Want to listen to the full episode and all our other episodes?
Hearsay allows you to fulfill your legal CPD requirements every year.
Our yearly subscription is only $299/year.
With a yearly subscription, you can access all of our episodes AND every episode we release over the next year.
Episode 106
Buy Episode
Practice Management and Business Skills
The Valuation Game: How, Exactly, Should You Value a Law Firm?
Law as stated: 24 November 2023
What is this?
This episode was published and is accurate as at this date.
Join Groves & Partners Managing Director Andrew Whittingham, as he figures out the valuation game in the Curiosity Recording Room. Touching on the importance of financial literacy for lawyers, the meaning and application EBITDA, and personal goodwill.
Practice Management and Business Skills| What area(s) of law does this episode consider? | Valuing law firms. |
| Why is this topic relevant? | It’s practically a meme about lawyers that many of us chose to go to law school out of a fear of numbers – or, at the very least, a general desire to avoid them. But the reality of legal practice means that numbers aren’t ever really that far away. A civil litigator might deal with costs on a daily basis. A transactional lawyer might deal with pricing. A criminal lawyer might deal with years and discounts, and a law firm partner might – for various reasons – stress about the monetary value of the firm they run. Valuing legal practices is an essential topic for lawyers because it directly impacts the financial health and strategic decision-making of firms. Understanding how to determine the value of a legal practice is absolutely crucial for mergers, acquisitions, partner buy-ins, and even exit strategies – it’s a topic that cuts to the heart of legal business. |
| What are the main points? |
|
| What are the practical takeaways? |
|
| 00:00:00 | DT | Hello and welcome to Hearsay the Legal Podcast, a CPD podcast that allows Australian lawyers to earn their CPD points on the go and at a time that suits them. I’m your host David Turner. Hearsay the Legal Podcast is proudly supported by Lext Australia. Lext’s mission is to improve user experiences in the law and legal services and Hearsay the Legal Podcast is how we’re improving the experience of CPD. So there’s a bit of a meme in legal circles that a lot of us chose to go to law school because we fear numbers and maths or, at the very least, we have a general desire to avoid working with them day to day. But the reality of legal practice means that numbers aren’t ever that far away. And speaking as a commercial lawyer who has a corporate advisory practice, I can attest to the truth of that, a civil litigator might deal with costs on a daily basis, a transactional lawyer might deal with pricing, a criminal lawyer might deal in discounts to sentencing, and a law firm partner might, for various reasons, stress about the value of the firm that they run. Now valuing legal practices is an essential topic for lawyers because it directly impacts the financial health and strategic decision making of law firms. Understanding how to determine the value of a legal practice is crucial for acquisitions, partner buy-ins, even exit strategies. And it’s a topic that cuts to the heart of legal business. Joining us today in the Curiosity recording room is Andrew Whittingham, chartered accountant and expert in the transaction advisory space. He’s the Managing Director at Groves and Partners. And today we’re going to step through a case study in law firm valuation. Andrew brings a wealth of experience and insights into the numbers that are invaluable for both seasoned legal practitioners and those just starting out in their legal careers. Andrew, thank you so much for joining me today on Hearsay. |
| AW | Thanks, David. | |
| DT | Now before we get right into it, tell us a little bit about how you came to be involved in this line of work. Have you always been working in transaction advisory valuations? | |
| 00:02:02 | AW | No, I started my career in insolvency, worked in insolvency and restructuring for quite a while. When you’re doing informal restructuring work, you tend to deal a lot in the transaction space, whether it’s related to debt or selling businesses. You also have a look at a lot of valuation type stuff when you’re dealing with IP and realising assets and that sort of stuff. So I started my career there, found I really enjoyed doing transaction related work and slowly moved in that direction. |
| DT | Yeah, insolvency is a kind of valuations-heavy practice area, isn’t it? Because even in the formal work where you might be acting for a receiver, selling all the assets of the business, maybe as a going concern, maybe on a liquidation sort of basis, you need to be really conscious that you’re selling them for market value. | |
| AW | Of course, it’s important for pre-insolvency transactions and post-insolvency transactions. I actually give advice to insolvency practitioners on both. So yeah, it was a good base level and I think in doing that type of work. Plus doing mergers and acquisitions work, I collaborate with lawyers quite a lot and I always have collaborated with lawyers, whether it’s banking and finance, employment law, intellectual property lawyers. So I deal with lawyers on an almost daily basis. | |
| DT | Well, and also because you advise a bit in transactions involving legal practices. | |
| AW | Correct. | |
| DT | And what sort of transactions are those? We spoke about a couple of them at the top of the episode. | |
| AW | So there’s quite a few different types of transactions in this space. For the top end of the market, the big firms, usually it’s a lot of partner buy-ins. You also have some mergers that occur between large practices. You also have an element of larger businesses or larger firms acquiring smaller businesses or regional businesses to give them a bit more of a market presence. And then you also have a small amount of small practices who are doing either succession planning transactions with bringing junior people through into partnership roles or having small practices being acquired by someone external of the business as an alternative to starting their own practice from scratch. | |
