Law firms looking to be bought “do not have the value they think”

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Poole: 

Many law firms looking to be bought do not have the value they like to think they have, while multiples used to set the price are beginning to fall, leading advisers have warned.

Meanwhile, the rise of fee-share law firms is “sucking out the next generation” of law firm owners, potentially causing yet more succession problems for the profession.

Andy Harris, a partner at accountants Hazlewoods, told a webinar on law firm valuations organised by Law Firm Ambition, a group of advisers and suppliers to the profession: “Most firms like to think they have a value but in reality I’m afraid that’s often not the case.

“There are lots of firms out there with little or no profitability, often with the owners of those firms earning less than their fee-earning staff.

“In those situations, there isn’t much value to a potential buyer and the best they can often hope for is to settle their debts and walk away without having to pay for redundancies and run-off cover.

“Sole practitioners in particular often carry little value because the client relationships tend to rest with them. If they’re looking to retire within two or three years after being acquired or merging, then there’s little value there to potentially acquire.”

But he said there were still “plenty of firms out there with a decent value”.

Mr Harris said net-asset value or EBITDA – earnings before interest, tax, depreciation and amortisation – were the main two methods used to value law firms, replacing the concept of ‘super profits’ (net profit less notional salaries and notional interest on capital).

“The reason we used EBITDA is because it strips out the effects of a firm’s funding model and also neutralises the position of whether you’re a partnership, an LLP or a limited company,” he explained.

“So you start with the firm’s normal profits. You adjust for exceptional income and expenditure. You make the EBITDA adjustments and adjust for notional salary to arrive at, in theory, a maintainable EBITDA and then multiply that.”

Turnover was used when valuing accountancy firms but this was because they have recurring fees. “For law firms, while clients might come back time and time again, it’s often because they want to because they like the individual rather than because they have to.”

But he said consolidator Knights has moved towards a turnover-based approach, paying a multiple of between 0.8 and 1.3 “for firms that fit within their growth strategy”.

Andy Poole, a partner at accountants Armstrong Watson, said deals were still on a net-asset basis where there was no goodwill or for firms that have more of an asset-based business, like personal injury firms “with much more WIP than fee earnings”.

Mr Harris said net assets were also used in “genuine” mergers where two firms of similar size were coming together.

He continued that determining multiples was “particularly tricky” at the moment: “It can be affected by the size of firm, type of firm, location of the firm, profitability, competition, barriers to entry and quality of its client base. It’s a skilful thing to do.”

Mr Poole identified competing factors: while the pent-up demand for deals caused by the pandemic could push multiples up, that a “lot of people” were looking to sell drove them down.

He went on: “Multiples are there to reflect risk and when you’ve got a bit of uncertainty [in the economy], you’ve got risk increasing. I’m seeing a very small but noticeable downturn in the multiples.

“But rather than risks of what might be happening in the economy going forward, I think potentially it’s the cost of capital – with interest rates going up – that causing that to happen because it’s costing the acquirors more to be able to buy.”

Mr Poole said he was seeing multiples of “anywhere from zero to seven”, with niche firms achieving the higher ones because of the high barriers to entry to their markets, and high street firms the lowest because there were no barriers to entry. Mr Harris cited a range of 1.5 to seven.

Consultant Andrew Roberts, director of Ampersand Legal and chair of the Association of Law Firm Merger Advisers, described contentious probate as a “really hot area” at the moment, with employment, intellectual property and partnership law other areas where specialist firms had increased value.

While there may be only 20-25 specialist intellectual property firms in the country, “if a buyer wants to buy a high street firm and the value’s too high, they will go to the next town because there’s likely to be a similar firm there”.

He said there were “lots of very good firms offering great service to their communities”. There was “a bit of value in that” but not much.

For many such firms, succession was the key problem. “If you haven’t got willing buyers internally, you need to go and find a willing buyer externally, which lowers your valuation to an extent.

“All these firms are good local businesses but the challenge is always replacing the key partners who wish to exit and how you do that in a relatively small location.”

He reported that in recent weeks he has seen mergers fail at the point of completion because professional indemnity insurers have “put the frighteners” on acquirors.

That meant those looking to exit needed to factor in run-off insurance and, with premiums going up, he advised firms to buy it “sooner rather than later”.

Private equity houses tended to overpay for law firms, Mr Roberts added, in part because they were “quite cheap compared to the other businesses they might want to buy”.

Mr Poole agreed that the multiples in law were lower than private equity was used to in other sectors, but this was because many were people businesses and hostage to senior people leaving.

A key question was why clients instructed a particular firm – because of the firm or its individuals. If the latter, then “you’ve got value leakage”.

He said: “There are some good multiples on offer from [private equity]… partly because they want to get in and be able to make a splash within the sector.”

Some consolidators were willing to buy distressed firms, as the upside if they were able to turn them around would then be greater, the webinar heard. But plenty were not.

Mr Roberts describe the rise of fee-share law firms as “the elephant in the room” because they were “sucking out the next generation of future owners”.

Whereas in the past “ambitious” lawyers’ only options were either to become an equity partner in their firm or set up on their own, fee-share firms were now “very attractive”.

Indeed, he said he was surprised by how many new small firms were setting up “when they could just go under one of these Keystone type banners and not have the hassle of running a law firm”.

The panel also debated the amount of value in a firm having a large will bank and a brand.

Mr Harris said: “In theory, a will bank represents a nice long list of future fees and profits, and in the right circumstances it can have a value.

“But key is for the will bank to be carefully managed. You need to know that the client is still alive, for example, and haven’t moved to another firm of solicitors. A bank of thousands of wills isn’t worth anything if you can’t get hold of the people.

“You need to be able to demonstrate that you’ve managed the will bank carefully, that you’ve kept in contact with those clients and it is generally a source of new work.”

Mr Poole said: “You need to assess how powerful the brand is in coming up with the multiple to apply. Why are clients instructing the law firm? How widely is the brand known?

“But the success of the brand will be dictated by the results that it generates and therefore if you’re basing it on an EBITDA model, you’re taking that into account anyway.”