CPAs, appraisers, and other business evaluators use various valuation methods to value law firms. To be quite frank, none should be relied upon as a valuation technique for legal practices.
In this post, I’ll break down the common valuation methods. I’ll briefly explain how each method works and how it falls short in measuring the value of a law firm.
The Asset-Based Approach
On the surface, the asset-based approach sounds simple: add up the value of a firm's tangible assets—like furniture and equipment—then subtract its liabilities. But here's the problem: for most law firms, these physical items are just a fraction of their true value.
Take, for example, a successful law firm with a highly respected reputation, loyal clients, and a team of experienced attorneys. According to the asset-based approach, you would only be valuing their office furniture and computers. But what about the firm’s goodwill—the relationships, reputation, and trust that bring clients back? This is the most valuable asset, yet this method provides no guidance on how to calculate it.
Relying on this method alone can lead to a dramatically undervalued assessment. In one article I found online about law firm valuation, one author wrote that "the asset-based approach is the most reliable and accurate law firm valuation method." Yikes!
The Cost Approach
The cost approach involves calculating what it would take to recreate an identical version of the law firm being evaluated. On paper, this might seem like a logical method—just tally up the cost of replicating the office, furniture, equipment, and technology systems, right? But in practice, this approach is riddled with problems.
For starters, how exactly do you put a price on recreating the firm’s intangible assets? Take, for example, a solo attorney who has built a firm from scratch over 20 years, investing countless hours of hard work, building deep client relationships, and establishing a solid reputation in the community. How do you put a price tag on that? You can’t just hire another attorney, lease a new office, and say, "Here’s the cost to duplicate this firm." The sweat equity, personal brand, and years of trust don’t fit into any neat formula.
And how exactly can you price a firm’s culture or the loyalty of long-term clients? Beats me, and I’m willing to bet it confounds you, too.
The Market Approach
The market approach sounds simple: if the law firm down the street sold for X and the one across town sold for Y, you should be able to figure out what your firm, Z, is worth. It’s like pricing a house based on what your neighbors sold for. Logical, right? So far, so good.
But here’s where it falls apart. First, most law firm transactions are confidential. Whether it's a sale to internal partners or an outside party, good luck getting access to the real numbers. Without reliable data, how can you base your valuation on similar sales?
Second, the idea of "comparable" law firms is almost laughable. Let’s say you find out the selling price of a $10M personal injury firm and a $5M immigration firm. Does that help you figure out the value of your estate planning practice? Absolutely not. These firms operate in entirely different markets, with different clients, fee structures, and revenue models.
The market approach is flawed because it depends on limited, confidential data, and it assumes that all law firms are comparable.
The Rule of Thumb
Many use the "rule of thumb" valuation method because of its ease. It is similar to the market approach. Under this method, a firm's value is estimated as a multiple of revenues, usually gross revenues. For example, using a multiple of 1.5 and an annual gross revenue of 1.0M, the rule of thumb yields a value of 1.5M. Change the multiple to 0.5, and the value drops to $500K.
In mature marketplaces for other professional services (e.g., dentists, CPAs), one can derive a somewhat accurate multiple by crunching numbers from data based on past sales of similar businesses. However, the market for law practices is underdeveloped. No meaningful database of transactions exists. Most law firm deals are confidential, so without comprehensive data, using a multiple is pure speculation.
Even with a database, one would be hard-pressed to find a reliable multiple because data would be incomparable. Practice areas are too different from one another. Using a multiple for various types of law firms assumes that all practice areas generate revenue similarly, which is not true.
Consider a family law practice, an immigration practice, and a personal injury practice. Using similar multiples for all three is nonsensical. While all three provide legal services, each firm attracts clients and makes money differently. The only thing in common is that the owner is a lawyer. Put another way, if you have a gas station, a hotel, and an advertising agency, each grossing 5.0M a year and is owned by a lawyer, would you value them similarly? Of course not, but that's what people try to do with multiples and law firm valuations.
The "Excess Earnings" Model
As noted by one commentator, "This is a calculation that reflects the amount by which the five-year average earnings of the practice, less the fair return on physical assets, exceeds the fair compensation figure of a comparable attorney, capitalized as a function of the risk of retaining the clientele versus the competitiveness of the practice. Essentially, this approach seeks to capitalize the future net income stream expected by the buyer.” You were able to follow that, right?
The Discounted Cash Flow Method
The Discounted Cash Flow method sounds complicated—and honestly, it is. This method involves estimating a firm’s future cash flow based on its historical performance, and then applying a growth rate to predict its value at the end of a certain time frame (called the "terminal value"). Those future cash flows and terminal value are then "discounted" to today’s value. The idea is to figure out what the future revenue stream is worth in today’s dollars.
Confused? You’re not alone.
This method assumes you can reliably predict future cash flow and growth rates for years to come—an especially tough task in a law firm, where income can vary widely depending on client retention and practice areas. Plus, determining the right discount rate involves a lot of guesswork, which can lead to very different valuations depending on who’s doing the math.
This is another gobbledygook method that’s better off ignored.
My Approach
After appraising law firms (and only law firms) for the last 15 years, I’ve developed my own approach to law firm valuation. And believe it or not, even lawyers can understand it!
To start, think about the following:
Imagine it is a Friday afternoon. After years of hard work, an owner is ready to ride off into the retirement sunset. When Monday morning comes, will clients still contact the office and work with the successor?
If the answer is "yes," consider two more questions:
- How much revenue would a successor generate during the first few years after a transition? Put another way, how much predictable future revenue can a successor capture?
- If the owner were still actively practicing and referred all that work, how much would the owner expect to receive in referral fees, calculated as a percentage of the revenue?
Of course, no one pays referral fees, but thinking about predictable future revenue in the context of referral fees is a concept that lawyers can wrap their heads around. Do the math (a percentage of predictable future revenue over a time frame), and we have a starting point to determine the approximate value of a law firm.
The initial step in determining a law firm's value is analyzing how past revenues have been generated. Then, after examining the revenue source, the next step is to predict whether clients from that source will work with a buyer.
My method is admittedly not the seemingly precise number-crunching exercise that many people expect to see in an appraisal. Indeed, I would be the first to admit that it is more art than science.
That said, this method provides a logical framework for considering the relevant information to arrive at a law firm's potential and realistic value—and you do not need a finance background to understand it. Indeed, the most frequent comment to my appraisals from clients is “This makes sense.”
Isn’t that the point? Getting an appraisal that’s easy to follow and lays out the relevant issues? At the end of the day, it’s not about getting the fanciest appraisal or the one that values your firm at the highest numbers. What’s important is that the method makes sense and openly admits all the assumptions and risks at play.
Get Your Law Firm Appraised Without Being Confused
My appraisals are designed to be easily understood—no bean-counter mumbo-jumbo here. The result? A logical, straightforward report on which you can confidently rely when negotiating the sale of your practice.
I’ve worked with over 200 lawyers across 30+ practice areas. If you want a comprehensive appraisal that isn’t confusing, give me a call at (612) 524-5837 or connect with me online.
“I liked Roy’s approach to the valuation of my immigration law firm, as it took into consideration more than just numbers. The report was put into layperson’s terms so that everyone involved in the transaction could easily read it and understand it. I gave Roy a short turnaround time near a holiday, and I really appreciated his prioritizing (my matter) to meet that timeframe.”
– Small law firm owner, Mid-South