| DT | And I said at the top of the episode that valuation is something that as a lawyer in private practice, you need to be thinking about whether you’re the owner of a law firm or whether you’re just starting out. Because, as you’ve identified, valuations aren’t just about two big law firms merging. They’re not just about acquisitions at the top end of town. They’re also about the value for which you buy into the practice that you hope to one day be a partner of. And that’s whether it’s a very, very large practice or a very, very small one. And it really helps to understand how that value has been arrived at, why you’re paying what you’re paying. | |
| 00:04:44 | AW | That’s exactly right. There’s commonly two ways in which law firms and professional practices work with partner buy-ins. And it’s related to the goodwill in the practice. Some practices are what you call no goodwill practices where you don’t pay anything to buy into. It’s less common these days, probably more common in accounting practices. But then there’s a lot of transactions which happen where you’re basically paying to own part of the goodwill in that practice. And that’s where valuation becomes really important. |
| DT | What are some of the common misconceptions that your clients, other lawyers you see in the market have about the way practices are valued? | |
| AW | I think one of the common misconceptions or the common issues related to valuing legal practices is certainly around personal goodwill and the separation of personal goodwill and the goodwill of the practice. Now, as a professional practitioner, whether you’re an accountant or a lawyer or a consultant, more often than not, but particularly the case in the legal profession, you generate work because of you as an individual, not because of the law firm branding that you’re attached to. And so it becomes quite difficult sometimes to separate the practice’s goodwill from the individual lawyer’s personal goodwill. But at the end of the day, it comes down to who has the relationship, why does the client choose to work with that firm or that lawyer? | |
| DT | Yeah, a lot of senior practitioners have pretty portable practices and you see they’re moving from firm to firm. Most of that practice is assumed to go with them. Now, let’s start with the basics. If you had a new client coming to you asking for a valuation of their law practice today, where would you start? What are the basics of valuing a law firm? | |
| AW | So, typically, we take a market approach when we’re looking at valuing a law firm. There’s a number of different factors that can affect a multiple. There’s two ways of looking at it. You can use an EBITDA multiple, which is generally how we would value most businesses in the market if there’s comparable transaction data to apply. But the difficulty becomes with law firms, there’s a personal goodwill element, but some of the cost bases are quite different. So, as a general rule, we’re looking at an EBITDA multiple probably between one to three times maintainable earnings or EBITDA. However, it’s not just that simple. Sometimes we have to revert to a revenue multiplier and that can range anywhere between 40 cents on the dollar of revenue to 100 cents on the dollar of revenue. And it’s simply because the cost bases can be vastly different. If you’ve got a law firm in the city with high rental costs and high staff costs, then your profitability in comparison to your revenue might be a little bit lower. Whereas, if you’re in a regional market that don’t have a high rent cost and you’ve got really efficient use of employees, then your profitability might be higher. | |
| DT | There’s a lot to unpack there. I’m going to come back to EBITDA and the multiples that we’re looking at in the market in a moment. But first, you mentioned that the cost base can have a bit of an impact on the way you’re valuing any particular practice. Tell me a bit more about that. The inner city practice with the higher fixed costs versus the regional practice or the practice these days may be operating remotely with very low fixed costs. How do those fixed costs, how does that degree of operating leverage affect the valuation of the practice? | |
| 00:08:13 | AW | Well, it simply comes down to when we apply a multiple, what are we applying the multiple to? Because if we’re applying a multiple to a smaller maintainable earnings, then it’s going to be generally a lower valuation. Whereas, if there’s more profit in the practice, then you can end up with a higher valuation. |
| DT | Well, that’s right. A lower degree of fixed costs might mean that that EBITDA that you’re applying a multiple to will be higher or lower. Let’s talk about EBITDA for a moment, and then we’ll come back to how you arrive at all-important multiple. EBITDA – Earnings Before Interest, Tax, Depreciation and Amortisation – pretty common method of measuring the performance of a business, not just in law or professional services, but across the market. TIP: We’ve mentioned valuation multiples a few times. A valuation multiple is just a ratio that reflects the valuation of a company in relation to a specific financial metric. For example, EBITDA, like we’ve been talking about, or revenue, as we’ll talk about a little bit later. Imagine that you wanted to compare companies of vastly different sizes in the same industry. Applying a valuation multiple permits the standardisation of some of these figures to allow that comparison to be usable. For example, if a company’s EBITDA is 100 million, well, it can still be compared to a company with an EBITDA of 1 million if their multiples are the same in the same industry. And it doesn’t just apply to, say, comparing law firms of different sizes. It can be used for comparing the performance of businesses in all sorts of industries. Why is EBITDA a better method of measuring performance than some of the ones we might see on our income statement like profit? | |
