How to Value a Small Law Firm

Jun 24

12 min read

Law firm valuation is an exercise that most practitioners confront rarely and unprepared: on retirement, on the departure of a partner, on a proposed merger, on a family dispute or on the death of a sole practitioner. The question appears simple, namely what is the firm worth, but it has no single answer. The value depends on who asks, why they ask, what rules limit the transfer of the business, how much of the income depends on the individual practitioner and what liabilities attach to the work already done. A figure produced for a retiring partner's payout may differ substantially from one produced for a sale to an outside buyer, even though the firm and its accounts are identical.

The problem is sharper for a small firm. The principal asset of a law practice is its relationship with clients, and in a small firm those relationships are often attached to one or two individuals who are free to leave and whom clients may be free to follow. Equipment, premises and software are usually modest in value. The balance sheet understates the business, and the profit and loss account overstates the transferable earnings, because it reflects the work of an owner who is paid, in part, through profit. A competent valuation therefore requires adjustment of the accounts and an analysis of what a buyer would be acquiring.

This article explains how a small law firm may be valued, the choices that determine the result, the regulatory constraints that limit what can be sold, and the steps a practitioner can take to improve and document the value of the practice. It does not state market multiples or industry benchmarks, since reliable figures vary by jurisdiction, practice area and period, and a valuer should be instructed to base any such figure on verifiable transactions. The rules on the sale of a legal practice, on ownership by non-lawyers and on client files vary by jurisdiction, and practitioners must check those of their own regulator.

Why the purpose of the valuation matters

A valuation must be prepared for a stated purpose and on a stated basis. The commonest purposes are the following, and each tends to point to a different approach.

Sale to an outside purchaser or merger. The question is what a willing buyer would pay for the stream of earnings that survives the seller's departure.
Retirement or exit of a partner. The agreement between the partners governs, and the valuation method may be fixed by contract rather than by market considerations.
Succession to a continuing partner or associate. The price is influenced by the buyer's ability to pay out of future profits, and often agreed in a negotiated instalment structure.
Matrimonial or estate purposes. The law of the jurisdiction may prescribe the approach to the valuation of a professional practice and the treatment of personal goodwill.
Insurance and funding. A lender or insurer may require a conservative figure reflecting what could be realised in a forced sale.

The standard of value must also be stated. Fair market value assumes a hypothetical willing buyer and seller. Fair value, in some legal contexts, is a statutory or judicial concept that may exclude discounts. Investment value reflects the benefit to a particular buyer. A figure quoted without a stated standard of value is of little use, and a partner who proposes a number should be asked what basis it assumes.

The two layers of a law firm's value: tangible and intangible

A small firm's value can be divided into the assets that appear on the balance sheet and those that do not.

Tangible and balance sheet assets

These include office equipment, furniture, library, leasehold improvements, computer hardware, and bank balances belonging to the firm. They are valued at depreciated cost or at a realistic resale value, which is usually lower. The firm's own money in its office account is an asset, subject to its liabilities. Client money is not an asset of the firm in any circumstance. It is held on trust or in a fiduciary capacity for clients, appears as an equal and opposite liability and must be excluded from any measure of value. A valuer who includes client account balances in the firm's cash has made an elementary error.

Work in progress and unbilled disbursements

Work in progress is time that has been recorded but not yet billed, and unbilled disbursements are costs that the firm has advanced. They are a real economic asset because they will convert to cash when billed and collected. They are also uncertain. Their value depends on the realisation rate, meaning the proportion of recorded time that clients actually pay, the age of the items, the fee arrangements, and whether the matter will conclude before the firm is sold. Contingency or conditional fee matters carry particular uncertainty, as the fee is payable only on success and its amount may depend on the outcome.

A conservative approach reviews work in progress matter by matter, discounts old items, excludes time that is unlikely to be recovered, and recognises that a buyer will not pay full value for items on which it must complete the work at its own cost. The agreement should specify who is entitled to the fee on a matter that straddles the completion date, and how the fee is apportioned between work done before and after.

Accounts receivable

Billed but unpaid fees are assets, subject to recoverability. An ageing analysis shows how long invoices have been outstanding, and old balances should be written down. A valuer will examine whether the firm has a practice of billing late, as a firm that bills irregularly will show a large balance of work in progress and a lower balance of receivables, and the distinction affects the timing of cash.

Goodwill and the client base

Goodwill is the excess of value over the net tangible assets. In a law firm it is the expectation that clients will continue to instruct the firm. The difficulty is the extent to which that expectation attaches to the firm as an institution, which can be sold, or to the individual practitioner, who cannot be. The distinction between enterprise goodwill and personal goodwill is central to small firm valuation. Enterprise goodwill arises from the firm's name, systems, location, staff, repeat institutional clients and recurring work, and it survives a change of owner. Personal goodwill arises from the personal reputation and relationships of a practitioner, and it leaves with that person. Some courts, particularly in matrimonial contexts, distinguish between the two and treat only the former as an asset of the business; the position varies and should be checked.

