Law practices are often valued in divorce proceedings. As such, lawyers frequently assume that it should be relatively easy to apply similar valuation principles when trying to sell a practice. Nothing can be further from the truth.
Business appraisals determine the economic value of a company for eventual use in a particular situation. They are often useful to lawyers in two specific situations: during their own divorce or when selling their own practice.
In the former, spouses seek an equitable property distribution of the law firm’s value. In the latter, a law firm owner hopes to cash out in a manner that rewards years of sweat equity.
In both settings, parties often look to some form of earnings value approach. This is based on the idea that a business's value lies in its ability to produce revenue in the future.
Such methods typically place past revenue, profits, or cash flow numbers into a formula to predict future performance. The reasoning behind this assumes that looking at past performance is as good a starting point as any. The only uncertainty when using these formulas is how to best address market risks.
In the divorce setting, market risks are minimal. There is relative certainty about the amount of business going forward. For example, consider a solo practitioner going through a divorce who has grossed $350,000 annually for the past four years. That lawyer has generated a certain amount of profits and cash flow. One can reasonably assume that those numbers will not change substantially in the near future.
The same cannot be said in a sales setting, however. Let’s use the same example from above.
Will a buyer of the same $350,000 practice generate similar numbers as the divorcing lawyer? I have no idea. This is because, for some practice areas, past performance may bear little relation to future performance. The transferability of an attorney’s book to a buyer is hard to predict. In large part, this is because many services that lawyers perform are one-time or, at best, sporadic. Also, certain client relationships may not be as easy to transfer as the seller and buyer hope. Finally, at times the goodwill of the selling lawyer is so personal that the buying lawyer may not be able to much revenue at all.
What does all of this mean for a lawyer seeking to value a practice in a buyer-seller scenario? Don’t rely on the literature, which includes articles or court decisions, that describe how to appraise a law practice when parties divorce. The divorce setting and the sales setting are simply too different.