Selling a Properly Valued Practice Can Turn Fear Into Opportunity

Reprinted from:

Published 8/09

In the wake of the economic downturn, some lawyers are finding that selling their practice is a viable option for replacing lost nest eggs.

Within less than a year, retirement has suddenly become a distant dream for many lawyers. The global financial crisis has made pension plans and nest eggs shrink dramatically. Lawyers who once looked forward to a comfortable "second season" fear they may outlive their financial assets if they don't continue working. Not long ago the prospect of replacing hundreds of thousands of Baby Boom lawyers slated to retire within a few short years seemed to be the biggest challenge that law firms faced. Now, with aging lawyers forced to work longer, and firms continuing to hire (although at a greatly reduced rate) new, lower paid lawyers out of law schools in order to increase their leverage, something has to give. The result is layoffs, de-equitization and other efforts to reduce the firm's labor force that so dominate the legal headlines.

All of this describes the anguish at the large firms. For small and solo practices, the retirement issue is much different. Lawyers in these practices have also been hit hard by the recession. These lawyers have never been close to the top of the compensation scale to begin with, and they generally represent individual clients and small businesses in the type of matters that pay less and matters that can be postponed in times of financial distress. These lawyers, however, may well be much better positioned for retirement than their counterparts in large firms because they have something of value to sell: their practices.

Right Price, Right Terms

Driven too often by fear, increasing numbers of lawyers with small or solo practices want to know how to value their practice so they can sell it and get cash now before their retirement situation worsens further. This type of panic reaction should be avoided if at all possible. Lawyers rushing to sell their practices and retire should consider why they want to do so, what they want to do with the rest of their lives, and whether they in fact actually want to retire. The value of a given lawyer's practice may be more or less than the amount of money that lawyers want to have for a standard of living in retirement. The more urgent is the desire to sell, the lower will be the price; the less urgency, the greater will be the price.

Not every law practice is salable. Some practices are so small and personal in nature that the purchaser might not succeed in keeping the clients. This, however, is a rarity. Even the smallest and most personal practices might be saleable for the right price and under the right terms. Even in today's market, there will be buyers. Those law firms that are well run and free of debt will be positioned to take advantage of many opportunities to be offered by purchasing other practices. If the buying attorney were assured of receiving that which was offered for sale - a law practice of a certain volume of revenue or a certain client base that remained with the buying attorney for a designated period of time - a deal likely can be reached even for the smallest firm. It's a win-win situation for both buyer and seller.

Business Versus Ethics

The real problem in valuing a law practice for sale far too often lies with the seller rather than with the buyer. Far too many lawyers still believe they have little or nothing of value to sell, irrespective of the size or profitability of their practice. However, experience shows that even such lawyers would find selling their practices a viable option, one that is now sanctioned (if grudgingly) under the Code. In 1991 the American Bar Association adopted Model Rule of Professional Conduct 1.17 which affirmed that an entire practice could be bought or sold, and modified the Rule in 2002 to permit the sale of an area, or part, of a practice. The ABA's approval was less than enthusiastic - its official commentary on Rule 1.17 warns that "the practice of law is a profession, not merely a business. Clients are not commodities that can be sold at will." But the rule at least affirmed that lawyers can at some point in their careers reap the financial value of what they have built up over the years by their own hard work, creativity and ethical conduct.

Certainly the sale of a practice is not purely a business transaction. The Rules of Professional Conduct set forth very precise ethical requirements for transferring one's interest in a law firm. Here are a few examples:

• Fees charged to clients cannot be increased solely because a practice is sold - even if the purchaser is a larger firm that may charge higher rates than sole or small firm practitioners.
• The selling attorney must give ample written notice to clients before the transfer that they have the right to their files.
• The selling attorney must also inform clients of their right to retain other counsel.
• The selling attorney must close out all client trust accounts, and some jurisdictions require keeping trust account records for a period of years.

There are other ethical issues in a practice sale that can be answered only by reference to the Rules in specific situations. If the practice sold is just a portion of a firm's total practice, some jurisdictions prohibit splitting off a single practice for purchase or sale. Another possible concern again relates to the sensitive nature of client files. Does client confidentiality prevent the selling attorney from discussing specific clients or their matters? If so, how can a buyer know the nature of the practice without some disclosures? Would a buyer be willing to purchase something, sight unseen? What if the selling attorney has made an error in a client's matter, and the problem doesn't surface until after the sale - what is the malpractice insurance coverage? Issues like these must be negotiated and resolved before the sale.

Valuing "Goodwill"

One of the thorniest issues in selling a practice involves both ethical and business considerations: the issue of goodwill and how to value it. "Goodwill" in this sense is the reputation, client base and client loyalty that the selling lawyer has created over the life of the practice. Firms with bad publicity and malpractice and disciplinary matters hanging over them have little goodwill.

The issue of whether goodwill exists mainly has been limited to the selling negotiations. Typically smaller firms understand the value of their client relationships and reputations and, when negotiating for the sale of a practice, discuss compensation for goodwill. However, larger firms argue that there is no goodwill and will walk away from a transaction if "sellers" want to be compensated for their goodwill. The parties may not talk about goodwill; they may say there will be no deal if the seller insists on goodwill. Often, however, there is a "credit" for a factor that might be analogous to goodwill in terms of the cost of the capital buy-in. There has to be some adjustment for this factor, irrespective of what it is called.

Reaching agreement in advance addresses the concern that arises if the new lawyer seeks to buy the firm outright and change the name that clients have come to know. Often when a firm is bought by outside interests, the buyers assert that clients will not remain with the firm once its proprietor leaves, and thus offer a lower purchase price. The selling lawyer then is left to assert that goodwill infers that the reputation of the firm continues beyond the removal of any one individual. With that reputation come the client list, the phone number and the ongoing nature of the practice (with staff and systems in place).

Fixed Sum

Goodwill issues are just one illustration that a business is worth only what someone is willing to pay for it, and time is an important consideration. The value may be different at different points in time. Of course, valuation and price may not be the same thing. But, in the context of buying a law practice, one must look at valuation in terms of the expected future earnings of the practice. Many people believe that the price to be paid must be based only on the figure generated by the existing practice, but that price can also include future earnings that may be based on the buyer's talents brought to bear on the purchased practice.

However, it is generally preferable to sell (and buy) on a fixed, set sum . There can be bonuses and payment terms that take into account the buyer's legitimate concerns. Purchasing attorneys may well prefer to take advantage of their own efforts to increase the revenue and reap the rewards, usually with an appropriate involvement of the selling attorney during a transition period. While many lawyers believe there should be a percentage of revenues paid and not a fixed fee, this approach locks both sides into an agreement that allows no upside for a buying lawyer. Both parties' concerns can be addressed with a fixed sum. And this also moves away from ethical concerns about selling files.

Fair Opportunity

Not every older sole practitioner is perfectly positioned to sell a profitable practice, and not every big firm senior partner is facing an abrupt and painful end to a career. But the fact remains that the sole practitioner has definitely built something of value and can be in the position to realize a benefit by selling. The big firm partner likely earned good money while with the firm, but may not have enough saved to be financially independent if the de-equitization axe falls. Certainly selling a practice requires working out many technical valuation issues. But there are numerous business brokers, law firm management consultants, accountants, valuation firms and appraisers who know how to sort through the concerns and find qualified potential buyers. With their help, the transaction can be a fairly valued opportunity for both seller and buyer.