Determining The Value Of A Lawyer's Practice
by Joel A. Rose
The value of a lawyer's interest in the practice is normally a matter of concern to himself/herself, their family, their partners and associates. It is particularly a matter of expectation in the thoughts of an associate who has a career interest in the office with which he/she is employed.
Insurance Agency and Law Office Comparisons
Robert M. Morrison and David A Bakst, in their book titled "Insurance Agency Purchases and Mergers" stress the great differences between individual practices. In special considerations in establishing price, they note seven factors which make up the value of a practice for an insurance agency.
One consideration is expirations (which could be related to the possibility of business which may expire if a law practice were purchased). For example, they note that one buyer of Swedish ancestry was able to retain 100 percent of the business that cam from members of a Swedish Lutheran Community.
Goodwill is indicated as a factor, and if a seller is able to continue his/her name and personal presence for the period of time, the goodwill in a law firm will have a much better chance of continuing. If he/she has developed his/her associates who may buy the practice to a point where they are able to continue with the established clients, the goodwill of the seller can also be maintained.
The market in which the seller operates can be evaluated to a substantial extent. Related to the lawyer's situation, if insurance companies, for example, have been accustomed to providing defense practice to the law firm and remain with the firm, this factor has to be evaluated much differently than if these clients had been diminishing their business or had left for other firms in the area for reasons which would readily require explanation. The geographic area and growth of neighboring communities and the relationship of the practice to these markets would also be important. The internal operations of the office are of considerable importance in a law firm, as with an insurance agency. The office efficiency and the development of an organization take time to develop. An inefficient office with a high overhead or one with a gross that is low or high because of poor or good business practices would be an important area of assessment.
The continuity of the practice in an insurance agency or a law firm is of considerable importance. If a substantial time elapses since the time of the death of an owner, or if there has been a loss of key personnel, this might well effect the value of the practice significantly.
The insurance industry places a great value on gross potential which may be affected by the departure or emergence of local industries, the merger of local industry into national complexes where the headquarters have changed, the positive and negative factors of this nature. Where the economy is expanding, and the population increasing, the situation would be much different from one where reverse trends were occurring.
The last special element cited by these authors for the insurance industry deals with the matter of competition, which is also a consideration for the lawyer. Particularly in smaller communities, the position of the law office in competition with others can be of considerable importance. Where competitors are weak, the situation would be different from that community where vigorous competition may now have developed. In a unique situation, one attorney in an isolated community was the only lawyer available to serve his current and potential clients. Because of complete lack of competition, the practice of this attorney could be valued at less than normal, since the litigation possibility which might occur where competitive attorneys were in residence, and which would often provide a larger gross and sometimes higher fees, were completely absent from his/her practice potential.
In addition to these seven special considerations cited for insurance agencies, certain financial aspects particularly cited are those concerned with the cash flow aspects of practice, the accounts receivable of the firm, interest payments on installment payments for the purchase price, and any other assets and liabilities that may be shown on the balance sheet of the firm which are worthy of consideration.
Sale of a Physician's Practice
The American Medical Association, has developed for physicians a number of guidelines. The decision to sell an active, profitable medical practice is not unusually among physicians in the United States. Sometimes the professional person has no real compelling reasons, other than wanderlust or the desire to relocate in a new environment. The physician or some member of his immediate family may decide to accept a salaried position in government or with other enterprise. Most frequently, the decision to retire creates a sale situation.
In an optimum case, a general practice may yield a substantial above-average income. It may be located in an area where medical practice is not overly competitive. A prospective buyer may be ready to negotiate price. The seller has no desire to press for a sharp bargain for the practice to which he/she has devoted most of their professional life. How may they arrive at a fair asking price?
The fair price of a medical practice is little more than an intelligent guess. The practice experience of others who have sold or purchased a medical practice may aid the seller and buyer in their negotiations.
In a medical practice, there is an inventory of medical supplies, drugs and equipment which must be valued.
Significant value may attach to a highly desirable office location or long-term lease which might otherwise be unavailable except through the purchase of the lease. Leasehold improvements may also be evaluated.
