It doesn’t matter if you’re a sole practitioner or a partner in a multi-principal firm, the fundamentals for growing value are the same.
Whether you’re currently planning for succession, a merger or acquisition, restructuring, debt funding, or would just like to know what your firm might be worth.
Watch this Grow Your Law Firm Webinar, to gain an insight into the value of the business which you have been investing all of your time and efforts in. We’ll explore the drivers that impact a law firms’ value and discuss strategies to increase this value.
Hello everybody and welcome to this month’s grow your law firm webinar. Sorry, I was just running a couple of minutes behind but we’re ready to go now, so welcome.
My name’s Matt Schlyder, I’m the Principal of FWO Chartered Accountants. We are the Lawyers’ Accountants and work with legal firms throughout the east coast of Australia on strategies to help them improve their profit and cash flow, as well as acting as their accountants. Today’s topic that we’re going to be talking about is understanding your firm’s true value.
Over the years, I’ve done a lot of different things with legal firms. Some of that is strategic planning that is around driving profitability and cash flow improvements. Some of it’s in relation to succession strategy. Some of it’s in relation to funding and some of it’s just in relation to their own personal financial strategies.
What never ceases to amaze me is the view that most principals of firms have in relation to the value of their businesses, firstly in terms of understanding how their value is calculated and secondly, in their own minds, undervaluing what it’s really worth.
Often, they say that their firm isn’t valued or has no value, which is not consistent to what happens with transactions, particularly when principals buy into firms or where there are acquisitions being made. This value is important for a lender looking at how to prescribe a value to a firm that they’re going to effectively lend against.
So, my goal for today is to give you a little bit of an insight into understanding how your firm is valued and some very simple areas to focus on so that you can implement actions in your firm to drive an increase in that value.
At FWO Chartered Accountants, FWO stands for financially well organised. Part of that whole strategic business and personal planning that we support our clients with is relying on principals of firms realising the capital value of their firm upon retirement or prior to retirement and succession.
This is where principals of firms dedicate their life to generating their income and then hopefully building an asset that somebody will pay for. So, it’s a critical issue that you really need to be thinking about not just in terms of making sure you’re generating enough profits as you’re going along, but you really want to implement strategies in your firm so that you maximise that full value.
So, an essential part of your overall financially well organised strategy needs to be focusing on your business strategy. The ultimate measure of the success of your business strategy is the value of your business.
Let’s hop into it. Why would you consider a value for your business? So, as I mentioned just before, one might be succession. So, you’ve got some new principal or principals looking to acquire an interest in the practice, and so that’s often the first time where principals start to consider value.
Now they look at it and go: ‘what’s it really worth?’ or ‘how much am I going to require them to pay me for it?’. Often when I get involved with firms around their succession strategies, we need to actually step back and have a look at the fundamentals of the business and say, ‘well look, this is what this business is worth’. If you bring in a new principal, then there’s part of that revenue and that profit that you’re no longer going to receive. So, you’re actually foregoing income and there’s a capital value to it. What is that value?
Other times, when firms are looking at acquisitions from an acquisition perspective, you really want to be making sure that the vendor hasn’t got a really good picture of a value, because it might mean that you get to acquire it at a cheaper value.
But you also need to consider the flow on effect of you acquiring a business and then what impact that has on your overall value, because often the profitability that is projected by the vendor firm is going to be a different profitability when it comes to your firm. Maybe that’s because of changes in revenue, but you might have an upside in that, not just a downside.
That may be that the vendor firm may significantly under price, so you might be able to get some really strong economies of scale with structuring your administration or structuring reducing rents or whatever it might be. But at the end of the day, by you acquiring that practice, you’re paying a dollar value for it. And you want to be able to turn that dollar value into a higher value, be it straight away or even in a short period of time after that acquisition.
So, we’ll talk a little bit today about how valuation methodologies work and how by simple strategies, you can you can go about increasing your value even higher for an acquisition.
Funding’s a very interesting one because often firms don’t understand their value when it comes to going to a bank and asking them for some money. That money might be to fund a succession strategy, or it might be to fund the acquisition strategy, or it might simply be to fund an internal growth strategy in the business.