| AW | So, the reason we use EBITDA is because it is essentially an indicator of the cash earnings of the business and that those cash earnings can be applied to a new business owner by removing financing costs like interest, by removing tax implications, and by removing depreciation and amortisation. Now, when we’re looking at valuing a business, we’ll also go one step further and have a look at what we call normalised EBITDA, and that means stripping out personal expenses. They may have a personal motor vehicle that’s sitting in the company that’s used for the company, so then we strip out those costs as well. The whole idea of using EBITDA or normalised EBITDA is to have a look at what the business looks like if it was in the hands of another owner and what the maintainable earnings of that business would look like. | |
| DT | Yeah, it’s sort of a representation of the performance of the business agnostic to the decisions you’ve made about how to finance it. So, the big one there is obviously if you’ve borrowed money from the bank to finance your startup costs, you’ll have some interest expense there on the income statement, but another owner might pay for it in cash and it might be generating a lot more profit when you get rid of that debt. Equally, you might choose to purchase all of your plant and equipment in cash, you depreciate it over time, that gives you a nice tax shield, increases your profit, or you might choose to lease all of that equipment, own none of it, you pay a bit of interest but you don’t get the depreciation tax shield, get rid of all of those factors when we use EBITDA. | |
| AW | Yeah, exactly. | |
| DT | I often think when I’m talking to clients about EBITDA and why it’s a good measuring tool, I think of the case of American Apparel, it was a US company but applies equally here. At its height, it boasted some really great performance on an EBITDA basis, you know, really high EBITDA. The problem was that at the time, the company was funded by debt with a very high interest rate and so the shareholders are actually receiving very little in the way of profit. That made the business desirable to third-party purchases but less desirable to shareholders. | |
| AW | That’s exactly right and what EBITDA is showing in that example is the underlying business profitability regardless of how they’re funding the business. | |
| DT | Yeah, absolutely. Now, we apply multiple to EBITDA to arrive at valuation or a kind of initial valuation. I suppose that you might then adjust for various reasons but one to three times is relatively low, isn’t it? You often hear of small businesses being valued anywhere from three to five times EBITDA, you hear of large, mature subscription-based businesses with a high degree of confidence in their maintainable earnings being valued at up to 10 times, 12 times EBITDA. So why is the multiple low in professional services? | |
| 00:12:27 | AW | The main reason is because there’s a lack of recurring revenue. So for law firms, it’s actually quite similar to my business in a way where we get referred work, we do the work and the client is hopefully happy and then they move on with their lives. We don’t have clients for a long period of time similar to a law practice. So lawyers may have recurring clients but they may not have recurring revenue from those clients that they can bank on year in year out. So there’s an element of they need to constantly be going out and winning more work to consistently perform on a revenue basis. TIP: So Andrew just made a really great point. A client of a firm might be a repeat customer, but you can’t really rely on that future revenue if you don’t know why the client’s coming back and for what. One day it could be a dispute, the next it could be a small business or real estate transaction. You don’t really know the monetary value of that possible future work, or if it’ll… occur at all. But you can attempt to measure the law firm’s goodwill, the likelihood of repeat clients and new clients. Now there are issues here and Andrew is going to touch on some of them later in the episode, but imagine that one partner in a three partner firm brings in the vast majority of the work and really has the relationship with all of the clients and that partner decides to leave, leaving the other two and the firm substantially worse off. Of course, really strong relationships with clients can also be an issue with client concentration. If you have too few very large clients that make up the total revenue pool of the business, then losing one of those clients can be disastrous. It’s a huge risk for the value of the business. |
| DT | I guess it comes back to that personal goodwill, doesn’t it? The firm in my hands might not produce any work that I’m not independently winning myself. And so what you’re paying for there is really what you believe comes with the goodwill of the business. | |
| AW | Exactly. | |
| DT | It seems then that if the multiple could be as low as one or as high as three, there’s a great deal of variation in the method that you’re using to value a law practice. So what sets apart the one times EBITDA practices from the three times EBITDA practices? | |
| AW | There’s a number of things that affect what multiple we land on and just to be clear, we don’t adjust. Once we’ve understood the maintainable earnings of the business, we apply a multiple to it and that’s essentially the valuation of the business. | |
| DT | You’re pulling the levers and you’re making the adjustments in how you arrive at the multiple and how you arrive at the EBITDA. | |
| AW | Correct. And so where there is quite a large degree of subjectivity in what we do, it’s around the multiple. There’s a number of things that can affect multiple personal goodwill we’ve already spoken about. The overall financial health and trajectory of the practice. Is it growing or is it contracting? What does the cost base look like? What’s the gross margin look like? What’s the profitability in the practice? Service lines matter as well. What are they practicing? How complementary are the service lines together? So insolvency and restructuring as an example. If you’ve got a service line that deals with insolvency and restructuring but then you also have a service line that deals with banking and finance and you have a service line that deals with debt collection and you have a service line that deals with litigation. All those are very complementary services which will increase the multiple. And then a few other areas would be the location of the practice. Is it metropolitan? Is it regional? There are other little permutations there where if it’s a regional practice, simple things like does it have parking for customers and all that sort of stuff. Retention of key staff is pretty important as well. Practices which have a high turnover in staff generally will transact for lower multiples. And then I guess these days there’s a lot of technology coming out in the legal space and I think adoption of technology and synergies and efficiencies that you can get in managing your practice will also affect the multiple. | |
