Crunching Numbers - Law Firm Valuations
Valuing professional service firms is not a new innovation. Firms have traded for decades in many areas of professional service including marketing, surveying and accountancy, both in private or trade sales and in public offerings. Additionally, death and divorce frequently trigger the need to assess a value that goes beyond the value of assets on the balance sheet. It is clear, however, that the Legal Services Act is already providing a huge catalyst to change. Already we have two examples of external investors valuing and then acquiring UK law firms. In the latest move, the Australian listed law firm Slater & Gordon have acquired UK firm Russell Jones & Walker (RJW) for £53.8m. How was that figure reached?External investors in law firms are fundamentally motivated by the future and predictable ability of the acquired law firm to drop cash to the bottom line. In other words, the attention is focused on the ability of the acquired entity to increase operating profits over time. What is vital to recognise is that investors will not be willing to invest money in law firms just to enrich the partners. They will only invest if they are satisfied that their investment will lead to further growth plus the opportunity in due course to reap a capital harvest.
Assessing value
Sophisticated investors look at more than one valuation methodology when valuing a firm and triangulate the results of each test. What they will try to value is the future earning potential of the firm and so they will first look beyond the current value of the assets to assess the value of predicted future cash flow, which is easier to do for a firm like RJW than for traditional general firms. Typically, this requires a discounted cash flow analysis. Investors might also apply a leveraged buy-out test which values a firm by having regard to the maximum amount that can be borrowed by the new business to finance the purchase of the ownership interests.The most commonly used yardstick, however, is the multiple of earnings valuation, which applies a multiple to the net predicted earnings of the firm before interest and tax, but after deducting a basic living salary for the selling partners (for instance on a notional or market basis). The multiple will vary from two or three times the resulting net profit (known as EBITDA) – in the case of a small firm – to double-figure multiples for larger firms with highly predictable future prospects. In the case of RJW, preliminary analysis suggests a valuation of around five times predicted EBITDA for 2013.Even if this allows you to make a rough guess at the value of your law firm, remember that for every seller there must be a buyer. Why would anybody want to buy your firm?
