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How to value a small law firm.

I own 100% of a two person firm that grosses about 200k a ye dakotalaw11/17/18
There are three main factors: 1) base value. This is eit dingbat11/17/18
When I bought into a small firm my partners required that I themapmaster11/17/18
Wow, just wow the info in this thread. Should be made a sti wutwutwut11/17/18
I agree. kappel11/18/18
My multiplier would be low. Which doesn't seem unfair to me. dakotalaw11/18/18
Good. Both parties should think it's fair. I strongly reco dingbat11/18/18
Interesting stuff. Thanks for taking the time to spell that notiers11/19/18
I spent years working in the financial sector, and have done dingbat11/19/18
As a practical matter, be careful in agreeing to purchase a jeffm11/19/18
Congrats dakotalaw on growing the business, it doesn't seem wutwutwut11/19/18
What dingbat is using is the "internal transfer method" - i. guyingorillasuit11/20/18
I do agree that it makes sense to talk to an entity formatio dingbat11/20/18
From what little I’ve seen of these, there’s really not garfieldfan11/21/18
I've seen a lot of older attorneys who think that one year's dingbat11/21/18
"What happens if one partner is bringing in a lot more busin jeffm11/21/18
I agree it seems insane to buy in. At least other than for themapmaster11/21/18
+1 Garfield - no partners. It's better to be king. R 2ski11/21/18
whether to stay solo, have associates, or have partners is a dingbat11/21/18
dakotalaw (Nov 17, 2018 - 5:05 pm)

I own 100% of a two person firm that grosses about 200k a year. However, only about 20% of the business is repeat business. The firm does have its intellectual property, which has gotta be worth something, and about 10k in assets. Employee wants to become 50/50 partner. I also want this.

What is the right purchase price for half of this business?

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dingbat (Nov 17, 2018 - 5:52 pm)

There are three main factors:

1) base value. This is either the average annual gross revenue, or the average net income, over the last few years (assuming the last few years have been fairly steady).
For a firm with low overhead, gross revenue makes sense, but for a firm with high expenses, net income makes a lot more sense.

2) multiplier. Let's start by saying this number will be different if applied to net income than applied to gross revenue.
The multiplier is highest for ongoing income streams. It'll be high, but not as high, for a lot of repeat business. And it'll be very low for non-repeating business. You'll also need to adjust for how much is based on the reputation/connections of the individual versus the firm.

For example, take two firms that bring in $250k/yr profit with minimal overhead. Firm 1 is a multi-partner firm whose main business is evictions for local slumlords, who send all their cases to the firm, but don't care which attorney does the work. The multiple will be quite high as there's a lot of repeat business tied to the firm. So maybe 2.5 X, or $625k
Firm 2 is a solo doing divorce. Everyone has heard of the solo's name, but wouldn't know what firm he or she works for. There's also very little repeat business (yeah, yeah). The multiple would be quite low, maybe 0.25 X, or $62,500.

3) adjustment for payment plans AND transition plans.
Let's start with the second part. If someone is just selling the firm's letterhead and goodwill, and is exiting out the door the same day, you got to make an adjustment downward for the trouble of needing to figure everything out and reinvent the wheel. For joining a partnership or corporation, then there's not so much of an adjustment, though it does depend on the nature of the business.
Now for the more important part - the payment plan. This is as much a matter of practicality than anything else. If the employee can pay cash or get bank financing, that might be worth a discount. On the other hand, if the seller will be providing some kind of financing, which is more often the case, then an adjustment might be made based on the terms. A longer term and a lower interest rate may justify an increase in the purchase price.
The payment plan can be tricky - if there's no other way to sell the business, the seller may just need to swallow their pride. On the other hand, if a new partner can't afford the buy-in, the other partners could be more demanding - but the new partner should never feel ripped off.


Alternatively, you could get creative.
You could agree that the employee will receive no raise or bonus, but instead receives a percentage of equity every year until it's 50/50 (instead of a raise/bonus, their ownership draw increases every year).
Or you could agree to sell X percent ownership every year, with the price tied to that year's performance.

Keep in mind that you'll want some kind of vesting and/or buyout arrangement, maybe disability-buyout insurance and/or life insurance. Basically, if your new partner doesn't show up for work on Monday, for whatever reason, that you're not screwed

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themapmaster (Nov 17, 2018 - 6:51 pm)

When I bought into a small firm my partners required that I pay my share of the physical assets but I didn’t pay anything for goodwill. If they would have required me to pay goodwill of any meaningful amount to them I would have been pissed because my small law associate wages suck (relatively speaking) and would have sought another job.

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wutwutwut (Nov 17, 2018 - 10:41 pm)

Wow, just wow the info in this thread. Should be made a sticky.

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kappel (Nov 18, 2018 - 4:10 pm)

I agree.

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dakotalaw (Nov 18, 2018 - 12:09 pm)

My multiplier would be low. Which doesn't seem unfair to me.

Thanks.

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dingbat (Nov 18, 2018 - 5:15 pm)

Good. Both parties should think it's fair. I strongly recommend walking your associate through your calculations, and talk through how you determined your multiplier.

You could ask him/her what he/she thinks is a fair multiplier. If it's a little bit higher, you've made some extra dough. If it's a little bit lower, see if you two can talk it out. If it's much lower, he/she doesn't value your business and/or your contribution, which could be a sign of trouble to come.

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notiers (Nov 19, 2018 - 10:56 am)

Interesting stuff. Thanks for taking the time to spell that all out.

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dingbat (Nov 19, 2018 - 2:03 pm)

I spent years working in the financial sector, and have done literally hundreds of valuations. I've also done research into the valuations of law firms, and while not much is public, there's sufficient data.