I’ve had plenty of clients over the years that have undertaken new areas of law for growth strategies in those areas, with law requiring significant investment in working progress and sometimes unbilled disbursements.
So, you may be going to the bank and saying ‘we need money to fund that’ because you can only fund it out of debt or out of equity. The bank needs to have a good understanding of what the mechanics are of that business and what the profitability of the business is, including answering questions like:
- How does this business work?
- Why would we lend money?
- Are we comfortable that this firm is going to be able to repay it?
By their very nature of how they make money, banks lend. But to lend money, they must be clear on security that’s provided.
Banks will lend you money based on the security of your practice to support that debt. So, the bank, in their very activity of lending money, assess how secure it is. Security therefore equates to value. So, the banks by lending money are saying to you that your business is worth something. It has a value. And then as I said a bit earlier, often value is considered as part of that personal financial plan.
As you’re going along in your practice, whether you’re a sole practitioner or a multi-principal firm, you’re going to be diverting your cash that you receive from profits at some point in time for building your own personal wealth. But if you focus on your business as one of your major assets, you can achieve capital growth in your business at a much faster and much more controlled rate than what you can from any other passive investments.
So, with good structuring comes good profitability growth. With the driving actions in your business that make the predictability of that profit more likely, you can effectively increase that value of your business. It’s also a pretty cool way of growing your personal wealth.
Providing small business CGT concessions apply to you when you sell it, you can, providing all those provisions apply, effectively get your whole capital value of the business out of it by selling it and not paying any tax on it. So, it’s a pretty big incentive from a planning perspective. So, there are some issues or some reasons why you might consider value. Now let’s have a look at what it is that really impacts on the value of your firm.
There’s only two fundamental drivers of value and it doesn’t matter what methodologies are used by valuers or yourself. At the end of the day, the price that a willing purchaser will pay to a willing but not anxious vendor always comes back down to these two key components of valuation and the first one is profit: What is the amount of the profit that this business makes?
If a business doesn’t make any profit then nobody is going to pay you anything for it, usually. There might be reasons why they would. But basically, if you’re not making any profit or your profit’s marginal, then there’s no basis or there’s no real return that anybody is going to receive for buying that from you.
Profitability is, from a valuation perspective, generally based on EBIT (after principals’ salary) so earnings before interest and tax and what your profit is, but after factoring in commercial salaries for the principal.
So, if those principals don’t receive salaries, then you’ve got to work out what that commercial salary should be, because those commercial salaries need to come into play in calculating how much profit an investor would make after paying somebody a salary that they could otherwise earn.
This is true whether it’s another legal firm that’s buying it or whether or not you’ve got it for succession purposes. But at the end of the day, profitability is your key number one starting point in assessing your value and the reason for that is because it is a return.
So, if you want to drive your value up, you’re going to drive your profit up. So, the higher the profit, the greater the impact that has on your value. The second thing is business risk and I describe business risk as the probability of returning the same or better profit and cash flow.
Business risk takes into account all those things that determine and create your profitability and your cash flow. And so, the lower the business risk, the higher the valuation because somebody will be willing to pay a high price.
If there is a much higher probability that profit and cash flow would be returned after purchase, there’s also a whole bunch of things that impact on business risk, such as the reliance of the principal to bring in that profit and to find those new clients, as well as to manage the business day to day. There’s also the amount of working capital that’s required in the business, so the higher the funding required for the business, generally the lower the profitability. The better the cash flow, the lower the risk and the higher the value.
Also, what are the systems and processes that are within the business that can mitigate risk? These might be from a production perspective, the quality assurance processes and the strong legal management systems that are in the business. These can also include supervision systems, the spread of a number of principals, and the different areas of law. There’s a whole range of different things that impact on that business risk that I’m going to run through shortly with you.
You can implement a couple of the key drivers that I see around business risk, reducing your business risk and increasing your profitability. And in doing so, you will increase your value.
So, let’s understand the formula then.