The American Medical Association guidelines go on to say: "A physician buying a practice may consider himself/herself fortunate if they can retain one-half to two-thirds of the practice of the seller. If his/her good fortune continues, they may be able to balance this loss in a few years with new patients. There are instances, too, in which an aggressive and qualified doctor has taken over a modest practice and with this as a foundation has built a flourishing practice within two to three years that grosses far in excess of his/her predecessor.
As a yardstick, the physician offering their practice for sale may estimate the value of his/her goodwill at 25 to 50 percent of its annual net income (gross income less expenses). Assuming that the practice by its nature is transferable, a practice that yields an annual net income of $200,000 might be worth between $50,000 and $100,000 to the right buyer. The prospective buyer in determining what he/she is willing to pay for a practice should estimate the extent to which he/she is likely to improve his/her position economically by purchasing another's practice. If he/she can do as well in salaried practice or within a short time by starting a new practice, he/she will be unwilling to pay more than a token amount for the goodwill of the seller's practice. Likewise, depending upon the individual personal and professional qualifications of a prospective buyer, the same practice may have a greater or lesser value.
Determining and receiving a fair price depends largely upon obtaining the right buyer. He/she must have the ability to keep his/her predecessor's practice intact and more than incidentally the financial resources and inclination to take a calculated business risk. The right buyer must possess not only adequate professional qualifications, but also favorable personal characteristics which are just as important in determining whether a young physician will be able to take over an established practitioner's following. Most practice are not sold outright for cash. Usually, payments will be spread over a period of two or three, or more, years. If the buyer is unable to handle the practice successfully, he/she may be unable to continue his/her practice.
A wide choice of physicians in the community directly affects the salability of a practice. Patients may be deeply devoted to a physician who has been their friend and neighbor for many years, but after he has left, many of them may be attracted to the offices of other physicians in the community whom they may know personally or by favorable reputation. If competition is too
great, the best practice may prove to be of no value to a successor.
United States Law Practices
The following comments on United States law practice were made by Logan Fulrath of the New York Bar:
"There does remain, after a lawyer dies, the office which he/she has established and more particularly the files which he/she has assembled over the years."
"If the deceased lawyer has been engaged principally in the trial of cases, either for other lawyers or for transitory clients in particular litigations, his/her practice is likely to be so closely associated with his/her personal endowments and skill that a substitute to carry on could not be found, and his/her files are not likely to have permanent value."
"But if the deceased lawyer has been engaged in practice for decades and has constant and continuing clients for whom he has prepared wills, trust agreements and income tax returns, and has handled a variety of legal and personal matters, his/her practice is capable of being continued and his/her files have an enduring value for reference. Lord Eldon, in 1810, defined goodwill as ´the probability that the old customers will resort to the old place.' In that view such a practice of a deceased lawyer has goodwill. But it is of doubtful value. Many clients would like to continue to render legal services to their satisfaction."
With a more mobile lawyer population in the United States, with a more active and important bar organization, and with more uniform training and quality of practitioners, a reconsideration of how to handle sale or acquisition of a law practice may be in order.
Under standards used for other professional practices, such as accounting, a legal practice with a reasonable expectation of a continuing practice could be worth perhaps a year's gross income or two year's net income for the lawyer whose qualification is acceptable to the clientele on his/her succession to the practice. The value of the practice could also be dependent on the profitability of estates maturing, the value of uncollected bills or unbilled items, the assets and liabilities, and other factors. A plaintiff's practice in a metropolitan area which is dependent on the skill of the trial lawyer may be worth a different figure from a general practice in a small community.
The practice of a lawyer going on the bench or into important public office may have a value which derives in part from the past, acquired reputation of the proprietor and the gross produced by his/her associates.
An employed associate or often several lawyers employed by the office may have much to gain by acquiring the practice of the proprietor. The widow of a deceased sole practitioner will usually receive at least the payment for that amount which can be attributed to her husband's services and costs advanced from those successors or from those attorneys who are selected by individual clients.
