Having undertaken a number of instructions involving the valuation of legal practices in the context of divorce cases, this article reflects on the value of goodwill in a typical law firm.
It is trite to say that the value of an asset is governed by what someone will pay for it but, in the context of a legal practice it is important to recognise that goodwill typically arises in one of two circumstances. The first is the admission of a new partner or new partners to an existing practice on terms whereby they “buy-in” by acquiring goodwill from the existing partners.
Sometimes the terms of these transactions are subject to provisions set out in shareholders’ agreements or partnership agreements that define the price to be paid, often on the basis of a formula reflecting underlying profits or assets. The incoming partners sometimes pay the existing partners as individuals but equally commonly they are required simply to pay money into the practice to fund working capital that is credited to their own capital accounts and which they are entitled to withdraw when they leave.
“younger partners are less willing to take on large debts”
When setting a value to goodwill in these circumstances affordability for the incoming partners is often an important issue. If a practice is keen to attract talented new and often younger partners it may be willing to compromise on the price it charges them as a cost of entry to prevent it from being prohibitively high. There is considerable anecdotal evidence that younger partners are not only less willing to take on large debts to fund a buy-in to a partnership but that increased housing costs mean that they may simply be unable to afford the levels of borrowing that older partners might have taken on in previous decades.
The second way in which goodwill can be realised is on the sale of a legal practice as a whole. In recent years such sales have been far less common than mergers. In a merger, typically nothing is paid by either party to the other whereas in a sale substantial consideration can sometimes be paid, albeit usually on an “earn-out” basis.
For example earlier this year it was announced that listed law firm consolidator Gordon Dadds Group acquired two Bristol legal practices for a total consideration of £2m of which £280,000 was paid upon completion with the balance payable over five years. The vendors warranted that the fee income of the enlarged business would not be less than £20m over those five years and any shortfall will reduce the consideration on a pound-for-pound basis.
Conversely the consideration increases if the fee income exceeds £20m, with the total payment capped at £6m.
“alternative business structure”
Typically it has only been firms that have been funded by external investment, such as Gordon DaddsGroup, that have been in the market for this type of acquisition with traditional law firms having little appetite for such deals. For that reason, in the absence of an acquisition by an alternative business structure, significant value is only ever likely to be paid for goodwill if the practice being acquired:
- generated an exceptional level of profit significantly above that necessary to remunerate its principals;
- benefitted from recurring fees from identifiable existing clients;
- had a nationally recognised or regional brand; or
- had developed a reputation for a niche or specialism that would be difficult for someone else to replicate.
“diluted by the cost of run-off cover”
In any circumstances the value of the law firm is likely to be diluted by the cost of run-off cover that will have to be met unless the acquiring firm is willing to take on the historic risk of claims. Such cover typically costs about two and a quarter time the annual premium of the practice.
If no value is ascribed to the goodwill of the practice its value should be ascertained with reference to its net asset value. In those circumstances careful consideration needs to be given to the value of unbilled work in progress which is often reflected at less than its fair value in the accounts for tax-planning reasons, especially in relation to work undertaken on a contingency basis.
Ultimately many solicitors who are sole practitioners or partners in small firms are finding that the best they can reasonably expect on retirement is that they can realise their capital accounts for full book value in sharp contrast to small accountancy firms which continue to change hands for values approximating to one times recurring annual turnover.
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