| DT | Yeah. I mean I suppose EBITDA is still a measure of your revenue less your expenses. The efficiency of your practice still matters. | |
| AW | Correct. | |
| DT | And what sort of margins do you tend to see on expenses? What’s common? | |
| 00:16:51 | AW | So the old rule of thumb for professional practices is the third, a third, third model. You’ve probably heard of this before. Out of the revenue that you generate, a third goes to staff costs, a third goes to operational costs such as rent, insurance, all that sort of stuff and a third is profit. TIP: So back when I started practicing, I was told about the third, a third, a third rule, or the rule of thirds, in how, for the expected margin of a law firm, and you still see it used today. It’s a simple heuristic for working out where. The charge out rate of a particular staff member should be going to, and what, as an owner of a law firm, you should be expecting at the end of the year. Suppose you have a lawyer whose charge out rate is $300 per hour. The third, a third, a third rule suggests that of that $300, $100 should go to that staff member for their remuneration, 100 should go to the firm’s overheads like rent and 100 should go to the owners of the firm as profit. Now this is a basic model but it’s very useful because it gives you a heuristic for all sorts of different things. You can sense-check the remuneration of your staff based on their charge out rate. For example, if their salary isn’t equal to a third of their expected annual billings, then maybe you’re charging them too much or too little. Similarly, it’s a good rule of thumb for your fixed costs. If they’re more or less than a third of your expected revenue, maybe you’re paying too much or however, it’s a model that can’t really take into account extraordinary circumstances, especially ones arising in the external environment. Like inflation, rapidly rising employee wages, or a commercial real estate crisis caused by a global pandemic. But it’s changing a little bit I think especially in the legal industry the staff costs have gone up significantly. Plus there’s another market trend that’s happening at the moment where everyone’s moving to more work from home or hybrid working arrangements which means that the rent costs have been going down because firms just don’t need the type of space that they used to require. So at the end of the day it really depends on how the practice is being run. |
| DT | It sounds like there’s a bit of a threat to valuation there I guess in the sense of rising labour costs but, silver-lining, there’s maybe an opportunity to improve the margin there if you can adapt and reduce some of your fixed costs. | |
| AW | Yeah, that’s right. I think there’s only so much you can control from an operational cost perspective in a professional practice. Your staff costs are generally going to be something that’s going to be more significant than not. Your rent costs you can control somewhat but you still need an office. You’re still always going to have clients of a certain generation that want to come to your office and meet in person and all of that but it’s the other costs that you can really reduce if you can to help you make more profit and regardless of whether you’re exiting a practice or not a more profitable practice is going to put more money in the pockets of the owners. | |
| DT | Absolutely. Maybe we could talk through some of the factors that we’ve just described in the form of a case study. Could you share a valuation of a practice that you’ve done recently that maybe brings to life some of these issues around EBITDA and multiples and the things that affect them? | |
| AW | Yeah. So I was recently assisting a client to acquire a legal practice. One of the issues that we ran into was that it was a one principal practice. The principal had left the practice 15 months prior to the transaction. | |
| DT | Oh yeah. I can already see where this is going. | |
| 00:20:08 | AW | For a number of reasons which I can’t talk about but the principal had left. She was, at the time that she left, the only registered solicitor in the practice. So the practice had to do a consulting arrangement with someone external to sign off on the legal advice that was going out the door and what happened in the end was basically the valuation was around I think the 50 or 60 cents in the dollar revenue. If we convert it to an EBITDA multiple I think the multiple was around one times multiple simply because there was an issue with personal goodwill. Now there was multiple other issues with that transaction including valuation of WIP. WIP is something that most professional practices and most law firms don’t record on their balance sheet but it is an asset which needs to be accounted for when we’re doing working capital allocations and working capital adjustments. Just to give you an example, WIP for a personal injury firm may be only 70% recoverable whereas if you’re talking about an intellectual property lawyer who’s working for a big multinational it’s probably more likely it’s going to be 100% recoverable. |
| DT | Because in the former case your WIP is going to be paid out of costs orders, you don’t really expect to recover much from your own client and in fact you might have an arrangement with them that you’re only being paid out of cost orders whereas the latter client that’s a transactional work for a very credit-worthy client. | |