The two drivers are profitability and business risk. We apply them to a valuation formula, we take out EBIT (after principals’ salaries) and we multiply that by an earnings multiple. So, the higher the ratings multiple, the lower the business risk. That gives you your business value.
At the end of the session today, I’m going to take you through some of these numbers to explain it. But let’s say just for a really simple example, you’ve got a profit after principal salary of one hundred thousand dollars and that hundred thousand dollars is very reliant on that principal being there.
So, the risk is high in the business, meaning they might only have a one or two times earnings multiple, which would then give the business a value of somewhere between 100 and 200 thousand dollars.
But let’s say that the one hundred thousand dollars is made regardless of whether or not that principal is at work. This is because of some strong systems that they’ve set up or where that work comes from. It might be because of a good advertising marketing strategy that isn’t reliant on the principal, so that somebody could come in and pick it up and run it. Then that earnings multiple might be two to three times, rather than one to two times.
So, you can see just from that strategy that a lower business risk might mean that a firm valued on a profit of one hundred thousand dollars may be worth two hundred to three hundred thousand dollars in comparison to one hundred to two hundred.
That’s a very high-level example, but you can also take away from that. If you increase that profit from one hundred thousand dollars to two hundred thousand and you increase the earnings multiple from say one and a half times to three and a half times, you’re going to, by implementation of strategies to reduce business risk, significantly increase your business value. I’ll show you an example of that shortly.
So that’s the formula.
So, coming back at that, we’re going to look at the strategies you need to implement in your business to drive improved profitability. What are the strategies you’ve got to implement in your business to reduce business risk? Then you can increase your earnings multiple so that you increase your business’s value. It’s just a bit of a summary of the earnings multiple scenario.
The likelihood of earnings models is based on the likelihood of the net profit and net cash recurring. If there is a higher risk in the business, there’s a lower probability that those profits and cash flow will recur.
Generally, we see valuation earnings multiples of between one to two times that profit. Medium risk is generally about three times. As a rule of thumb, I value business at three times its profit for a lower risk business, where they’ve got good strong systems, good non-total reliance on principals for generating revenue and a range of other strategies in that business that bring the risk down. Those low risk businesses can attract four times or even higher depending on who the purchasers are. But generally, I’d say you need a low risk for you to attract an earnings multiple of at least four times. So, there’s just a bit of a spread to show you between high risk to low risk and what those earnings multiples might be.
Let’s have a look at some key drivers to profitability. These are the areas of your business that you really need to be focusing in on so that you can improve your profitability.
The first thing is the right ratio of labour costs to revenue.
What I see in most firms is that they have a very high ratio of labour costs. They carry too much labour cost in the business for the amount of revenue that they generate. So, it’s getting that ratio right.
The lower the labour costs and the higher the revenue, the greater the profitability. Therefore, more of that revenue that you generate is going to drop down to the bottom line and increase the profitability of the firm. So, you’ve got to really think about that. How much labour can we afford to pay for the revenue that we need to produce and increase our profit?
So, in driving profitability up, there’s only one of three things that you can do. One of them is to increase your revenue, the second is to reduce costs and the third is to do a mixture of both.
I’d suggest in most firms that it’s usually the latter. It’s a mixture of both. They generally need to change some of their processes in their business, so they do not require as much labour, so the business isn’t as inefficient as it currently is.
But also, there’s usually a massive gap between what they should be billing out in revenue and what they currently are. This could be due to the timing of billing perspective or a pricing issue, or a whole bunch of stuff.
But to start with, your biggest variable that you need to be focusing on is that ratio between labour cost and revenue. The second thing is the solicitor to legal support ratio.
Businesses where there is a very low ratio of legal support people, what I’m talking about is paralegals and legal secretaries, the lower that, generally the higher the value. Now that will be because the solicitors are being efficient.
The solicitors will be utilising their time and utilising technology to support and produce that revenue. I’ve seen firms where there is a high legal support ratio cost. It’s not always the case, but where there’s usually a high legal support cost and headcount to solicitor headcount, those firms generally are inefficient because they don’t actually recover this cost in their revenue model.
