A Better Way to Value a Law Practice

“So, what’s my law practice worth, Roy?”

If only I had a dollar for every time someone has asked me this question…

No one really liked my old answer to that question: “Whatever someone is willing to pay you.”

So instead I turned to posing a hypothetical.

Will the Phone Keep Ringing?

When a client asks me what their practice is worth, I pose the following:

Imagine it is Friday afternoon. You’ve been running a successful law practice, but are now ready to ride off into the retirement sunset at the close of business that day. When Monday morning rolls around, will your existing clients or potential new clients call you and be willing to work with your replacement?

If your answer is “no,” your practice is probably worth little to nothing at all. It may be best to simply close your practice when you retire.

If your answer is “yes,” I will then ask two more questions:

How much revenue do you realistically think would continue with your successor from your former clients/files for the first few years after the transition? Put another way, how much predictable revenue is there?

If you were still actively practicing and had referred all of that work out to another attorney, how much would you want to be paid for that in the form of a referral fee?

Do the math (a percentage of predictable revenue over a time frame) and, voilà! There’s a number to start with to determine a reasonable value range for a law practice.

There Is No Precise Way to Value on a Law Firm

Before going into detail about my method, I want to first debunk the idea that a precise number—or even a narrow range—is possible. In my opinion, it is not.

Some CPAs and law firm consultants will frequently attempt to plug and play with the numbers in a law firm’s past financials. Then, presto! Your law firm is worth “X” amount.

This approach usually works for many businesses other than law firms. When these businesses are sold, it is reasonable to assume that a certain amount of revenue should continue with the new owner.

Even for certain professional service firms, a formulaic approach is defensible. For example, if a CPA firm is sold, a new owner can reasonably assume that a certain percentage of the CPA firm’s clients will use the new owner to prepare their tax returns. In such instances, future revenue is somewhat predictable.

Furthermore, a formulaic approach to valuation is logical for many businesses because the buy-sell marketplace for them is usually a mature one. People have been buying and selling like businesses for years. As a result, certain formulas have become more or less the “accepted business custom” when valuing them. In other words, the market itself has validated a formula’s use over the course of time.

Selling Law Practices Is a Relatively New Phenomena

In contrast, the marketplace for law practices is quite immature. It has only been about 25 years since most states began to repeal the ethical prohibition of selling law firms.

Further, the profession is just beginning to think seriously about selling practices due to the fact that baby boomer lawyers have only recently started to retire in significant numbers. The buying and selling of law practices remains a very new phenomenon. There has not been enough time for the profession to adopt any “accepted business custom” regarding valuation.

As an aside: Yes, I am well aware of the bean counters who regularly value legal practices when used as experts in divorces. I don’t have a problem with that for one simple reason. When a lawyer who is married on a Friday becomes newly divorced on Monday, it is reasonable to assume that when the phone rings on Monday, it will be business as usual. This is not the case when an entirely new lawyer is in the picture.

The Ginsburg Valuation Method

There is no better way to explain my method than to work through it with an example:

Assume your law firm has consistently grossed $500K annually for the past few years. You realistically believe that for the next 4 years, it should gross $400K, $300K, $200K and $100K, respectively, from your old clients/files. You should probably assume that the revenue attributable to you will likely decrease the longer you have been away from the practice.

In essence, you’re “referring out” $1 million worth of business. Now, what would be a fair referral fee in that type of scenario if you were still actively practicing? Or, phrased in a valuation context, what percentage of future fees do you think you are entitled to as the selling lawyer?

No, there is no magic percentage, if that’s what you are hoping to see. Here’s why.

Think about why personal injury lawyers have historically relied on the “third-of-a-third” referral fee. Based on my research, there is no rhyme or reason. If I had to make an educated guess, however, about 50 years ago some lawyer decided to do just that. Then another lawyer across town heard about it and thought, “That’s sounds OK to me. I think I’ll do that, too.”

Before you know it, the concept spread so much that if you asked someone, “why a third of a third?,” the answer you hear is the same one that lawyers have used to justify just about anything: “That’s the way we’ve always done it.” In short, there is no rationale to support the third-of-a-third formula, but we still do it.

With that said, I don’t think that 33% is necessarily the percentage one should use when calculating law practice values. I do, however, think it is the highest it should ever be. Don’t forget that the buying lawyer still has overhead to cover. If too much revenue goes to you, the retiring lawyer, there will be insufficient profit to generate interest from potential buyers.

