Solo practitioners and small law firm owners wanting to know what their practices are worth frequently rely on the “rule of thumb” valuation method. The choice is an easy one to make, because the method is simple; even lawyers who can barely read a balance sheet or a profit and loss statement can understand it.
Calculating the Rule of Thumb
In many situations, the rule of thumb is expressed as a multiple of revenues—usually gross revenues. In most industries, you can derive the multiple statistically from the sales of many businesses of the same type.
Example: The multiple for an accounting practice may be 1.5. Thus, if the accounting firm’s annual gross revenue is $200,000, the rule of thumb equates the firm’s worth to approximately $300,000. Change the multiple to 1.0, and the value of the firm equals $200,000.
The multiple for law practices is not consistent, however. In literature that I have reviewed on the subject, authors suggest a range from as low at 0.2 or 0.3 to as high as 3.0 or 4.0. No one supports their choice of multiple with anything remotely resembling a statistical analysis of like-sales data. Indeed, it seems they base their multiples on anecdotal evidence alone. If I didn’t know any better, I’d think they have pulled these numbers right out of thin air.
The Challenge of Finding the Right Multiple
For many reasons, I am not surprised by the great differences in multiples.
- First, the marketplace for law practices is a very immature one. You cannot create a meaningful database due to the low number of deals occurring in the industry.
- Second, and even more problematic, is the fact that most of lawyers complete these deals confidentially—no one but the lawyers themselves know the terms.
- Third, even if there exists a sufficient base of knowable transactions, you would be hard-pressed to find a worthwhile multiple due to incomparable data—practice areas are too different.
How to Accurately Value a Law Practice
The key to valuing any law practice is predicting future revenue when the original owner is no longer around. Is a $250,000 solo family law practice worth the same as a $250,000 estate planning practice? I don’t think so. Most family law revenue derives from one-time events, with only occasional repeat business (e.g. modifications). Contrast that with an estate planning practice, which carries with it the likelihood of revising previously drafted wills or probate work.
Moreover, repeat business can vary greatly even within practice areas. What if elder law work constitutes a significant amount of the $250,000 revenue of an estate planning practice? Should you use the same variable for that firm compared to a more traditional estate planning practice? Once again, I don’t think so. The likelihood of future revenue will vary too much.
The New Rule of Thumb
Even small practices in similar practice areas are usually so dissimilar that one cannot compare apples to apples. In short, my new rule of thumb for valuing a law practice is that there is no rule of thumb.
