I'd like to introduce you to John. He is a sole general practitioner in a small rural community. John was in Family Court this morning with a cranky Judge, an unreasonable opposing counsel, and John's client is upset even though the result was better than expected. Back at the office, and late, John finds several of his more difficult clients waiting to see him. As he settles behind his desk, the telephone rings and it's John's bank manager who tells him that his trust account is overdrawn, and that it must be corrected immediately. John is having a bad day.
As he rushes out the door on his way to the Bank to find out why his trust account is overdrawn, John's thoughts turn, however briefly, to retirement from the practice of law. After all, John is now 60 years old, but he hasn't given much thought, really, to retirement. If he wanted to retire, how would he go about doing it, he wonders?
As a sole practitioner, John's options are rather limited. He can either wind down his law practice, or he can try to sell it. John knows that he likely hasn't enough money set aside so that he could just live off the interest income it generates. If he could find a buyer for his law practice, he could opt to stay on under an employment contract. This should assist in transferring his clients to his successor, as well as provide him with some income. John could take payment, over time, for his practice, in the form of annual payments for several years.
The question is: what can John sell his law practice for?
John has a friend, Bob, who is an accountant and a business valuator. John calls Bob, and they decide to meet one day, after work, for a beer. John explains to Bob that he's thinking of retiring from practice, and that he wishes to sell it. He asks Bob for advice on how to value a law practice.
Bob explains to John that professional practices are valued by combining the fair market value of tangible hard assets and goodwill. Tangible hard assets are things like cash in the bank, furniture, fixtures, equipment, supplies, library, leaseholds, real estate, accounts receivable, and work-in-progress, less liabilities. Goodwill is an intangible asset which is the value that exists over and above the hard tangible assets.
Tangible hard assets can be valued by hiring an appraiser. Book dealers can appraise the library; used office equipment dealers the equipment, furniture and fixtures; real estate appraisers the office building. Accounts receivable are aged and discounted for doubtful accounts and collection costs. Work-in-progress can present a major valuation problem. Can it be billed? How much? Is it collectible?
Goodwill is defined simply as the advantage which arises from the good name, reputation, and connection of a business. In order to have value, though, goodwill must be transferable. There are four types of goodwill: personal, individual, location and service.
Personal good will of an individual is the result of that person's abilities, good name and reputation, and is not transferable by contract or otherwise. Personal goodwill expires when the person leaves the practice. It has no commercial value.
Individual goodwill is that which accrues to a practice by reason of a person's abilities, business contacts [like a rainmaker], good name, reputation and professional stature, and could be harmful to the practice if that person left. This goodwill does not expire, and can be preserved by entering into an employment contract and non-competition agreement when the person leaves the practice. Some law practices have more goodwill attached to them than others. Estate practices have a value that will generate business in the hands of a successor, depending on the number of wills that the firm has. A firm with steady, repetitive clients, such as lenders, will often have substantial transferable goodwill.
Identity and acceptance of a firm's service in the minds of its clients is another form of goodwill. This goodwill is not dependent on the individuals and is commercial. Examples are very large law firms who have goodwill attached to them through the firm's name and reputation, and not necessarily through the individual lawyers working with the firm.
"But Bob," John asks, "how can you determine the value for goodwill?"
There are four established ways to determine the value of goodwill: asset based, earnings related, excess earnings, and per cent of annual maintainable earnings.
The asset based approach is used where all goodwill is personal and therefore non-transferable and, where the practice is unable to earn an adequate return on investment and should be liquidated.
Using earnings to value a practice should result in a higher value than that determined by the asset based approach. If the value determined using the earnings related approach is lower than the fair market value of the net tangible assets, then the value of the practice is the asset based value. If the value is higher, this additional value can be attributed to goodwill.
Goodwill assumes continued patronage. For a professional practice, the existence of goodwill cannot be automatically assumed -- it has to be demonstrated.
Professional goodwill is usually determined by demonstrating that the law practice being valued has generated earnings above a fair return on the investment in net tangible assets. These excess earnings indicate the existence of goodwill, but they have to be adjusted up or down for things like comparable salaries or earnings of other lawyers with similar experience, overtime hours by the proprietor, increase in earnings due to certain professional skills and expertise, and the geographic location of the practice. Once you have calculated the excess earnings, you have to determine what portion of earnings represents a fair return on the tangible assets used in the practice.
Goodwill can also be calculated based on the net fees generated by the practice after remuneration to the proprietor. Goodwill can range from 0% to 100% of maintainable fee revenue. For example, if the practice is a litigation practice consisting primarily of referrals from other lawyers, then the goodwill based on maintainable fees would be near 0%, particularly where the referrals are to the lawyer and not to the firm. However, an estate practice with a large inventory of wills would have significant goodwill, near 100% of annual maintainable fees. But this approach requires a subjective analysis of the client mix of the firm and an assessment of future maintainable earnings that will remain after the "rainmaker" retires.
Bob says to John, "so what do you think?" John orders another beer, and asks Bob if he can help him value his law practice. Bob agrees. John wonders where he put that Lotto 649 ticket he recently bought. And how does one hire an articling student anyway? Stay tuned to see what John does next.