You own a small law firm. For the first time, you want to make one of your associates a partial owner. But how do you determine the price of admission for the “buy-in?”
You have likely heard other small law firm owners discuss how they successfully asked associates to “buy-in” to become a partner. You may logically think, “The firms must have followed some method to determine value.” And you would be right. But, it is highly unlikely that they based their chosen numbers on any strict accounting valuation method.
Of course, you could hire a CPA. Your CPA could plug numbers into one, or a few, appraisal methods. Presto! You now know that your firm is worth “x” amount (or several amounts, as formula valuations can vary significantly). But should you base your asking price on that?
From my experience, I can tell you that those other small law firm owners probably didn’t hire a CPA and rely on their appraisal methods. If you dig a little deeper into how they determined appropriate “buy-in” prices, you will likely find that the answer is often, “Well, it seemed fair to everyone.” In short, there was no particular rhyme or reason to their numbers.
The question then becomes how do parties determine an amount that “seems fair?” That answer usually depends upon the strong influence of two factors.
The first factor asks the question of what the insider can realistically afford. Few lawyers have tens of thousands of dollars waiting for the day when they receive an offer to buy-in as a partner at their firm. Further, traditional financing is rarely available. Most banks won’t touch a law firm buy-in. Why? Banks see law firms as way too risky when compared to more conventional businesses.
What most insiders can afford is foregoing annual bonuses or salary increases during the buy-in term. Combining those amounts over the term of the buy-in is generally affordable and does not have a major impact on an insider’s cash flow. The reality is that most buy-in candidates will balk at any proposal that will have a significant impact on the lifestyle that they have become accustomed to while working as an associate.
The second factor considers at what price a candidate would instead choose to look elsewhere. If you make the price of partnership admission too high, your candidate will quickly run another assessment. They’ll ask quite simply, “Should I open my own shop?”
Insiders will compare the risk of leaving to the known cost of buying in. As a result, existing partners are forced to choose between two non-attractive alternatives.
The value of a small law firm to a prospective insider is more subjective than one would imagine. If you’re an owner, be prepared to accept less than you probably think your firm is worth. At least you can still save a few bucks by skipping the call to your CPA.