The biggest problem is that most attorneys never do any evaluations, and those that do, very rarely. If they ask their friends, odds are they don't know either, so the false rule of thump "once annual revenue" gets repeated way too often.

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jeffm (Nov 19, 2018 - 2:26 pm)

As a practical matter, be careful in agreeing to purchase a practice which requires you to relocate. Frankly, I doubt I'd ever buy anyone's practice, but I do see the value it has in helping you get your name out there.

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wutwutwut (Nov 19, 2018 - 4:29 pm)

Congrats dakotalaw on growing the business, it doesn't seem that long ago you were talking about picking up your first associate.

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guyingorillasuit (Nov 20, 2018 - 8:30 pm)

What dingbat is using is the "internal transfer method" - i.e. to establish the adjusted net cash-basis book value of the firm plus a multiple of some average of past earnings. This may or may not be the best approach. You need to go to a lawyer in the nearest big city who handles small-firm sales and ask for advice on valuation and formation (the OA). The OA will need to address a lot of the issues that dingbat identified - a comprehensive insurance portfolio, oppression issues, termination of a partner, origination for fee purposes, etc.

You are structuring a difficult transaction at the end of which you will spend more time with your partner than with your wife. Spend lots of money on getting it just right - certainly at least as much as your wedding.

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dingbat (Nov 20, 2018 - 9:31 pm)

I do agree that it makes sense to talk to an entity formation attorney to structure the operating agreement - and each party should get their own attorney,

But while getting a professional valuation makes sense for somewhat larger firms, for a solo or small shop, the cost of obtaining a professional valuation can easily be greater than the difference between the "back of the envelope" calculation and the true value. If all parties can (grudgingly) agree to a fair multiple, use that, and only resort to getting a professional if you can't amicably reach an agreement. (note: when you disagree and the opposing party grits their teeth and says "fine", it means it's absolutely not fine, and you'll have a problem later. This negotiation isn't about winning, it's about making sure everyone is happy with the final result)

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garfieldfan (Nov 21, 2018 - 8:10 am)

From what little I’ve seen of these, there’s really not a multiple. It’s more like one year’s gross payable over five years to completely buy someone out with the seller staying on at least for a bit.

With these numbers, it seems insane for the person to buy in (no offense). Minimal repeat business, very low gross. There’s not enough meat on that bone to justify an investment.

Wasting money on operating agreements or valuations seems particularly silly.

If the proposed seller thinks the associate is valuable, just make them a partner and give them 20% of the upside after you set reasonable salaries, the hard assets stay your’s. That gives the original partner full control and the newer person a feeling like they are now part of it. If the office grows, you will need to figure out a long term arrangement, whether that’s eat what you kill after split expenses or whatever else. But if this person adds value and you want to retain them, just giving them a small piece seems better than trying to get them to buy in for half of a virtually valueless business, IMO.

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dingbat (Nov 21, 2018 - 8:58 am)

I've seen a lot of older attorneys who think that one year's gross payable is the right price, because that's what they've heard from other attorneys. It's a BS way of doing things, and anyone with half a brain would know that that's wrong. (of course, try convincing sh-tboomers of that)

As for an operating agreement, if you're just taking over someone's practice and they're going to leave imminently, yeah, there's no need. But if you're talking about becoming partners, it's invaluable. What happens if one partner is bringing in a lot more business than the other partner? What if one partner suddenly decides to stop working, but still tries to collect half the earnings? What if one partner gets into an accident and is no longer able to be actively involved with the business? What if one partner loses his/her license?

As for giving 20% of the upside and keeping the hard assets, that's not a partnership. You're basically keeping the associate as an associate, and just giving him/her a raise. And if an associate is valuable enough that he/she is being considered for partnership, a raise won't be enough.

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jeffm (Nov 21, 2018 - 10:15 am)

"What happens if one partner is bringing in a lot more business than the other partner? What if one partner suddenly decides to stop working, but still tries to collect half the earnings?"

Thus, the reason why not to become partners. There is something to be said for garfield's take. There are no property rights or control given up by seller, and he can end the arrangement at will (if you write it up that way). IMO, it's a much smarter move than partnering for people who do good work and don't want to become too entangled with other people's actual or potential flaws or personal problems.

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themapmaster (Nov 21, 2018 - 9:40 pm)

I agree it seems insane to buy in. At least other than for a modest amount in the four or very low five digits. Doesn’t OP do family law? Why would any associate buy goodwill of a two man family law shop that grosses only $200,000? To the extent a family law shop means anything, its the attraction it gets from high income earners. Any attorney who hangs out a shingle should be able to get really busy within a few years with crappy low income earners’ custody cases. And when you’re talking about high income earners who are getting a divorce, it is my experience that they look, by and large, for an attorney and not for a firm and have little allegiance to the firm. When I joined a small firm, it was in the wake of the retirement of a very busy family law practitioner with 20+ years of experience. Yes, we retained business from that attorney, but in terms of gross revenues, I would say what we retained was like 10% or less of the gross revenues that she brought in. Granted I was fresh out of law school but even if I were an experienced attorney stepping in I doubt we would have retained even 25%.

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2ski (Nov 21, 2018 - 10:43 am)

+1 Garfield - no partners. It's better to be king.

Remember, with partnerships you get the spouse. She may bring lots of poor decision making influence on your new partner.

Even with the formula's sellers always overvalue and buyers undervalue. As mentioned, you MUST get a equal win for it to possible ever work. Any animosity it just a ticking clock to failure.

Good on you for eyes open.

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dingbat (Nov 21, 2018 - 8:19 pm)

whether to stay solo, have associates, or have partners is a whole different conversation.

Personally, my opinion is:

- if you're bringing in more business than you can handle, get an associate
- if you're able to cross-sell work you can't do, get a partner
- if you can't get along with other people, stay solo

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