Your Firm has Real Value

Principals of firms are constantly undervaluing, or even disregarding the value of their firms. More specifically the dollar value of its goodwill.

I continue to see practitioners purchasing equity in firms, even smaller, sole practitioner firms. If the incoming principal didn’t think there was a value, they wouldn’t pay anything.

Banks are lending to firms to enable succession and acquisitions to occur, and securing it solely against the firm, without any personal security other than guarantees from the principal(s).  Believe me, if the banks didn’t think there was value, they wouldn’t lend money for it or against it

So, what’s your practice worth?

The value is that which a willing and educated buyer will buy and a willing, but not anxious seller will sell.  At the end of the day, a buyer will consider the risk and return to work out how much they will pay.  The lower the risk and the higher the return, the greater the value.

To improve value, you need to:

  1. Increase your profit and maintain your risk level,
  2. Maintain your profit and reduce your risk level, or
  3. Increase your profit and reduce your risk level

Profit is what the firm makes after it pays all principals a commercial salary.  Risk level is the likelihood that the profit will be earned into the future after the purchaser buys the practice, or an interest in the practice, and turns into cash.

Considerations

If the profit you make in your business is just enough to pay you a commercial salary, then your value will be minimal.  This is because your profit is non-existent.  Also, it probably won’t have a strong cash flow and will struggle to fund itself.  So, the risk is very high.

If your firm totally relies on you and your fellow principals to bring in all the revenue, and to a large extent, to do all the work, but makes a profit after commercial salaries to principals, then there will be a value, but the value will be lower due to the risk.

Contrast the above with a firm that generates work without the principals, either from brand strength or proactive marketing activities. The firm can function and maintain its profitability because of it’s leverage and reduced reliance on principals. Higher profits, lower risk equals greater value

How to increase your value

Increase your profitability by better client engagement. Estimate the work early and advise your clients of the fees as you progress, especially if it’s out of scope, you need to re-price.

Follow what your costs agreement or engagement terms are. Educate your clients on what your firm does and challenge their attitudes to price and value. Remove discretion around time entry.  Build systems and educate fee earners around what doesn’t get entered into WIP.

Engage your fee earners around their time entry and billing budgets. Monitor the value of time entered against budgets every week, encourage your fee earners to plan their weeks around work to be done to achieve their budgets, run a weekly matter workflow meeting to focus on priorities.

Consider Improving your cash flow from regular and systematic billing to reduce risk.

Structuring for Succession

Implementing succession into your professional firm can be an extremely daunting thing. For most, this can be a new experience. For others, this maybe a second attempt at a bad succession strategy. Regardless of the reason, many questions are common in any succession.

The most frequently asked questions I get are:

  • I’m wanting to retire, but don’t know how
  • What is my current practice worth?
  • Who is going to buy it?
  • How will I be paid?
  • Over what period will my succession process last?
  • What are the tax implications?
  • The two biggest questions that come from a selling practitioner once the decide they want to sell are:
  • How do it do it?
  • What’s the firm worth?
  • The first thing I need to tell you is … the closer to exit date without any plan the lower the value.

Considerations for enabling succession

To drive growth in your value, you need to increase your profits and reduce the risk. If you are considering your succession strategy and it is still a couple of years away, you need to start implementing strategies now to drive the value upwards.

To enable succession, you first need to put yourself in the potential purchaser’s position. This is harder than you think as you will always take a bias viewpoint of your own interest.

Many practices have engaged my services to manage the process just for this reason. Some taking up to two years to transition and agree because of said parties involved.

When enabling succession, you need to make the firm attractive. Key areas that need consideration are:

  • Current legal structure
  • Current debt and cash flow structure
  • Funding that is available
  • Distribution strategy
  • Risk mitigation
  • Partnership criteria

What are the common succession pain points?

