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Law firm valuations in flux

|Written By Julius Melnitzer

As the profession evolves at an ever more rapid pace, experts are mulling the impact of change on the value of legal practices.

Stephen Cole is optimistic about law firms’ valuation prospects.

“Dental practices have become very valuable commodities because young dentists can’t build practices the way previous generations did,” says Stephen Cole, senior adviser in the Toronto office of Duff & Phelps Corp., a valuation and corporate finance consultancy.

“The same thing is happening at accounting firms, and law firms will follow, largely because there are fewer entrepreneurial opportunities and the ones that are available are valuable.”

But James Cotterman, a U.S.-based consultant and principal at Altman Weil Inc., sees things differently. In an article on the valuation of law firms and law practices, he suggests “the valuation landscape has changed and generally not for  the better from a seller’s perspective.”

Cotterman notes the number of sellers, comprised largely of retiring baby boomers, is growing rapidly; successor purchasers are more aware of the challenges of transferring practices; clients and referral networks have become more unpredictable; clients are more willing to consider alternatives to the “traditional, long-standing relationship with a single trusted adviser;” and technology is changing how the profession works, which affects both the lawyer-client relationship and its value.

“Buying professional practices is recognized as a much more difficult activity today than it was a decade ago,” wrote Cotterman.

“Pricing models, and reasonable hopes and expectations for pricing conversion and future pricing increases are vastly different today.”

Traditionally, buyers and sellers assumed clients would stay with the new lawyer or firm after a short transition period; the new firm could imbue the clients with its pricing model; and historic rate increases would repeat themselves.

“All three of those assumptions must be examined far more critically today,” according to Cotterman.

“Clients may not ‘go along’ with the handoff and it’s likely they will be much less willing to accept an upsell in pricing. And the rate increase patterns pre-recession are unlikely to return in the current environment.”

Indeed, in some ways things are going in the opposite direction. As Cotterman noted, a trend is developing whereby practitioners are leaving large firms to practise in smaller environments where they can keep pricing down.

The upshot, Cotterman noted, is that due diligence in the course of purchasing a practice “must be more thorough and conducted with greater skepticism.”

John Olmstead, president of St. Louis-based legal management consultancy Olmstead & Associates, sees the primary problem as one of too much supply.

“So many lawyers are hitting succession at the same time and they’re all competing for buyers to pick up their practices,” he says.

“On the other hand, there is a growing recognition that goodwill can have considerable value, particularly in small and solo firms.”

When it comes to the Canadian context, the looming prospect of alternative business structures, which would allow investment in law firms by non-lawyers, is a further complicating factor.

“Potential buyers and sellers should take note of the liberalization of standards in the U.K. and elsewhere that, for the first time, have allowed outside investment in law firms by non-lawyers,” wrote Cotterman.

“A similar change in the U.S. would be a potential game changer for firm valuation.”

Both the Law Society of Upper Canada and the Canadian Bar Association earlier this year released reports emphasizing that the status quo isn’t a viable option for the legal profession. Core recommendations in the reports included proposals that would permit alternative business structures such as multidisciplinary partnerships.

To be sure, both the CBA and the LSUC processes are at early stages. In neither case have the recommendations become organizational policy. The law society is currently consulting about the relative viability of the four models for alternatives business structures proposed by a working group.

Still, if non-lawyer investment becomes a reality, the change would certainly affect the profession in different ways depending on the type and size of the firm involved. Outside investment in law firms would potentially create a more competitive market, particularly on the retail side. As well, small firms may be less able to handle the competition than their larger counterparts, thereby detrimentally affecting their value.

As for the large firms, alternative business structures could affect their valuations as well, but they might be in a better position to deal with the changes. And if the large law firms ever go public, their value could increase exponentially.

“If law firms go public, they will have their value measured like advertising agencies or public consulting firms,” says Cole.

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