Normalising the earnings of a small firm

Most valuation methods for a going concern begin with the profit that the firm earns, adjusted to reflect what a buyer would earn. The adjustment, called normalisation, is the most important step in valuing a small firm, because the reported profit of an owner managed practice often bears little relationship to the economic return on the business.

The principal adjustments are as follows.

Owner remuneration. If the principal takes a share of profit rather than a market salary, the reported profit includes the reward for the principal's labour. A buyer who must employ an attorney to do that work will deduct a market salary. The normalised profit is therefore the reported profit, less a realistic salary for the work that the principal does.
Non recurring items. One off income, such as a very large fee on an exceptional matter, and one off expenses, such as the cost of relocation, should be removed.
Personal and discretionary expenditure. Costs of a personal nature that the owner has run through the business, where legitimate and documented, are added back. Extreme caution is needed, since an aggressive add back undermines the credibility of the whole analysis.
Non-market rent and related party costs. If the firm occupies premises owned by the principal at a rent above or below market, the figure should be adjusted to a market rent.
Accounting basis. A firm that accounts on a cash basis may show distorted figures for a year in which work in progress grew or fell. Conversion to an accrual basis gives a truer picture of the year's earnings.

Illustrative arithmetic

The following is illustrative arithmetic only and does not represent market data or a recommended multiple. Suppose a sole practitioner's firm reports a net profit of 180,000 in a year, in whatever currency the firm uses. The practitioner draws no salary, and a market salary for an attorney of equivalent experience, for the work performed, would be 110,000. The profit includes a single fee of 20,000 from a matter of a kind that the firm does not usually undertake and does not expect to recur. Normalised earnings are therefore 180,000 less 110,000 less 20,000, which is 50,000. If a valuer and a buyer agreed that an earnings multiple of 2 was appropriate for a hypothetical firm with such a profile, the value of the goodwill and operating business would be 100,000, to which the net tangible assets and realisable work in progress would be added. The example shows that a firm with a reported profit of 180,000 may be valued on only a fraction of that figure, and it illustrates why a practitioner who anchors on reported profit will be disappointed. The multiple is a hypothetical assumption in the example and should not be used as a guide.

The principal valuation approaches

Professional valuers generally use one or more of three approaches and then reconcile the results. The choice depends on the firm and the purpose.

Approach	How it works	Best suited to	Main limitation
Asset based	Adds the realisable value of tangible assets, work in progress and receivables, less liabilities	Firms being wound up, or with little recurring income	Ignores goodwill and the value of the continuing business
Earnings or income based	Capitalises normalised earnings by a multiple or discounts expected future earnings to present value	Established firms with stable earnings and transferable client relationships	Highly sensitive to the assumptions chosen, including the multiple or discount rate
Market based	Compares the firm with the prices paid in sales of similar practices	Where reliable comparable transactions exist	Comparable data is scarce and often unreliable for small practices

Fees based rules of thumb, such as a percentage of annual gross fees, are commonly mentioned in the profession. They should be treated with great caution. A rule of this kind does not account for the profitability of the firm, the dependency on the principal, the quality of the client base or the level of liabilities, and a firm with high costs and low profit may be worth far less than a similar firm with lower costs. A valuer who relies on a rule of thumb alone should be asked to support it with a sample of verified transactions and an analysis of earnings.

Risk factors that increase or reduce value

The multiple or the discount rate that a valuer applies reflects the risk that the expected earnings will not materialise. In a law firm the principal risk factors are specific and can be examined.

Client concentration and dependency

A firm that derives a large share of fees from a small number of clients is more vulnerable than one with a broad base. The loss of a single institutional client may transform the profitability of the practice. A valuer will examine the fees by client over several years, the length of the relationships and the existence of written instructions or panel appointments, and will consider whether the client's instructions are likely to continue after a change of ownership.

Nature of the work

Recurring work, such as retainers for businesses, regular conveyancing for institutional lenders, and routine corporate compliance, is more valuable than one off work, such as a single contested case, because it implies repeat business. Practice areas that depend on referral sources, such as estate agents or accountants, raise the question whether the referrer will continue to refer after the sale.

Key person dependency and staff

If the owner generates most of the fees, the business's value depends on a successful transfer of those relationships. Employment contracts, restrictive covenants consistent with the law and professional rules, and the retention of key fee earners and support staff are significant. A buyer will inquire whether the staff intend to stay, and whether their remuneration is at market levels.

Liabilities, claims and regulatory history

Past work carries continuing risk of negligence claims and regulatory complaints. A buyer will scrutinise the claims history, notifications to insurers, the terms and period of professional indemnity cover, the arrangements for run-off, and the firm's compliance with client money rules. An unresolved complaint or a qualified accountant's report on client accounts may reduce the value substantially or prevent a sale. Contingent liabilities, such as undertakings given to third parties, should be identified and disclosed. Practitioners should expect a buyer to seek warranties and indemnities on these matters.

Systems and documentation

A firm with documented procedures, reliable time and billing records, a clean conflicts register and an organised contract and file repository is easier to value and to transfer than one that depends on the memory of its principal. The reliability of records is itself a component of value, because a buyer discounts figures that cannot be verified.