Looking to the other end of the spectrum, I believe that the lowest acceptable percentage is in the five to ten percent range. Anything less than that is probably not worth the effort to make a deal.

So where does that leave us?

To me, 15% to 25% “sounds OK.” I’ll be the first to admit there is absolutely no science to support this range. Instead, I base it entirely on experience.

In many of deals that I have been involved in (as well as deals where I haven’t), the parties used a percentage within that range. So it apparently sounded “OK” to them, too. I, therefore, see little reason why it shouldn’t “sound OK” to potential sellers and buyers as a starting point to calculate a practice’s value.

Let’s apply this thinking to the example above. If you assume a 20% share of the $1 million future revenue, you get a $200K value.

Of course, this number is a very soft one. The percentage figure is subject to the parties’ negotiations. Further, the $1 million gross revenue is, at best, an educated guess of future revenue.

If the parties agree to 15% of predicted revenue of only $500K, the value quickly reduces to $75K. On the other hand, if the parties move forward with 25% and $1.5 million of revenue, all of a sudden the same practice is “worth” $375K.

Why My Method Is Better

Even with the admitted lack of precision, I prefer my methodology to any bean counter’s fancy formula for two reasons.

  1. As an initial matter, it is simple enough for both the buyer and seller to understand. Have you recently read explanations of the capitalized excess earnings or the discounted future earnings approaches as methods to value a practice?
  2. Second, both parties should be able to come to the table with a gut feeling that the valuation method used is reasonable. Few in our profession question the logic and fairness of referral fees. It’s an accepted professional custom when the referring lawyer still practices. Shouldn't the same fairness perception carry over when the “referring” lawyer or, more accurately, the transitioning lawyer, no longer practices? Why should the cost of obtaining a “referral” be viewed differently than securing future revenue from the selling lawyer’s clients?

Referral Fees vs. Compensation Origination Fees

I want to be clear that my method should not be interpreted in any way, shape or form that actual referrals are taking place. But thinking about future revenue from a retiring attorney’s book of business in the referral context is a concept that lawyers can get their heads around to determine what might be a fair value for a law practice.

An alternative and just as valid way to think about valuation is in the context of law firm compensation origination percentages. All lawyers know that, in varying degrees, law firms reward origination. Lawyers are used to this; they believe that they should be “rewarded” for simply bringing in business.

Accordingly, a retiring lawyer could be “rewarded” for the future work from former clients/files. But, here again, there is no magic percentage. Anecdotally, the range at many law firms is fifteen to thirty percent for origination. Why shouldn’t that be the range for a practice that is being sold?

Admittedly, the range is a very wide one. But if no consensus exists among law firms (or even lawyers at the same firm) about what a fair percentage should be to reward lawyers for origination, why would there be a consensus in the marketplace about what a practice is worth?

“Rule of Thumb” Valuation

There is even a way to turn my method into a “rule of thumb.” The “rule of thumb” method assigns a multiple to annual gross revenue to arrive at a value. Using my earlier example where the annual gross revenue was half a million dollars, a multiple of 1.0 yields a half a million dollar value; a 0.5 multiple; a quarter of a million dollar value.

If you use my method, you can back your way into a multiple by playing with two figures; the estimated predictable revenue over a period of time and the agreed upon percentage of that revenue that goes to the seller.

Thus, if the predictable revenue is one million dollars over four years and one assumes a 25% payout to the seller, the practice is then worth a quarter of a million dollars. Since the firm’s annual gross revenue was half a millions dollars, you get a multiple of 0.5 after the fact. Change the percentage to fifteen that produces a value of 150K, the multiple then becomes 0.3.

Ready. Aim. Fire.

If you want a “gut check” of what your law practice may be worth, make two assumptions. First, determine how much predictable revenue there will realistically be for your successor from your clients/files. Second, consider what would be a fair “piece of the action” percentage for you to receive for that future revenue. Both numbers are moving targets, but at least now you know where to aim.

I met Roy when I heard him speak about marketing when his seminar was sponsored by my state’s bar association. I was so impressed, I invited him to conduct the CLE for all of my firm’s lawyers. After that, I hired him to do marketing coac…" Read the rest
– Managing Partner, mid-sized Toledo, OH law firm

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