Creating Value Financial considerations are always in the


picture. How much value have you creat- ed? What is the value of the firm for the purposes of selling your ownership interest in the law firm? Valuing the law practice or the firm for purposes of selling an owner- ship interest to the next generation of law- yers is deferred and will be addressed in Part II below.


Exit Plans


When it comes to structuring the exit plan, Of Counsel arrangements or consult- ing agreements are excellent vehicles for providing the retiring partner with a re- duced role and appropriate compensation, based on a variety of factors, which may in- clude the value of the business being tran- sitioned. Lawyers structuring such an ar- rangement have great flexibility. Only lack of planning will stand in the way of devel- oping an innovative approach for succes- sion from one generation to the next and creating for oneself a beneficial wind-down to retirement.


Conclusion


Succession planning involves several specific considerations, which every firm should address:


1. Making sure the ages of the firm’s lawyers are balanced across more than one generation.


2. Making sure hiring decisions are based on the eventual future need for leaders and rainmakers.


3. Educating all lawyers in the business of law—that is, how the financial model works and what is necessary to attract clients and lead to financial success and stability.


4. Looking for opportunities to in- volve all lawyers in some aspect of management, in order to evaluate whether they have the skills to be- come future leaders of the firm.


5. Making sure the evaluation of the firm’s lawyers includes contribu- tion to the culture of the firm and its shared values, in order to reinforce the importance of those qualities in the future leaders of the firm.


6. Having a valuation process that can be employed to set a realistic value on the firm, for purposes of support- ing the transfer of ownership inter- ests in connection with the plan for succession.


7. Developing a client transition plan that involves the next generation of lawyers participating with the firm’s most important clients, while pro-


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But the critical point is that small firms and solos need to plan for the future. Make decisions about growing the firm and move beyond hiring for the short term. Instead, create a firm identity and an institution- al approach. Address succession planning and have an exit strategy that will allow clients to continue to be well represent- ed and, at the same time, will permit the founder or other senior lawyers to retire gracefully, achieving rewards for the value of the firm they have created.


Part II:


Valuing Ownership Shares of a First Generation Law Firm


The second part of this article addresses the factors involved in valuing a law firm for purposes of admitting new partners and retiring senior partners. Regardless of the entity structure (partnership, professional association, or professional limited liabili- ty company), law firms face issues of how to value interests in the firm for purposes of internal transfers (which we will assume to be partnership interests in this article). While general business valuation tech- niques are relevant, the personal service aspect of a law business presents compli- cating factors. Valuing ownership interests in a law firm is unique and far different than valuing interests in a manufacturing com- pany or a retail operation.


Background


Some firms do not require payment for acquiring an ownership interest and are referred to as “free in, free out.” In other words, new partners are not required to pay for the purchase of an ownership in- terest and retiring partners do not receive payment for selling their share of the eq- uity. In those cases, retiring partners re- ceive a return of capital and any other re- tirement-type benefits are usually limited to funded pension plans. However, most law firms require new partners to pay for shares and retiring part- ners receive value for selling their owner- ship interest in the firm. Many firms are mo- tivated by the desire to reward the founders and/or the current partners for the “sweat equity” involved in developing, growing, or maintaining a successful firm. In other cases, the firms simply want the new part- ners to feel invested in the firm and may set a modest price that is more symbolic than actually representing a valuation. In attempting to create a realistic valua- tion, it is important to start with an under- standing of what is being sold. Likely to be included are hard assets, work-in-process,


THE VERMONT BAR JOURNAL • FALL 2011


tecting the more senior lawyers on issues of compensation and status.


receivables, and goodwill (value of clients retained going forward), with a reduction for any debt. The value of the firm’s client base is both the most important aspect and the most difficult to evaluate. The client re- tention possibility will depend on the na- ture of the practice and the extent to which they consider themselves firm clients, as opposed to clients of individual lawyers. In a sense, what is being sold is a network of contacts that represent nothing more than an opportunity to retain or acquire clients. When we look at the legal profession,


we see three methods used for valuing law firms:


1. Arbitrary Valuation Process For lack of a better approach, many small firms simply set an arbitrary price when transferring an interest in the firm between partners. Sometimes the amount to be charged is set out in the partnership agreement and other times it is set on an ad hoc basis when transactions occur. Al- though common, such an approach is not recommended. It lacks credibility and does not position the firm well for the long term.


2. Formula Technique


Some firms develop a common sense formula to value the firm that focuses on fi- nancial data, without applying sophisticat- ed business valuation techniques. A stan- dard formula would include: • The value of the real estate (if any); • The fair market value (or book value) of any furnishings, equipment, or oth- er personal property;


• A percentage (perhaps 80%) of the re- ceivables less than a certain age (say 120 days), after eliminating clearly un- collectible receivables from the list;


• A percentage (perhaps 70%) of the work-in-process, after eliminating old work-in-process that is unlikely to be billed;


• Less any debt Formulas usually ignore good will, although that is not always the case.


The formula amount is then divided by the number of shares or points outstanding to get a value for each share or point, for purposes of valuing any transfer.


3. Business Valuation Techniques To apply a business valuation technique,


let’s start with the fundamental principles for valuing a company’s earnings or cash flow. In such a process, the value of an own- ership interest is considered to be a func- tion of the factors listed below. • The expected stream of benefits, typi- cally in the form of cash flow


• The timing of receipt of the benefits • The risk that actual benefits will devi- ate from the expected amounts and time frames


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Succession Planning


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