| AW | That’s exactly right. So in this case we had to really do a lot of due diligence on the WIP to make sure that could be converted into debtors and then converted into cash post-completion. The other little permutation there was and I’ve had many arguments with counterparties over solicitors trust accounts but it was in relation to the funds that were in the solicitors trust accounts. My general view is they’re not assets of the company because it’s not their money. That’s why it’s a trust. | |
| DT | That makes sense to me. | |
| AW | But the argument comes where say for instance you’ve got $50,000 sitting in trust for one client and you’ve got $50,000 worth of WIP sitting there for the same client, if you’re counting the WIP you shouldn’t count the trust account money. It’s really just a guarantee for payment of the WIP. So trying to avoid double counting on trust account monies and WIP and debtors to the extent possible is very important as well. | |
| DT | Yeah, there’s a lot of traps there in terms of double counting isn’t there? Because I see WIP as such a bug bear for… well, not just valuing practices, but even just looking at their performance. Because, yes, sometimes people don’t regard WIP as an asset but often they regard it as kind of the same as earnings; “well it’s recorded, it’s on the clock, we’re going to get it even if we haven’t yet billed it and even if we maybe aren’t certain that the client’s going to pay the bill when it’s issued.” | |
| AW | And to a certain extent debtors as well. So if you’ve got debtors sitting there that are over 90 days due generally those are much less collectible than more current debtors. | |
| DT | Yeah but also if you’re looking at the performance of the firm the earnings that you’re looking at to calculate your EBITDA, well, that was once debtors and that was once WIP. So I suppose as you said what you really need to be looking at is the cash flow cycle. How long does it take for recorded time to turn into earnings? | |
| AW | Correct. | |
| DT | And are you then including WIP as a kind of extra asset where I guess in that normalisation process there’s a greater amount of WIP there than you’d ordinarily see in the cash flow cycle? I mean when do you regard it as an asset in that valuation as opposed to just? Well those are future earnings that are no different to the past earnings that we’re using to value the business already? | |
| 00:25:01 | AW | Well it depends what basis the valuation has been done on. So as an example if we’re just doing a valuation of a business, more specifically a valuation of a law firm, we might be doing it for a number of reasons. It might be for tax purposes, it might be restructuring or it might in some instances be for a family law proceeding. So in those circumstances we’re actually valuing the equity in the company or the partnership or the trust which owns the business. So we actually have to develop a value for the business and then we have to develop a value for the balance sheet which sits behind the business. So when you’re doing that you need to consider things like WIP; whether it’s recorded, whether it’s included in the value of the business or not, but then also look at other things that might not be recorded on the balance sheet like employee liabilities. |
| DT | Well, as we said, staff costs are some of the largest contributors to our expenses on our income statement. I imagine they’re a pretty large liability on the balance sheet. | |
| AW | Yep it can be and simple things like long service leave often aren’t accounted for on a balance sheet. | |
| DT | Yeah, of course. I suppose that’s often forgotten. | |
| AW | Sometimes staff bonuses there’s no provision recorded on the balance sheet even though the bonus might have been earned but not payable for six months there’s been no provision on the balance sheet. And then in terms of acquiring a business or selling a business if you’re selling something on a working capital inclusive basis that’s when these calculations can make a big difference. It can increase the purchase price, it can reduce the purchase price, and it’s really important to get an understanding of what a normal level of working capital is in the business. | |
| DT | It would increase the purchase price where there’s more cash than is needed for ordinary working capital in the business and you’re leaving it behind. It would reduce the purchase price where you’ve identified that there’s not enough working capital to keep the business running. | |
| AW | Yep, so working capital surpluses will generally increase the purchase price, working capital deficits will generally reduce the purchase price but there’s always a push pull between buyers and sellers when it comes to how we’re defining working capital, how we’re calculating it. There’s been many a transaction fall over and disagreement on working capital. | |
| DT | Well I guess in professional services that number can vary so widely because you can have WIP on the clock for so long, you can have debtors outstanding for so long. It’s not like an inventory-based business where you have 30-day payment terms and you’re expecting them to be mostly paid on time. | |
| AW | Yeah, exactly. And then it becomes a lot more complicated when you’re looking at a legal firm that does a lot of spec work. | |
| DT | Yeah, I bet. | |
| AW | Because I mean the lawyers working on these jobs will tell you “yeah, we’re definitely going to get a settlement or we’re definitely going to get a result from this one” but you just don’t know. | |
| DT | It’s a feeling. Yeah. Your example before of that firm with four nicely complementary product lines, some of which involve working for repeat clients that are very credit worthy, the opposite of that is the spec personal injury practice which probably sees a client once in their lives. If that client’s lucky they never need another personal injury lawyer and they’re doing all of that work up front on the expectation of success and the expectation of the credit worthiness of the other party. | |
| AW | Correct. | |
| DT | So I suppose you see our one times and our three times examples are probably those two ends of the spectrum. | |
