Private law practice ownership transfers have been on the rise in recent years. Not surprisingly, the issue of valuing a law firm has gained in importance.
In the US private law firm sales are endorsed by the American Bar Association under the Model Rule 1.17. A growing number of states now permit the sale of a privately owned law practice.
Recent sales of law practices offer you a defensible way to estimate the value of your law firm. Valuation multiples derived from comparable law firm sales are a common way to value a law practice. Price to gross revenues is the most typical multiple used to assess the practice value.
Law practice goodwill – a large part of practice value
More than many other professional service businesses, private law firms tend to develop considerable goodwill. This is very important since the overall practice value is affected by how transferable the goodwill is. As in all professional practices, goodwill is actually made up of two parts: the personal goodwill and the practice goodwill.
Law firm value is driven by goodwill transferability
The distinction is significant because it is generally much easier to transfer the practice goodwill to the new owners. Personal goodwill, as the name implies, is created by the individual professionals.
Client loyalty translates into repeat business for an established law practice. The question is: what happens when the current owner leaves the law firm?
Client retention and earnouts
Client retention is one indication of how well the practice retains its value over time. Private law practice sales often entail earnouts. Under an earnout arrangement, a portion of the law firm’s sale price is held back for a period of time. If the client retention goals are met, the amount held back is paid to the sellers.
Law firm value depends greatly on its size
Market-based valuation multiples vary to a large extent by law firm size. It is not unusual for a law practice grossing over $1,000,000 in annual receipts to command a price to gross revenue valuation multiple greater than 1.5 times.
For smaller firms grossing under $300,000 the valuation multiples rarely exceed 0.5 times the annual revenues. Again, one reason is that the larger law firms tend to do a better job of creating the practice goodwill. In contrast, most of the goodwill in a small law firm is personal in nature.