The sole practitioner in the United States must now realize on the interest in his/her practice by means other than sale. He/she can develop the value of his/her interest in ongoing practice if he/she makes a partnership or buy-out arrangement with another attorney which includes succession to the practice.
A lawyer's fee for service usually is based on a number of building blocks. These building blocks generally consider whether there is an hourly rate base, a contingent basis, or community custom or other base.
The following factors and percentages of fees for arrangements among sole practitioners have been traditionally considered:
1. Business Origination (and maintaining the client) -- 33-1/3%
2. Doing the Work -- 33-1/3%
3. Overhead -- 33-1/3%
These three factors are already taken into consideration if each lawyer's ratable participation is determined on cases handled on an hourly (time x dollar rate) basis.
For example, Lawyer A may relocate from New York to Illinois. Lawyer A, with his client's consent, transfers a case to Lawyer B. Lawyer A has spent 75 hours on the matter. Lawyer B completes it in 25 hours. The final bill, at $100 per hour, is $10,000. Lawyer A's $100 hourly rate considered Business Origination, Doing the Work, and Overhead. Lawyer B's $100 rate considered Maintaining the Client, Doing the Work, and Overhead.
On contingent matters, such as personal injury cases, the obtaining of the matter and initial work in ascertaining the facts and the law may be valued at 1/3 of the ultimate money received by the attorney who completes the work particularly since many cases may have been handled by the originating attorney which have come to no money return.
On percentage matters, such as an estate, where there may be a large fee, an agreement can be made for Lawyer B to be paid for the time-dollar value of his effort, and Lawyer A could take the rest of the fee. Of the same could be done on an unprofitable matter. In the latter situation, if Lawyer B agrees with Lawyer A to handle the case at his time-dollar rate, Lawyer A may realize little or nothing.
The value of a lawyer's interest in individual matters will be increased if his/her successor is able to benefit from a system for recording client arrangements, well-kept client ledgers, time and billing records and properly maintained files. This also permits an inventory to be accomplished more readily, and may result in the payment of a stated sum.
Merging of Practices
In very many situations in law practice, and this is largely true also in accounting practices, it is valuable for the sole practitioner or firm to consider an offer to join forces with one or more other organizations of lawyers. The situation may involve a person who is selecting a way of gradual retirement, in which case his/her practice may have a value and a continuing arrangement may be made for his/her part-time services. More often, the lawyer or law firm will first assess the compatibility and economic feasibility of the merger. After determining that it is appropriate to proceed to join forces, favorable billing and other economic arrangements can be concluded with further considerations including a plan for ongoing income distribution arrangements among the partner and salary arrangements for employed lawyers and others who become part of the merged organization.
The plans for valuing a withdrawing, deceased, or otherwise terminating partner's interest in an organized law firm are many. Law firms will generally turn to one or a combination of the formulas listed below:
1. A dollar figure set for each percent of the share of interest or for each share of stock in a professional corporation (This can be reset each year or on agreement or formula).
2. A valuation placed on the goodwill or contribution of those who originated the firm.
3. A valuation placed on the contribution of a partner other than originators of the firm.
4. Capital attributed to the partner whether contributed in the form of cash, library or other assets.
5. A calculation to include unbilled work inventory and accounts receivable.
6. A figure or formula related to annual earnings.
7. Provision for a gradual reduction in earnings over a period of years.
8. Provision for some participation for the rest of the life of the partner.
9. Participation in earnings or other value based proportionately on the number of years of service with the firm.
11. Funded pension arrangements under the partnership or professional corporation form of practice.
The author's consulting organization recently conducted a study of a number of law firms located in New York City and upstate. Almost half of the partnerships studied indicated that they had agreed on a system for evaluating a partner's interest in the firm. Some preferred a fixed figure consisting of a sum payable to a retired partner or the estate of a deceased partner over a period of time. Other firms used a flexible figure based on the earnings of the partner or based on attributed billing.
Most of these firms compute the value of the partner's interest on the basis of past earnings. Percentage of interest is the second most prevalent means of determining payments for payments.