| 00:28:25 | AW | Yeah, exactly. And that’s why there’s multiple factors that come into where the multiple will sit as opposed to just looking at profitability because if you just look at the financial health of a business you’re missing some of the risks, the non-financial risks that sit behind the business whether they’re employee risks, personal goodwill risks, maybe they don’t have insurance in place. There’s a number of risks that can sit behind the financials. |
| DT | Let’s talk about some of those non-financial risks. I’d like to learn a bit more about that. How do you go about identifying those and how do you take a non-financial risk and turn it into something financially measurable? | |
| AW | So personal goodwill is a good example and I just want to be clear on personal goodwill as well. It’s not about who’s doing the work in the law firm, it’s who holds a relationship with the client. Because that’s the reason that the work is being generated by the practice. So in looking at that, what we’ll generally look at is whether the firm has any reporting on which partners are generating what and from what clients, whether there’s a concentration risk there. So one partner might have two clients which generate them three million dollars worth of work. That’s a bit of a risk if one of those clients decides to walk away and his practice is halved overnight. So we look at that, we look at other risks like employee retention, whether they’ve got succession plans in place within the practice. There are a lot more transactions happening in the legal space. However, sometimes for a practitioner or an owner of a legal practice, the best financial outcome for them to exit the practice is a succession plan and bring people through the practice into an equity position transferring knowledge skills and relationships to those people to take the practice forward. That can more often than not lead to a better financial outcome. So they’re some of the things that we look at. We look at what the services are that are offered and then the other thing that we have a look at is technology and IP. What sort of intellectual property have they got that may be generating revenue but maybe making the practice more efficient and more competitive in the market? | |
| DT | Yeah. I was going to ask about that because we are seeing in the market increasingly so-called new law practices that work less on a relationship-based model. That might even offer a kind of subscription-based service. The client really has the relationship with the practice whether that’s legalvision or Law Squared or Sprint Law or something like that and there isn’t that traditional model of the rainmaker partner who secures that work with a close personal relationship. How are those sorts of practices valued? Are they likely to have higher or lower multiples? | |
| 00:31:12 | AW | Probably higher. Simply because you’ve removed that personal goodwill risk and particularly in the case of a firm that’s on a subscription model you’ve got recurring revenue and I don’t have an analogy of being on a subscription model. Some people don’t use it that much. They like knowing that they’ve got a law firm that they’re subscribed to that they can call on if they need to. There’s a reason why a lot of gyms make money. It’s because people pay subscriptions and don’t tend to use it as much as they do. So we can easily track what recurring revenue comes through those practices and we probably place a little bit more importance on that recurring revenue. Just as an example in the accounting field, so my business we do valuations and transactions advice. We’re always having to go out and find new clients whereas a tax accountant has the same clients year in year out. Their practices have a lot more recurring revenue. So therefore they’re probably more valuable than my practice. |
| DT | Yeah because there’s a high degree of confidence that the person who came in for their return last year is going to come in this year. Can you give me an example of the sorts of technology or IP that you’re seeing in practices that can positively influence the valuation? | |
| AW | So there’s been an uptake on AI, definitely. There’s also been practices developing their own software whether it’s an employment law firm developing balloting software, whether it’s a commercial law firm spending money on their own internal software to draft contracts and agreements and all that sort of stuff. I think more to that point around technology. Generally in a post-Covid world where everyone’s used to doing things online we’ve seen a lot more smaller law practices actually outsource some of the legal work overseas. | |
| DT | Yeah. Legal process outsourcing. | |
| AW | Correct. | |
| DT | Yeah. It was very popular ten years ago. I remember a lot of discussion about legal process outsourcing at the top end of the market. | |
| AW | Yep. | |
| DT | But it sounds like it’s actually being picked up in the mid-market. | |
| AW | That’s exactly right, yeah. And it’s the same with accounting firms. I mean the big firms – the Deloittes, KPMGs. They went and did deals with other firms around the world to set up outsourcing facilities around the world but they haven’t got the benefit, probably, that they thought they would get out of doing that. I think for smaller firms if they can spend a bit of time on their own IP and processes there’s no reason why they can’t have someone in the Philippines helping prepare a simple sale contract or a simple supplier agreement. | |
| DT | You mentioned before that in some transactions rather than using an EBITDA multiple you use a multiple of revenue. When do you decide to use a multiple of revenue as opposed to a multiple of EBITDA? | |
| 00:34:19 | AW | Usually the multiple of revenue is to sense check the EBITDA multiple. So you can start with the revenue multiple and work your way down to an EBITDA multiple or you could use the EBITDA multiple and work your way up to a revenue multiple. But we would only use an EBITDA multiple when giving valuation advice but we use the revenue multiple to sense check it. So if we find that we value a legal practice at say two million dollars but it’s only doing one point five million dollars of revenue well that tells me that we’ve probably slightly overvalued it a little bit because it’s out of that 40 cents in the dollar to 100 cents in the dollar revenue rule of thumb. |
