How much is that law firm in the window?

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As revealed by Nigel Wallis, consultant at Legal Futures Associate O’Connors Legal Services Limited

Wallis: Law firm buyers being more cautious

Shortly before the Queen’s Coronation in 1953, Liverpool-born singer Lita Roza topped the hit parade with the much-loved pop classic ‘How much is that doggie in the window?’ The track was pipped to the coronation order of service by Zadok the Priest, but the Archbishop of Canterbury was rumoured to be humming it throughout rehearsals.

The rising cost and availability of solicitors’ professional indemnity insurance, the banking sector’s waning appetite for the legal sector, the growing burden of regulatory compliance and, for some at least, the reduction in demand for services, is causing some law firm owners to wonder if the time might be right to exit the market.

It remains unclear if these factors are denting the valuation of law firms or if acquirers consider them just minor bumps along the rocky road of business life.

We are certainly seeing some evidence of law firm buyers taking a more cautious approach to the way they structure deals and conduct their due diligence – not surprising, given the market for law firm capital transactions is relatively new.

Not so long ago, the only option for a lawyer at retirement was to hand in his or her pencil stub, express delight at the passing years and shuffle off home with an engraved carriage clock.

So, we thought now might be a suitable time to revive our corporate finance party game.

We’ve called it ‘How much is that law firm in the window?’ and it might make a fun pre-dinner icebreaker at your next management team away day. The game is far removed from Love Island, so it’s perfectly safe to play in mixed company and the level of maths involved is no more complex than the Lotto.

Start by giving each member of your management team a sheet of paper and a crayon. Let them choose their own colour. It’s the small things that win people over. And it’s worth recapping the difference between adding and multiplying, as this will help to manage expectations.

Next, ask them to follow these six steps:

STEP 1: Explain that the value of a law firm is the price a willing buyer is prepared to pay to a willing seller – a familiar concept since Flog It! arrived on the BBC. Tell them that this price is represented by ‘X’ and ask them to use their crayon to write ‘X’ on their piece of paper.

STEP 2: Invite them to list the net profit figures for the firm’s last three completed financial years, excluding interest and tax. Then ask them to add their best guess for the current financial year. You may need to supply these figures to them, as not everyone reads the management information packs you spend days putting together.

STEP 3: At this point, you can explain that these four figures represent the firm’s earnings before interest and tax, otherwise known as the firm’s EBIT – a cross between eBay and Bitcoin, with a twist of Penn & Teller magic thrown in.

STEP 4: Before attention spans get stretched too far, ask them to make some quick adjustments to each EBIT figure. The main one is to add back the difference between what the equity owners earn in terms of salaries and profit shares and what a buyer could reasonably expect to pay someone else to do their jobs.

As you can imagine, some people can become quite defensive at this point, so you need to remain calm. Try threatening to delay dinner if they don’t behave, which usually works.

There are other adjustments you could suggest but, if you delve too deeply into depreciation, amortisation, bad debt provisioning and WIP verification, there is a strong chance of losing everyone to the cocktail bar. There is no shame in quitting while you’re ahead.

STEP 5: If the four adjusted EBIT figures look broadly similar and you feel they fairly reflect your true trading pattern, simply ask everyone to get out their smartphone calculators, add up the four EBIT figures and then divide the total by four. This should establish your average four-year adjusted EBIT.

If there has been a marked increase in your adjusted EBIT figures in recent years, suggest applying a weighting to the more recent years – for example, by doubling the last two figures and dividing by six. Explain there is just one more step to go before they have found ‘X’ and, more importantly, they get fed.

STEP 6: To find ‘X’ (in truth a ballpark estimate of ‘X’), all they now have to do is multiply the resulting average four-year adjusted and weighted EBIT figure by a price earnings multiplier.

‘What price earnings multiplier should we apply to our law firm?’ one of them is bound to ask. Try not to tut and look skywards. Instead, congratulate the individual on an excellent question and explain that this is where the alchemy begins.

Price earnings multipliers are governed by a wide range of factors such as economic conditions, the special characteristics of your firm and multiplier trends in different sectors. Professional services businesses tend to attract earnings multipliers of between one and five, though there are always outliers. As business valuation is an art not a science, ask them to take their pick.

Any colleague who goes for a multiplier of five gets a second pudding. Any colleague who goes for a multiplier of one does the washing up.

If everyone goes for a multiplier of five, remind them of the Seven Deadly Sins. If everyone goes for a multiplier of one, send them all to bed without their dinner and head straight for the cocktail bar on your own.