What’s your firm worth? Understanding law firm valuations
Kalman Shiner, CPA
Attorneys who routinely retain appraisers to value businesses as part of their practice may believe they know what is involved when their own firms must be appraised. And those who do not regularly work with valuators might think it is simply a matter of a “plug-and-play” mathematical formula.
However, both notions are mistaken. Law firm valuations are different from — and sometimes more complicated than — typical business appraisals in some significant ways.
Legal vs. other businesses
When most businesses are sold, appraisers can reasonably assume that they will continue to generate a certain amount of revenue. For closely-held professional services firms, however, that is not necessarily the case.
Clients might prove more loyal to specific partners than the firms themselves. If an owner leaves, the clients may follow that attorney or look elsewhere for legal services. Unlike some businesses, firms generally cannot enforce non-compete agreements against attorneys who leave a practice. Also, firms can have conflicts of interest that limit their ability to maximize revenues.
Another complication? The sale of law firms is a relatively new phenomenon (and even now the American Bar Association Model Rules of Professional Conduct require satisfaction of certain conditions). Valuators have yet to adopt a common method for valuing firms, and no comprehensive data is widely available.
Circumstances and methods
Because the acquisition of one firm by another often does not involve an actual payment, valuations are not commonly obtained for prospective sales. They are more frequently sought after the death or departure of a partner, or when a partner divorces, as well as for purposes of retirement planning, estate planning and life insurance purchases.
In some cases, a firm’s partnership agreement will specify the valuation method to be used. However, the language of these agreements can be surprisingly imprecise and easily give rise to disagreements.
Several valuation approaches are available, and professional valuators generally use a combination of the following, depending on the firm’s unique circumstances:
- Rule of Thumb
The appraiser takes the sum of average annual revenues and multiplies it by a certain factor. Factors generally can range from 0.5 to 3.0 and above, based on the number of clients, amount of repeat business and transferability of client relationships.
The valuator deducts the firm’s liabilities from the sum of all of the firm’s assets to calculate a net value. Note that this approach generally is disfavored for law firms because it ignores earnings and cash flows, two major indicators of a firm’s financial health.
- Discounted Cash Flow (DCF)
A DCF value is based on future revenues, rather than historical performance. The appraiser projects cash flows over a period of time and applies a growth rate to estimate a terminal value at the end of that time period. The cash flows and terminal value are then discounted to their net present value.
- Comparable Sales
As noted above, data on law firm sales are difficult to find, and an appraiser likely will not be aware of any unique circumstances behind the scenes of a particular sale that would require adjustments. Still, data from sales might prove helpful as a supplement to results produced by other valuation methods.
Whatever the reason for an appraisal, firms need to exercise the same care in selecting a valuator for their own business as they would for their clients. This means finding a qualified professional with proven experience valuing firms similar to theirs.
What Law Firms Should Know about Cloud Computing
Joel Herman, CPA
According to the American Bar Association’s (ABA’s) 2019 Legal Technology Survey, the majority of law firms (58%) have taken the leap into cloud computing. They are drawn in by cloud technologies’ 24/7 access from remote locations, relatively low cost of entry, predictable monthly expense and comprehensive data backup and retrieval. However, firms still have some significant and legitimate concerns.
Cloud computing generally refers to web-based software or services. Rather than installing software on the firm’s server or attorneys’ individual computers or mobile devices, attorneys access the software or services through an Internet browser or mobile app. The data is processed and stored on remote servers, not local computers or hard drives.
The survey found that attorneys see the cloud as a fast and scalable way to use advanced legal technology tools without a substantial upfront capital investment in hardware, software and support services. Instead, they can take advantage of monthly, per-user subscriptions. Almost half of respondents also view other economic benefits — including eliminating IT support, avoiding software management and version update requirements, and quick start-up times — as important.
Only about 30% of respondents cited “better security than I can provide in-office” as a benefit of cloud computing, while 65% of current cloud users identified “confidentiality/security” as their top concern. They also are worried about losing control of data (45%) and losing control over updates (25%). Among attorneys who have not adopted the cloud, concerns cited include confidentiality/security (50%) and loss of control (36%).
Yet, few attorneys seem to be doing much to protect their data. No more than 35% (down from 38% in the 2018 survey) of respondents are taking any one of 13 specified cautionary security measures listed in the survey question. The most used measure is secure socket layers (SSL), which is the use of encrypted links, followed by local data backups (27%, down from 36% in 2018), reviewing terms of service (27%, down from 34%) and reviewing ethical decisions on cloud computing (25%, down from 34%).
Only 23% evaluated vendor company history, despite the fact that 94% cited vendor reputation as important when selecting vendors. Four percent negotiated confidentiality agreements in connection with cloud services, and 5% negotiated service legal agreements.
As the ABA laments, this behavior makes little sense if attorneys’ biggest concerns about cloud computing are security and confidentiality. It also raises questions about their ability to satisfy ethical requirements regarding technology competency.
Law firms can take several steps to shore up their security and, in turn, their (and their clients’) confidence in cloud computing, including:
- Conducting a Comprehensive Risk Assessment
Attorneys clearly harbor some fears about vulnerabilities; however, they cannot take appropriate measures to reduce vulnerabilities until they have identified the risks.
- Establishing Appropriate Cloud Structures
There is no one-size-fits-all cloud structure. (See the following Sidebar: “Hybrid and Multi-Cloud Computing are Here”). Attorneys should choose the appropriate structure based on the firm’s particular needs, with, for example, some materials and aspects receiving heavier security than others.
- Managing Access
Require passwords to be changed regularly, install multi-factor authentication to log in, and grant different levels of access based on actual need. Administrative staff, for example, should have much more restricted access to confidential materials than attorneys. It is also critical to terminate access when employees depart and vendor relationships terminate.
Proceed with caution
Attorneys should look no further than businesses in other industries for evidence of the benefits of cloud computing. The question, ultimately, may not be whether to adopt cloud computing, but how to adopt cloud computing. This latest ABA survey makes clear that attorneys have significant steps to take in order to achieve appropriate levels of cybersecurity.
Sidebar: Hybrid and multi-cloud computing are here
While many firms have slowly transitioned into cloud computing, the field has swiftly advanced. For example, there are now several hybrid or multi-cloud computing options that enable firms to customize their experience.
Hybrid computing comprises separate public and private clouds, with data and applications shared between them. The public cloud component provides access to immense storage capabilities on a scalable basis, meaning law firms can increase or reduce depending on their current needs. Firms can use private clouds (hosted on their own servers) to store confidential and sensitive data.
Multi-cloud computing generally refers to using more than one third-party cloud service. It allows a firm to transfer vital workloads and applications to a functioning cloud if another cloud goes down. Moreover, multi-cloud computing facilitates a “cafeteria-style” approach. Firms can pick and choose among providers based on the features required for each application.