| DT | Yeah that makes sense. I think in a lot of valuation contexts you want to have those two methods to kind of sense check. I guess in the public sphere you do price to earnings and you sense check that with EBITDA. Sometimes for acquisitions that are big and speculative you might even do discounted cash flow analysis and then use the EBITDA multiple again as a kind of sense check of how much you’ve expected that cash flow to increase in this kind of cash flow analysis. So you’re really using revenue and EBITDA to sense check the end result. | |
| AW | Exactly and depending on what industry you’re looking at valuing it. They’ve all got wildly different multiples number one but they’ve got different methods that are generally accepted in those markets like a tech startup will only transact on a revenue multiple. | |
| DT | Yeah, right. And why is that? | |
| AW | Because they don’t make money. They’re not profitable. So they spend a lot of money on development. They spend a lot of money on funding growth and market share and how can you apply an EBITDA multiple to zero? | |
| DT | If you’re an unprofitable business. And then I suppose they would say well those are outstanding expenses. There might be capital expenditure, it might be a blitz for growth, and then we reach a critical mass of scale and then we’re tremendously profitable. I suppose you need to use that revenue multiple with these venture funded businesses that don’t really have any profit yet. | |
| AW | Yep, that’s exactly right. | |
| DT | Okay so we had a listener right now who’s thinking of bringing some new partners into their practice or maybe even looking to sell their practice as part of a succession plan. What are some of the things they could be doing now to improve the value of their practice? | |
| 00:36:24 | AW | Something that we touched on earlier which goes right to the heart of personal goodwill is having a succession plan in place in the practice. I mean as we get older in our professional careers we need to be constantly looking to hand down responsibilities to people that are coming through the practice. I think having an understanding of where your practice is today and where you want it to be by the time you exit is also very important and along with that having proper reporting to go with it. So I’m not just talking about income statements and balance sheets because at the end of the day that’s just a review of the financial health of the business. I’m talking about having KPIs for what industries you want to be working in, KPIs for how many new clients you want to get over on a monthly basis or a quarterly basis, having KPIs for how many partners you want to bring into the practice and so that all falls into the reporting. I think understanding where you sit in the market and your service offerings is important as well. If you want to bring another partner into your practice or you want to exit your practice maybe it’s a good idea to have another service offering as well before you do that or bring the partner in to give you that other service offering. Retention of clients as well, making sure your clients are happy, making sure that they’ll continue to do work with you is also very important and I think we touched on it earlier as well but staff retention it’s very important. So legal practices are businesses but they’re very different to other service-based businesses in a way where yes we’re selling advice right but essentially what we’re also selling is our people’s time and we need to make sure that staff are happy, that they’re remunerated well and that they have a good experience at work because if that’s not the case clients can see it because they’re dealing with stuff on a regular basis. So I think staff retention is quite important and then also just embracing these new technologies that are out there in the legal space, automation, simple things, improving templates and processes which mean that your staff can spend less time fixing a document and more time actually giving tangible advice to clients. |
| DT | And when you say passing down tasks to your staff as part of a succession plan we’re not talking about doing the legal work there. We’re talking about passing on the relationships. | |
| 00:39:44 | AW | Yeah there’s part of that. Succession planning covers a whole range of different things and I think there’s a couple of pieces to that. So passing down relationships and skills is very important because it will reduce the amount of reliance on you as a partner in the firm. The other part to it, is when you get to a point where you’re running a law firm or you’ve got your own law firm you want to constantly be putting yourself out of a job. You want to outsource admin functions or have people within your practice that can do things that take away the reliance on you number one but free you up to actually work on the business as opposed to in the business. And by that I mean manage your business like a business owner instead of being focused on doing client work, have the right people in your practice to do the client work so that you can work on the business and continue to grow the business. And it might be as simple as making sure that you’re still maintaining a few client relationships but slowly transitioning them across over time but the more time you spend working on the business the better placed you’ll be to get a better financial outcome on exit. |
| DT | And those really go hand in hand with improving employer retention doesn’t it? If your employees feel that they have a greater sense of responsibility that they have some upward mobility that there is a succession plan in place that involves them and they’re more likely to stick around. TIP: Now we’ve talked about succession planning a little bit this episode and we’ve actually spoken about succession planning on the show before with Craig West, CEO and founder of Succession Plus and he emphasised that succession planning needs to be a part of the conversations you’re having in your business as often as possible. It has to be a standing item for discussion with the firm and its staff in general meetings, for example. If you want to hear more about succession planning and some actionable advice from Dr. Craig West, check out episode 72 of the show. I think plenty of our listeners will be familiar with that feeling of working in a practice where the principles are the principles and there’s not really any plan to bring anyone else in. You know that you can only stay there for so long. | |
