There is a fundamental problem that many owner-managed law firms face when they come to sell: the people who have made the business successful can also be the reason a buyer is less willing to pay for it. In many smaller practices, the owners are not simply shareholders or figureheads. They are often among the highest fee earners, responsible for key client relationships, referrals and much of the firm’s management. This can make a firm highly profitable and provide the owners with a very nice living. But there is a catch.
The profit enjoyed by the owners is not necessarily the profit a buyer is buying.
The importance of adjusted profit
An owner may take little or no salary because they receive their remuneration through the profits of the business. The accounts can therefore show an attractive profit margin, but this may give a misleading impression of the profit available to new owners. A buyer will want to understand the firm’s maintainable, adjusted profit once the owners’ contributions are properly accounted for. If one or more owners generate a significant proportion of the firm’s fees, for example, the buyer will likely need to allow for the cost of replacing that fee-earning capacity. The same applies to key client relationships, referrals and management functions. If these depend heavily on the owners, the buyer needs to understand how they will be transferred and what it will cost to replace their contribution.
The result can yield a significant difference between the profit shown in the accounts and the sustainable profit under new ownership.
Where the paradox appears
The issue becomes particularly acute when owners decide to retire or substantially reduce their working hours. The buyer has to ask:
What happens to revenue and profit as the owners reduce their efforts and eventually cease working?
If a substantial proportion of revenue depends on the continued involvement of some or all of the owners, a buyer will reflect that risk in the valuation or deal structure. That could mean a lower price, deferred consideration, an earn-out or a requirement for the owners to remain involved after completion. Many owners only realise too late that, having spent decades building a successful practice, much of its ongoing value depends upon them continuing to work in it.
Essentially, they have created a cashflow asset, not a capital asset.
That does not mean the business has no value. It simply means its ability to generate cash is closely tied to its owners, making it harder for a purchaser to place a strong capital value on it, hence the paradox:
The more successful the owners have been at generating the firm’s revenue and profits themselves, the more work may be required to demonstrate that those profits can survive their departure.
What do the owners actually want?
If maximising capital value is important, there may be considerable merit in preparing for the owners’ eventual departure several years prior. Client relationships can be transferred, other fee earners can develop their own practices, referral sources can be broadened and management responsibilities delegated, but all of this takes time and effort. Done properly, the business becomes less dependent on its owners and its underlying profitability more transferable. That can be valuable whether the eventual succession is a sale, internal handover, merger or gradual reduction in involvement.
However, maximising value is not necessarily the right objective for everyone.
The important question is not simply “What is our firm worth?” It is “What do we actually want from our exit, by when, and what is the best way to achieve it?”
For some owners, maximising the capital value will be the priority. For others, the priority may be to retire quickly, reduce their workload, rebalance their lives, achieve certainty or simply move on. There is nothing wrong with that either. The important thing is to understand the financial consequences of the choice, so you are at peace with the achievable outcomes.The choice is not between a “good” exit and a “bad” exit. It is about understanding the trade-offs and deciding what matters most to the owners, and when.
If the owners want to leave sooner, the business may be valued more on the cashflow it can generate with them still involved than as a fully transferable capital asset. That does not mean a good transaction cannot be achieved. It simply means the owners should understand the potential difference between the outcome available now and the outcome available if they spend several years making the business less dependent upon them. That is the Exit Value Paradox: if you want to create a valuable asset, the best time to make yourself less essential to your business is while you are still essential to it.
Start the conversation early.
If you are thinking about succession or an eventual sale, it is worth speaking to a specialist law firm broker before you are ready to go to market. A good broker should help you understand what a buyer is likely to look for, where the firm’s value currently sits and what could be done to improve your options. And if you have simply decided that it is time to get on with it, the same advice applies. The objective may not be a three-year value-building exercise, but to understand the market, identify the right options and achieve the best outcome from the business as it stands.
If you are considering your exit, speak to Ortus Group before or when you decide to sell. An early, confidential conversation could make a significant difference to the options available to you.
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