The key to increasing the valuation multiple for small legal practice goodwill
As a lawyer, you will probably be familiar with the usual approach to valuing a business.
The usual approach is based on the valuation of future maintainable profits. If you aren’t that familiar with that method, you can review that method by visiting a previous article below:
Link to Valuation of Law Firm Goodwill article.
Now I certainly think that this valuation method is relevant to professional service firms and indeed if you had a valuation of your practice done, there is a good chance that this method would be used by the valuer.
When you talk with business brokers who specialise in selling professional practices however, something unusual becomes clear.
In many cases, practices are valued, based on a cents in the dollar of practice revenue. In other words, if the practice has fees of say $1,000,000, the practice goodwill could be worth
$1,000,000 X Industry based Cents in the dollar = Practice Goodwill
Let’s call this cents in the dollar figure, the “Valuation Multiple”
To explain what I mean, here is a past article explaining the difference in valuation between legal practices, accounting practices and financial planning practices.
Link to Article : Increasing the Value of a Small Law Firm
You can see that there is a dramatic difference in valuation between these types of firms when valued this way, with legal practices generally being valued by far the lowest.
So if legal practices are typically valued much lower than the others, the obvious question becomes :
“Can I lift the valuation multiple of a legal practice to a higher cents in the dollar value?”
The answer I believe is absolutely YES, for certain types of practices.
The Benefit in Increasing the Valuation Multiple of Your Legal Practice
The obvious benefit in lifting the valuation multiple of your practice, is that you can increase your practice’s value, without actually increasing it’s fees.
For example, If you can double the value of your valuation multiple from 20c to 40c per $1 of gross fees, then your practice will be worth double it’s current value, without increasing it’s fees by even one dollar.
If you can do that and grow the fees, then you can dramatically lift the valuation
Why are there these valuation differences between professional practices?
If you read the article on valuation multiples, you will recall that the difference in valuation multiple comes down to the quality of the income that the practice generates.
Let me recap:
At the low end of the valuation range, some legal practices, have little recurring income from clients. A family law practice for example, may generally need to continually find new clients, as the existing clients will not necessarily generate sufficient new matters each year.
In the middle of the valuation multiple range, an accounting practice typically generates a certain percentage of it’s fees from recurring work such as audit or taxation work. Because this work is likely to be recurring next year ( if the client stays), for valuation purposes, it is considered high quality income.
At the high end of the valuation multiple range, is a financial planning practice. They generate a significant amount of their income from recurring review fees or commissions.
These fees are highly predictable and if the client stays, the future practice income can be readily predicted with a high degree of certainty.
As a result, the valuation multiple for financial planning practices is typically much higher again.
So if that is the way it currently is, can I increase my legal practice goodwill valuation multiple?
If you can increase the “quality” of your legal practice income, then there is no reason why you can’t improve your practice’s valuation multiple.
Typically when I talk about quality, in this sense, I am talking about generating recurring income and there are a number of strategies to do that for various types of legal work.
Quality can all mean different things. Typically in other professional practices, one aspect of quality will be the size of the average fee.
If your practice generates it’s fees from a smaller group of larger clients, this will be generally seen as higher quality.
Thus if your commercial law practice has a core of “Mum & Dad with few or no employees”, type small business clients , on this basis, you might expect that it would be worth less ( on a cents in the dollar basis) , than a small practice that is made up of high quality SME clients.
In other professional practices such as accounting practices though, this improvement in the quality of the client, may lift the valuation multiple from say $1 in the dollar to say $1.20 in the dollar.
While this is still a 20% increase, the real increase in the valuation multiple that lifted the accounting practice from 20c – 30c range to $1.00 per dollar of fees ( an approx. 400% increase), was the recurring income.
So, while improving client quality is important, the critical quality, that will build your valuation multiple, is generating recurring income for your practice.
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Retirement planning for the principals of small law firms
This report will focus on the strategies that you need to put in place to both increase your pre-retirement income and also to maximise your practice valuation.
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To find out more please visit this link: Retirement Planning for Principals of Small law Firms