.
Well-suited for firms with variable earnings or huge growth potential
Arriving at an accurate valuation will require considering a law firm’s present state and growth potential. Here’s what you can assess to determine a law firm’s growth potential:
When in doubt, consult a professional appraiser or financial expert for an accurate valuation.
To maximize exit values, ExitWise can connect you with handpicked industry-specialized bankers, M&A attorneys, and tax accountants. Schedule a call with us to speak to an M&A expert.
The road to obtaining a successful valuation can get a little bumpy. Here are some of the challenges you might encounter.
These are some of the most commonly asked questions about valuing law firms:
You’ll get different answers when asking about the value of a small law firm practice, as this depends on various factors. Consider financial performance, client base, or law firm reputation to assess its value.
The previously discussed Multiple Earnings method and Discounted Cash Flow Method are the approaches you can use to assess the worth of a small law practice.
The 2020 Martindale-Avvo Attorney Compensation Report surveyed 823 practicing attorneys in the United States, revealing that the average law firm made $192,000 – slightly down from 2018’s $194,000.
While client base and retention are subjective, they do play an important role in valuation. Earlier, we mentioned two types of assets: tangible and intangible.
Client base and retention fall under the latter. Thus, it must be included when estimating an asset’s worth. This ultimately impacts a firm’s value.
Partnership structures make the arduous process of law firm valuation even more challenging. It starts with taking into consideration the contribution of each partner, whether that may be capital or knowledge.
Because we’re speaking about partnerships, they could have different tax implications depending on the law firm's location. Hence, this must be considered when obtaining a firm’s valuation.
The future earnings potential can be factored into the valuation process as it reflects a law firm's future growth and profitability.
This method involves looking at a longer time frame, about 5 years or more, and discounting them to the present using an appropriate discount rate.
The discount rate signifies the risk and opportunity of investing in a law firm. It can be determined from the expected return on comparable law firms or the firm’s cost of capital.
The total of the discounted earnings will then represent the business value derived from its future earnings.
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That wasn’t so difficult, was it? All you’ll need is 10 simple steps!
While you may face many obstacles along the way, from assessing intangible assets to adapting to unpredictable market conditions, the result of your valuation ultimately relies on your analysis and the decisions you’ll make throughout the process.
To assist you with that, ExitWise will form the bridge between you and M&A experts who can guide you in each step of the valuation process. Not only do you get to sell faster, but also for the best value. Get in touch with ExitWise to learn more!
Let Exitwise introduce, hire and manage the best, industry specialized, investment bankers, M&A attorneys, tax accountants and other M&A advisors to help you maximize the sale of your business.