So, what drives that labour cost up as a percentage of revenue and puts pressure on the profitability of the business? Firms these days are running a lot leaner in that legal support ratio. Some of that can be just purely from a cost perspective, sometimes with a bit of outsourcing. But often it’s just in terms of the requirement of solicitors and the principals to be a lot more self-sufficient in what they do and embrace technology to support that.
So, getting that ratio right can have a significant impact on your profitability. What was mentioned before, pricing is also a big one. My experience is that most firms leave 15 to 20 percent of the profit that they could earn on the table because they don’t price properly, and they take their own view. They believe their own line that the clients are price sensitive.
Now that’s a completely different topic and if you wanted to visit my website, FWOCA.com.au and see some of the past webinars I have addressed that topic a couple of times and I will be looking at it again in future. But, the clients aren’t price sensitive; clients actually don’t really know what they’re buying from you.
Even from the point of view of a client, the majority of revenue that’s generated in most firms comes from advice and advice pricing is totally determined by you. It’s about having a position that ensures that the work you do is appropriately priced and does end up in a bill that produces that better margin. So, one way of just driving profitability off the same labour cost is to price what you do appropriately and get paid for the work that you’re doing: the value you add and the outcomes that you produce for your clients.
Another big one is WIP conversion. So, measuring profitability generally is done on a billing basis, not on whether or not you put that time to WIP. But the faster you can convert to WIP, the higher the amount of revenue that you generate and the better the amount of cash flow that comes.
So, the more WIP that you can convert into billings, the higher the revenue and the better your profitability. So, those firms have got really good systems and structures around time recording and billing policy. They often generate greater profitability not because they are busier, but just because they bring their revenue to account at the earliest possible time with good structures and good systems. So, there’s some simple strategies to focus on in terms of your driving profitability up.
So, focus on your labour cost and consider your capacity that you should be generating revenue out of that labour cost, and then make sure that it happens. Look at your legal support to solicitor ratios. Make sure you price things properly and get paid for the work that you should be getting. To do that, you should be getting paid and convert your WIP. Driving your profitability up has an automatic positive increase on your profitability.
The next thing we’re going to have a bit of a chat about is looking at what the drivers are for reducing business risk. Delegated decision making would probably be one of the main drivers in most practices.
So if you’re a principal of a firm, be it a sole practitioner or multiple principal firm where the principals have to be in charge of all the decisions that are getting made in that business, either individually or collectively as a group, then that business is very reliant on that principal or those principals for driving its profitability and growth and for its day to day operation.
The more reliant the business is on the principals of the firm, the higher the risk that the profitability and cash flow won’t recur if you are selling. So, if you get good decision making structures in your business where you’ve got other people implementing strategies and making decisions so that the business can operate effectively with or without the principal being there, and you can therefore demonstrate that those profits and cash flows will continue to recur, then somebody is going to be much more comfortable to pay a higher price because the risk is significantly reduced.
So, just think about that in your firms and think about delegated decision making in your firm.
Not delegating decisions can hold you back and I can tell you that most decisions that need to be made in the business don’t need to be made by a principal. The biggest challenge for principals is letting go and focusing on what they should be doing. That is developing new strategy, doing the right type of legal work, building relationships with clients and finding new clients.
The second thing is very strong financial management systems. So, if you are a purchaser of a business and you go in and the business’s financial management systems are a mess, you’re not going to have a great deal of reliance on the data that’s being produced.
So, there’s a direct correlation between the strength of good financial management systems and the value of a business because a good financial management system in a business indicates that there are the right checks and balances within that business, and particularly around these three areas: billing, cash flow and reporting.
Billing is a core part of a financial management system. Focus on the policies from processes that are requiring client engagement and timing of billing and entry of WIP and billing of WIP, because the more structured that is, the more confidence you would have that a practice is going to produce those revenues year in and year out. And the more managed it is, the tighter that it’s managed and the more accurate the data, you can produce an informed outcome for both the existing principal but also for any purchaser.