Regulatory and professional limits on the sale of a practice

A law practice is not an ordinary business, and the law may restrict what can be sold and to whom. The rules differ widely. In some jurisdictions only a qualified attorney may own a practice, and a sale to a non-lawyer is prohibited. In others, alternative structures exist and external investment is permitted under licensing regimes. In some, the sale of goodwill is recognised, and in others it is limited or prohibited as inconsistent with the client's freedom to choose an attorney.

Even where a sale is lawful, the following matters usually arise.

Client choice. The client is not property to be transferred. The seller may assign the firm's goodwill and files only with the client's informed agreement, and many regulators require that clients receive notice and the opportunity to take their file elsewhere.
Confidentiality during due diligence. A buyer will wish to examine files, but the information is confidential and privileged. Disclosure should be restricted to what is necessary and made on an anonymised or summary basis until the client has consented.
Client money. The transfer of client accounts requires a controlled process, a reconciliation at the transfer date and a record of the clients' consent where required.
Professional indemnity. The seller will need continuing cover for work done before the sale, and the buyer must ensure that its own cover extends to the acquired matters.
Notification of the regulator. Some regulators require prior notice or approval of a transfer, an intervention in a practice and a change in ownership.

A firm contemplating a sale should obtain advice on the rules of its jurisdiction at an early stage. A valuation that assumes that goodwill can be sold, where the law does not allow it, is worthless.

Structuring the price and the payment

The headline price is only part of a transaction. Because the buyer's confidence in the continuity of clients and earnings is limited, the structure commonly shifts risk back to the seller. Practitioners should understand the options.

Deferred or instalment payments. The price is paid over a period, which allows the buyer to fund it from the firm's future profits and gives the seller an incentive to assist in the transition.
Earn outs or contingent consideration. A portion of the price depends on the fees actually received from the transferred clients over a stated period. This protects the buyer against the loss of clients, but exposes the seller to the buyer's conduct of the practice, so the agreement should address how the buyer must treat the clients and the records on which the calculation is made.
Retention or holdback. A part of the price is retained to cover claims or undisclosed liabilities, to be released after a period. The release date and the method of determining claims should be unambiguous.
Consultancy or transitional arrangement. The seller continues to work for a period at an agreed remuneration, which assists in handing over relationships and demonstrates to clients that the change is orderly.

The tax treatment of a sale, including whether the proceeds are treated as capital or income, is a matter for the firm's tax adviser and varies by jurisdiction. It should be examined before the structure is finalised because it may alter the net benefit of the alternatives.

Improving the value of a small firm before a sale or exit

A practitioner who intends to exit within a few years can take steps that improve the firm's transferable value and reduce the risk of dispute. None requires a sale to be in prospect.

Reduce dependence on the principal by introducing clients to other fee earners, delegating work and documenting the relationship with each major client.
Broaden the client base and cultivate recurring work, noting that a reputation for particular expertise attracts a more stable stream of instructions.
Keep accurate time, billing and collection records, and bill promptly so that work in progress does not accumulate unrecoverably.
Clear any outstanding complaints and negligence concerns, keep client accounts reconciled, and obtain clean accountants' reports.
Put written engagement letters in place for all clients, and ensure that they do not contain terms that prevent assignment where the law permits it.
Document processes, templates and precedents, and make sure that the firm owns the intellectual property in them.
Formalise employment contracts for the staff who matter, with lawful retention incentives.
Obtain an independent valuation periodically, so that the firm has a documented baseline, and review it as the practice changes.

Practical next steps

Define the purpose of the valuation and the standard of value, and record them in writing before any figure is produced.
Gather three to five years of accounts, together with the management records of fees by client, matter type and fee earner, the schedule of work in progress and receivables, and the claims and complaints history.
Normalise the earnings, with documented adjustments for owner remuneration, non recurring items and non-market costs.
Identify what is transferable by analysing the client base, the nature of the work and the dependence on particular individuals.
Check the regulator's rules on the sale of practices, ownership, client consent and client money, and confirm what may lawfully be transferred.
Instruct an independent valuer with experience of professional practices, and ask the valuer to state the method, assumptions and sources of any multiple.
Consider the deal structure, including instalments, earn out, retention and transition arrangements, and obtain tax advice.
Where the valuation is for a partner exit, check the partnership agreement for any prescribed method before relying on market approaches, and apply the contract.

A firm that does these things before it needs to will find that the eventual valuation is quicker, less contested and closer to the figure the practitioner hoped for.

How practice management software supports valuation

Valuation depends on records that can be verified: fees by client and matter, recorded time, work in progress, collection history, and a reliable register of matters and conflicts. A practice management platform such as Legalytech keeps these records in a single system with a history that a valuer or purchaser can examine, and its contract repository and client portal help the firm to show that engagement letters, documents and communications are organised. Firms that maintain clean data throughout the life of the practice are better placed to demonstrate value when the occasion arises.

This article is provided for general information only and does not constitute legal advice. Practitioners should consult the rules of their own jurisdiction and regulator.