From Law Journal Newsletters, February 2014
One of the thorniest issues in selling a law practice involves the issue of goodwill and how to value it. “Goodwill” is the reputation, client base and client loyalty that have been created over the life of the practice. Every firm represents an investment of years of hard work and financial resources in growing the practice and building goodwill. Goodwill is both an accounting term and a qualitative dimension. Understanding both helps the average lawyer better understand the sale of a law practice.
Qualitative Dimensions
At the end of the day, the value of a law practice is based on a lawyer’s success and the many people that success has touched over the years. This is a significant legacy that contributes to organizational goodwill on retiring from the practice. It involves a lawyer’s reputation, practice management system and way of doing business — all the intangible elements that made the practice successful and provides the selling lawyer with what is most valuable to sell. The better a lawyer’s reputation, the more value the law practice will have. A firm with positive, provable goodwill shows that a lawyer has been focused and passionate about the practice of law, and effective at client service. By contrast, firms with bad publicity, a declining client base, or malpractice and disciplinary matters have little goodwill.
An increasingly important qualitative issue for small practices is technology. Many small firm lawyers, facing financial pressure, resist buying or updating technology because they are overwhelmed by the high up-front expense. They may have software and hardware that is going on 10 years old, or may not be using any case management software or document assembly software, or may not be backing up and storing client electronic files at all. Lawyers who do not use adequate technology may be committing malpractice per se, by failing to provide competent representation when measured as the standard of care in the local community. And such malpractice directly and negatively impacts goodwill. This “local community” is increasingly becoming global.
By the same token, the lawyer who has done the right things with practice technology — kept hardware and software up to date, invested in training to ensure staff uses technology effectively, maintained strong functional capabilities through knowledge management and client relationship management databases — should be sure to communicate those facts up front. Their value may not be easily quantifiable, but they definitely support the firm’s goodwill. The decision to sell a practice is no time to be modest, or to assume that the firm’s virtues are self-evident.
Ethical Dimensions
Another qualitative factor involves ethical considerations. Several years ago, new marketing regulations adopted by the New York State Bar asserted that “a lawyer in private practice shall not practice under a trade name.” Rules of Professional Conduct 7.5. If lawyers’ names must be used in the title of a firm, as this could be said to require, any lawyer who would be interested in purchasing a law firm would either have to “retire” the selling lawyer (and keep the name in the firm “trade name” since the rule enables the name of a deceased or retired member of the firm to be retained), or change the firm name.
If the firm name is changed, deleting the previous lawyer’s name, one might question whether the value of the firm’s goodwill is decreased or even destroyed. Many 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. The client list, the phone number and the on-going nature of the practice (with staff and systems in place) comes with that reputation. To account for this issue, negotiations that are already complex may become even more so as the parties have to work around the “trade name” restriction.
Beyond these “macro” ethical considerations, there is a “micro” one involving goodwill if an older lawyer sets out to groom a successor to whom the practice is sold. That grooming process should take place over a period of several years, during which there is a transition process as the successor is introduced to clients, who are assured that the successor will continue the same quality of service and counsel they have come to expect.
There is the risk, often inevitable, of such preparation in grooming and transitioning a successor from inside the firm. While eliminating discord if an associate so ingratiates him- or herself with clients, such a lawyer may start his/her own practice and take the clients along, leaving the former firm high and dry. Ensuring that the future successor understands how reaping the benefit of the firm’s accumulated goodwill is a personal benefit only when done through a planned succession can minimize or eliminate the danger from such “freelancing.”
Accounting Dimensions
Although there is no definitive way of calculating goodwill in an accounting or a valuation sense, appraisers often use the “excess earnings” model in which goodwill is defined to be a differential advantage resulting from the individual lawyer’s skill, reputation and special talent. Typical steps to calculate are:
- Ascertain average annual earnings of the firm over the previous five years.
- Fix the amount by which the law practice exceeds what an employee of comparable qualifications would earn, using local, not national, statistics.
- Compute a fair return on investment in physical assets used in the practice.
- The amount by which the five-year average earnings of the practice, less the fair return on physical assets, exceeds the fair compensation figure of a comparable attorney is the amount of excess earnings.
- Capitalize this amount as a function of the risk of retaining the clientele, the stability of the firm’s earnings during the time period chosen, and the competitiveness of the practice.
Lawyers typically do not understand this financial calculus and cannot comprehend even the possibility that their many years of effort may actually have produced a monetary value of some significance. This value can enhance their retirement, as a measure of organizational goodwill.
This value of goodwill can be passed on to a lawyer’s family and heirs when monetized through a practice sale. After investing years of hard work and financial resources in growing the practice, a well-planned practice sale allows any lawyer to reap the benefits of that value and realize the legacy that a years-long investment of time and effort created.
It is true that 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 the “seller” wants 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. Oftentimes, 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.
Of course, 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 — and valuation and price may not be the same thing. But, in the context of buying a business, even a law practice, one must look at the future. When valuing a law practice, one should also look to the expected future earnings of the practice. Many people believe that the price to be paid must be based only on this figure generated by the existing practice, but there can also be an inclusion of future earnings that may be based on the buyer’s talents brought to bear on the purchased practice in some cases.
Given this concern, it’s 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, which is not ethically permitted.
Conclusion
This discussion is not intended to be an exhaustive review of all aspects involved with goodwill in the valuation of a lawyer’s assets after years of practicing. Practice realities make the definition of goodwill different for every lawyer. What is common to all lawyers is that goodwill does exist and, to whatever degree necessary, should be taken into account for a practice sale. Lawyers who fail do so in effect are throwing away the value of the goodwill they have established, in the process relinquishing their life’s work without getting value in return. Lawyers should not ignore the fact that their life in the law is what has created the value of their estates as measured in goodwill. For virtually every lawyer, the value is there. After investing years of hard work and financial resources in growing the practice, effective consideration of goodwill allows any lawyer to reap the benefits of that value and the extensive investment of time and effort that created it.