| AW | Yeah. Unfortunately in the legal profession there’s a lot of practices where the partners are hanging on for dear life and they do not want to let it go. And young good lawyers are in those practices looking at the situation and looking at their own career trajectory and going well “he’s not going to give me what I need, so I’ll just go over here to the other firm that I’ve been talking to and I might not have more money right now but at least I’ve got a better career path where I can get through into a partnership.” | |
| DT | Yeah absolutely. I think we’ve given our listeners a lot to think about in terms of valuation. Maybe we can contextualise it a bit. How are our listeners who might be thinking of maybe they’re a regional practice looking to acquire a competitor. Maybe they’re a large mid-market practice looking to bring in some new equity partners. Maybe they’re a retiring practitioner who’s looking to pass on their practice. Any of those listeners in those situations? How can understanding what we’ve talked about today help them to make better decisions about those transactions? | |
| 00:41:55 | AW | So look there’s a couple of areas I think. First and foremost understanding valuations of law practices better will allow you to have some more informed decision making around growing your own practice whether that’s by acquisition of another practice or bringing in other partners. It’ll also allow you to mitigate some of the potential risks with transacting in the legal space whether it be personal goodwill, employee retention, and customer retention and I guess in addition to that customer concentration. So you don’t want to be acquiring a business that’s 50% of their fees is made up by one client. That’s a highly risky business to be acquiring and it can also allow you to understand the strategic fit that you may have with different service offerings, different partners and different firms. |
| DT | Yeah. I said this at the top of the episode and I really believe it. I think thinking about the value of your practice as a measure of whether you’re on the right track with the decisions you’re making about how you grow your practice is a really useful heuristic. You don’t need to be thinking about whether you’re selling it or whether you’re acquiring another practice. It’s just useful to think about; “well, is this improving the value of the practice? The decisions that I’m making if I choose to take on a client who has so much work, that I’m not going to be able to do the work for any other clients. Well that’s a concentration risk. Maybe that’s not a good idea if I’m thinking of taking on a new service line. But I know that those clients are probably not going to come back again or there’s not a lot of synergy with what I already do so it’s going to be hard to find those new clients. Well maybe that’s not a great idea. Would that contribute to the valuation? Maybe not so much”. | |
| AW | Yeah, definitely. I mean the spread of customers across industries. The spread of customers or clients across the total revenue in your practice definitely comes into the valuation I think, more than anything though having a profitable business and a business that you can keep a handle on as a legal practitioner is very important. I would say that money is very important but if you’re working 15 hours a day to earn half a million or a million bucks a year, the question you would ask the legal practitioners: “would you be happy with maybe 10 percent less to be working eight or ten hours a day?”. | |
| DT | Yeah absolutely, yeah. There’s more important things than money I suppose. | |
| AW | Exactly, yeah. Exactly. | |
| DT | Well, we’re nearly out of time but before we leave our listeners, if there was one thing that you wanted to leave them with from this conversation today, what would it be? | |
| 00:44:35 | AW | I would say it’s very important for legal practitioners to embrace financial literacy especially when it comes to how their own business works, what the metrics are that they can measure their own business by and what the business is valued at. |
| DT | Yeah, couldn’t agree more. We can’t succumb to that meme that I said on the episode of being afraid of numbers. We work with numbers in just about any practice area and we’ve got to be very familiar with the numbers of our own practice. My takeaway for today would be what you said about risk and identifying and quantifying risks in our practice. We talked a lot about EBITDA and multiples but valuation isn’t just about the financials. It is also about your employees. It’s about your personal goodwill risks. It’s about all sorts of non-financial factors that can impact on the financial outcome that you ultimately see when you sell your practice or exit your practice and it’s important to think about those things as well. Andrew, thank you so much for joining me today on Hearsay. | |
| AW | No problems, thanks for having me. | |
| 00:45:18 | DT | As always, you’ve been listening to Hearsay the Legal Podcast. I’d like to thank today’s guest, Andrew, for being a part of it. As you well know, if you’re an Australian legal practitioner, you can claim one Continuing Professional Development point for listening to this episode. Whether an activity entitles you to claim a CPD unit is self-assessed, but we suggest this episode entitles you to claim a practice management and business skills unit. More information on claiming and tracking your points on Hearsay can be found on our website. Hearsay the Legal Podcast is, as always, brought to you by Lext Australia, a legal innovation company that makes the law easier to access and easier to practice, and that includes your CPD. Hearsay is recorded in Sydney, on the lands of the Gadigal People of the Eora nation and we would like to pay our respects to elders past and present. Thanks for listening and see you all on the next episode of Hearsay! |
You must be a subscriber to access this content.