You may have an idea of how you can exist your practice, or even how to make it more attractive prospective purchasers, but what about the biggest challenges you will face during the succession process. The most common challenges that I see facing practitioners are:

  • Lack of consensus
  • No defined strategy
  • Assuming instead of agreeing
  • Agreement on valuation
  • Current structures are inhibiting
  • Deciding on a successor
  • Bias decision making
  • Timing of succession
  • Letting go

Plan ahead

Prepare detailed strategy and advice document for the firm to implement the plan, including step-by-step project implementation action plan regarding:

  • Consider Incorporation to make it easier for the new partner
  • CGT implications and procedures required to apply the small business CGT concessions to the sale by the partnership and restructure to an ILP, including personal taxation impact for each partner
  • Debt restructuring implications and deductibility
  • Review your current finance structure, both personally and business, and develop a debt strategy to retire debt and support your business cash flows

Consider preparing a valuation for your practice for capital gains tax purposes and to support the correct allocation of purchase price of Goodwill as the transactions are between related parties

Two Numbers

It is easy to get lost in the numbers, especially when you don’t know where to look. Most of the time it’s a combination of knowing what data to gather and collecting said data in its complete form.

Having analysed numbers for thousands of professional businesses, there are two high level KPIs that you need to focus on to drive performance within your business. These are Average Rate & Lock-up Percentage.

Continually focusing on these two numbers gives you the framework to drive improvement in profit and cash flow. Average Rate directly correlates to driving the profitability while Lock-up Percentage focuses on improving cash flow.

Average Rate

Average Rate is the calculation of revenue received over professional employee labour paid. This KPI tracks performance of individuals, teams, departments and the business as a whole.

At a very high level, this KPI tracks performance by incorporating productivity, write-offs and recoverability over direct labour costs. As this number increases, so does businesses profitability (margin).

Average Rate = Revenue / Paid hours of direct labour

Lock-up Percentage

Lock-up is a term that refers to revenue that hasn’t been billed or collected. Lock-up is a combination of unbilled revenue (WIP) and revenue that has been billed but not yet collected (debtors).

Lock-up Percentage is the rate once Lock-up is divided by annual revenue. This KPI is very important for cash flow. By tracking how many days revenue sits idle and its comparison to revenue as a whole, we can understand how we can release cash.

If you’re struggling to identify which KPIs are important for your business, more importantly if collecting said data in its complete form is also an issue, start tracking Average Rate & Lock-up Percentage. These two key KPIs will set your professional business on the right track.

 

Different Legal Firm Structures

There are many options available now for structuring legal practices.  These include:

  • Sole practitioners
  • Partnership of individuals
  • Partnership of discretionary trusts
  • Service entities
  • Companies

There are advantages and disadvantages for each structure, and the relevant choice, as always, is dependent on each principals’ and practice’s personal situation.

Since 2007, legal practices in Queensland have been able to incorporate.  Provided  there is compliance with the Legal Practitioners Act 2007, legal firms can now enjoy the same structuring advantages as most other businesses in Australia.

There are many advantages of incorporation, with the main ones being:

  • Succession
  • Asset Protection
  • Taxation
  • Cash flow management

Whilst any eligible legal practitioner can incorporate, the taxation benefits commonly considered to apply to all companies, may not apply to all practitioners.  It has long been understood that a company can retain business profits and be taxed at 30%, the company tax rate.  However, where the income is regarded as personal exertion income, this generally cannot be retained in the company and must be paid out to the principal.  A simple distinction between business profits and personal exertion income can be made by looking to who has earned the income.  Where there are at least the same number of principal and non-principal fee earners, on a full time equivalent basis, the profits are more likely to be regarded as business profits.  Whether a paralegal is considered to be a non-principal fee earner is a point for discussion.  My view is that they would not be considered a fee earner because they cannot provide legal advice as a legal practitioner.  So an incorporated legal practice where the principal is the sole fee earner with one or more paralegals and administration people will generally not be able to retain profits.  These profits would need to be paid out to the principal as wages and taxed at their marginal rates.

These rules are different to the personal services rules, and should not be confused with them.

One other issue that some firms don’t consider when they incorporate is the shift for cash to accrual in terms of the timing of when income is assessable.  For firms that were previously on a cash basis for bringing to account their income, when they incorporate they usually move to an accruals basis.  This means that the company (or principal if the company cannot retain profits) will pay tax on the income that has been invoiced, not received.  If when you sell your practice to a company, you do not sell the WIP and debtors, and you were on a cash basis, then during the next year the WIP and debtors will be collected on a cash basis in your name, but the company will be taxed on all invoices issued.  This can cause some cash flow issues if it is not adequately planned for.

If you’re considering setting up and Incorporated Legal Practice, make sure you seek advice to address all the issues that will impact on your decision.  Also be mindful of the significant advantages that incorporation provides and take a balanced view.