A valuation process requires taking into account business, talent and structural aspects that are different from those of other companies.

The valuation of law firms poses unique challenges in the field of financial valuation, given their unique characteristics and business model, which is human capital intensive and provides professional services.

Unlike companies in industries with tangible assets, law firms rely on intangible assets such as the reputation and experience of their professionals, which requires a very special valuation approach capable of capturing their operational and strategic capabilities.

In this context, the Discounted Cash Flow (DCF) method is suggested as the optimal approach because, although it requires a cash flow “normalization” process to adequately reflect the firm’s value generation potential, this adjustment consists of “normalizing” the real income from the activity, the costs of the business and those items that “do not move cash”. This is essential for a correct valuation.

In view of the three structural dimensions of law firms, a valuation process requires taking into account business, talent and structural aspects that are different from those of other companies, and the valuation must take these peculiarities into account.

In the valuation process, the following aspects, which are specific to these firms, should be taken into account:

• First of all, the firm’s “human capital intensity” implies that its revenue generation is based on the skills, experience and network of contacts of its partners and associates. Unlike industrial sectors, where fixed and technological assets contribute to the value of the company, the profitability of a law firm is correlated with the efficiency and capacity of its professionals and the business generation and client attraction skills of its partners.

• Likewise, reputation and associated intangibles, such as prestige in specialized areas and the depth of relationships with strategic clients, are critical assets that directly impact the firm’s profitability and sustainability. The quantification of these elements is complex, but it is essential given their contribution to the value added in legal services, where the firm’s trust and credibility are decisive.

• Finally, the partnership corporate structure implies that capital and profits are distributed among the partners, which makes comparisons with publicly traded firms difficult and requires a valuation approach that adequately captures the internal dynamics of incentives and the distribution of profitability.

Among the methods applicable to law firms, the DCF method is the most appropriate because it allows projecting future cash flows and discounting them at a rate that reflects the cost of capital and the specific risk of the legal business.

Unlike other sectors, in law firms the valuation must capture the value of the partners’ time and labor, as well as the costs associated with human resources, which are the main asset. For the DCF to accurately reflect the firm’s value-generating capacity, it is essential, as we have said, a prior process of “normalization of the operating cash flow”, i.e., an adjustment to the reality of the business, which will certainly not coincide with the firm’s “official accounting”.

This normalization is the fundamental key to a valuation of this type and is essential to ensure that the DCF faithfully represents the real value of the firm, excluding distortions that may derive from cyclical factors or internal structure.

The standardization process will require consideration of some of the following issues:

• Firstly, extraordinary revenues and expenses should be considered; for example, by eliminating those related to one-off projects or isolated events, so as not to overestimate the firm’s recurring revenue generation capacity; although sometimes this type of revenue – such as an exceptional success fee – is actually an inherent part of the specific business and its actual production cycle should be taken into account.

• A fundamental adjustment must also be made to partner compensation by setting a notional salary: since partners are usually remunerated through profit sharing rather than a fixed salary, it is essential to introduce a notional value that represents the market value of their work. This adjustment is key, as it allows reflecting the net operating profitability and comparing performance with firms with a traditional salary structure, giving internal consistency to the results and facilitating comparisons within the sector. Understanding the real concept of notional salary, and what it includes, which is not everything that can be paid as a partner, is key to avoid overestimating or underestimating this cost.
  
• Finally, it is necessary to find the correct discount rate for the premiums of the risks that these companies actually have, which are very different from other typical risks in the sector. When the valuation process requires obtaining the appropriate discount rates, the risk premiums that actually apply to the particular firm being valued must be adjusted very carefully. The risks of law firms are very different from the risks of other companies, and at the same time they are very “typical”, so that – once they have been correctly identified – their percentage estimate will be more evident and probably less subjective. Perhaps this is the part that requires more “art” or knowledge of the sector and allows the valuation to be more in line with reality.

It is known that there are other valuation methods, although in our opinion the DCF will be the appropriate one, this does not mean that other valuations can not be taken into account and be used as a contrast to the valuation performed. Thus, in some cases, additional methods can be used, such as EBITDA or revenue multiples, to establish a reference range of value.

However, these methods are useful only as a supplement, since multiples in professional services firms tend to be highly variable depending on the specialization, size and structure of the firm, and the market is also very opaque, with little or no information on this type of transaction.

Before concluding, it is necessary to point out that two other essential issues cannot be forgotten in a correct valuation of a law firm.

• On the one hand, the firm’s fundamental billing model must be taken into account. Knowing the main type of billing, hourly or fixed price or monthly equalization, etc., is essential. The billing typology percentages and the recurrence of revenues become key issues in the valuation, especially the financial capacities.

• And finally, it should be noted that a law firm’s client base is often closely tied to the senior partners, which introduces an element of volatility if services are dependent on one or two key partners. Diversifying the client base and developing stable long-term relationships helps to stabilize value and mitigate risks associated with concentrating relationships with individual partners. Similarly, a high level of dependence increases the risk premium and the value of the firm as a whole will decrease.

In conclusion, the valuation of a law firm requires a technical approach that encompasses both the revenues and the internal and operating structure of the firm. The “normalization” of operating cash flow, by adjusting partner compensation to an appropriate notional salary and market, and the exclusion of extraordinary events, is essential for an accurate application of the DCF method, as it allows projecting the real cash generation value of the firm, without forgetting the importance -in order to find the appropriate discount rate- of correctly valuing the appropriate and inherent risks of law firms.

This type of analysis, which should aim to integrate both the distinctive features of the industry and the peculiarities of the firm – efficiency in resource allocation, reputation management, appropriate risk premiums and client structure – can provide a complete and strategic view of a law firm in such a way that the valuation performed is able to reflect both financial and intangible value, thus offering a complete and accurate picture for current partners, potential investors and future potential partners.

*Partner of Black.swan Consulting.

Taken from: https://lexlatin.com/gestion-lexlatin/valoracion-firma-abogados-desafios?mc_cid=bfe9b21eda&mc_eid=51406880bb