In the context of law firm succession, let’s consider: • Benefit stream – The purchase of an interest in a law firm should result in an expected benefit stream, which can be in the forms of higher com- pensation, higher bonuses, profit dis- tributions, and so forth. The purchas- ing partner needs to compare his or her expected financial relationship with the firm relative to his or her mar- ket compensation. The difference be- tween the expected financial relation- ship as a partner and market compen- sation can be construed as the “ben- efit stream.”
The firm needs to perform a similar analysis. The firm is comprised of the current partners and there should be an analysis that determines that the firm’s value is enhanced by adding the new partner. The enhanced value may come from reduced risk by retaining talented professionals and also an in- creased likelihood for the achieve- ment of buy-outs as partners retire. The expected benefit stream can be considered to be payments in any and all forms in excess of fair mar- ket compensation for the work per- formed by the partner. Market com- pensation for a lawyer is not necessar- ily a single amount, though. A range may be worth considering, as many surveys will have results based on average, median, quartiles, deciles, and perhaps other metrics. The over- simplified use of average or median amounts may or may not be appropri- ate.
Compensation relative to market is a critical factor in the analysis and re- quires the careful exercise of profes- sional judgment. Examples of factors to consider include subjective and ob- jective measures regarding: • Internal firm factors—business de- velopment, client relationships, ac- tive participation in marketing ac- tivities,
staff utilization, billable
hours, firm compensation struc- ture, and so forth
• External benchmarks—compensa- tion surveys and perhaps anecdot- al information on what other firms are doing
• Timing of receipt of the benefits – The value is dependent on the timing for receipt of the benefits. Given that the capital requirements of a law firm are rather low, the cash basis profit may generally be available for distribution.
• Risk of deviation – Future benefits are typically discounted by a factor to re- flect the risk of receiving a return rel- ative to alternative investments that may be available to a buyer of an own-
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ership interest. Rates of return for ma- ture closely-held companies can vary broadly, based on an assessment of perceived risk factors. Estimates in the range of 17% to 35% would not be un- usual. For professional service firms, the risks may be within the range or possibly above the higher end of the range. Risk is higher when the profits generated by the firm (i.e., after con- sidering market compensation) are di- rectly attributable to the personal re- lationships between the law firm part- ners and their respective clients. The valuation process is based on an analysis of the firm and needs to include consideration of the aforementioned fac- tors. Several valuation methods can be useful for determining the value of a firm based on its earnings or cash flow. Theoret- ically, they should all yield the same result. The aggregate value of the firm’s intan- gible assets (i.e., workforce in place, cus- tomer relationships, going concern value, and so forth) is estimated by the extent to which the value determined from earnings or cash flow exceeds the net tangible as- sets. To establish a policy for buy-ins and buy-outs, there would be additional con- siderations although we deemed them to be beyond the scope of this article. With- out being all inclusive, such factors that may warrant consideration include the standard of value, the premise of value, professional/personal goodwill, existence of either excess assets or a capital deficien- cy, applicability of discounts and/or premi- ums regarding rights and restrictions per- taining to the subject interest, state law, and so forth. Predictable profitability (after market compensation) across a broad cross-sec- tion of professional legal services (i.e., risk reduction) can significantly improve the transferable value of an ownership interest in a practice.
Conclusion
Valuing the shares of a law firm is not a math problem. In fact, the determinative factor will likely be whether the benefit to an associate moving into the partnership ranks will be perceived as justifying the purchase price. How much more will the as- sociate earn as an equity partner? Finding the right dollar amount is the challenge. Valuing ownership interests in a law firm is more an art than a science. ____________________ Arthur G. Greene, Esq., is a law firm con- sultant based in New Hampshire. Arthur G. Greene Consulting, LLC, provides consult- ing services to law firms, with focus on the needs of small and mid-sized firms. In re- cent years, his consulting practice has in- cluded profitability studies, revenue en- hancement, firm audits, strategic planning, governance, succession planning, com- pensation plans, alternative billing meth- ods, and other aspects of maintaining a healthy firm. He has lectured, conduct- ed workshops, and authored articles and books on a variety of law firm issues. The Lawyers Guide to Increasing Revenue: Un- locking the Profit Potential of Your Firm is now in its second edition. His most recent book, The Lawyer’s Guide to Governance, was released in 2009. Arthur has served as Chair of the ABA’s Law Practice Manage- ment Section and he is a Fellow of the Col- lege of Law Practice Management. Arthur can be reached at
agg@boyergreene.com. William E. Howell, ASA, CPA/ABV/CFF,
provides business valuation services to closely-held and family-owned business- es. Mr. Howell’s background includes ex- tensive business valuation experience in many industries, senior executive roles with two closely-held companies, and CPA ex- perience with a Big Four firm. More infor- mation is available at www.williamehowell-
llc.com and he can be reached at billhow-
ellcpa@comcast.net.
THE VERMONT BAR JOURNAL • FALL 2011
21
Succession Planning
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