It’s the same with cash flow. The tighter the cash flow system, so that the business maximises its cash flow, the better the outcome is going to be from a value perspective.
So, focus on the financial management systems and who manages those systems. The worst managers of billing and cash flow generally are solicitors because they’re too focused on actually doing all of the work and dealing with the clients. The administration part of billing and cash flow isn’t high on their priority. It might be for principals, but where you’ve got delegated responsibility down to people who have no real financial management skills in business, and there is discretion that is given to them around how and when they do that, there’s no way that you could manage a highly efficient structured business from a cash flow perspective.
So, getting strong financial management systems in your business around billing and cash flow is critical. Good reporting systems indicate a business that is well managed. If there is not good, strong and accurate reporting, businesses would be just flying blind.
So, if you’re a purchaser of a business for whatever reason, whether you are acquiring an interest in a firm or you’re buying another firm or you’re selling entirely out of your business, if you can provide good strong reporting mechanisms where everything is accurate, it’s going to give a massive amount of confidence to any purchaser in terms of their attitude to the risk in the business.
Next thing is probably more important than both the delegated decision making and the strong financial management system: a proactive revenue growth strategy. What happens with most firms is they are totally reactive to their revenue strategies. What I mean by that is they’re totally reliant on the client contacting them to say ‘I’ve got a need, can you help me out with that?’
So, proactive revenue growth strategies focus on really strong product marketing and sales activities in the business. The stronger they are and the tighter they are, the more revenue that gets generated from structured strategies around driving revenue.
This makes it more likely that there will be a lower risk in the business because it means that those enquiries that come from your marketing strategies are not reliant on a single principal to go out and build relationships to find them.
The more enquiries that you can get coming into the business for the type of work that you want to have and the type of work that you want to do, the more you can maximise the revenue per matter that you generate out of this.
That’s not driven by a principal to sit there and think about what the market is. It’s driven by a strong marketing strategy and strong marketing tactics around really defined product offerings. This means that the risk of your profitability continuing will be a low risk business.
Look at those three key areas, making sure decisions are delegated in your business, have strong financial management systems, then have a proactive revenue growth strategy within your business that isn’t reliant on relationships of principals with clients and others.
In your referral network, you’re going to reduce that business risk and therefore increase the value of your firm. So, I’m just going to give you some numbers around that, so that you can put some meat to those bones.
I’m just going to show a simple little scenario here on the screen which shows this particular firm had total matters for a year of eight hundred and forty-six. So, it’s a very high volume, low average matter value of billing nine hundred and forty-one thousand dollars for the year. There’s then two hundred eighty-two thousand dollars’ worth of labour costs, which gives them the gross profit of six fifty-nine. There are other overheads worth three hundred and thirty-five thousand, and then that produces a net profit before principal salary of three hundred and twenty-four thousand.
Let’s say the principal salary in this business was one hundred and twenty-five thousand dollars and there’s two principals. This business is also very reliant on those principals for generating and running the business. So, it has a lower earnings multiple of two times. This makes the business value one hundred and forty-eight thousand dollars. Now that’s simply calculated by taking three hundred and twenty-four thousand, taking off two hundred fifty thousand dollars for principal salaries, and multiplying that by two times.
So, let’s have a look at what a dollar impact on value would be by increasing the profitability of the business.
So, let’s say we have a very strong marketing strategy where we’re increasing the number of matters for the business by 10 percent. So, we’re going to get those matter numbers up from a hundred and forty-six to nine hundred and thirty-one. But the business didn’t do any real marketing at all.
So, the 846 matters were opened and worked on in that year just came simply by reactive revenue. We’re going to implement a strategy that’s going to focus on particular revenue strategies of the type of work that we want to be doing. And generally, they would want to be of a higher average net value. So, what that does is just add an extra 10 percent of matters, which is what about 80 or 90 matters.
It increases the revenue at that same average matter value up to 1.835 million. So, about another ninety thousand dollars. But what you’re also going to do is you’re going to take stock that you’ve been pricing way too low for way too long and you’re going to reprice your base pricing for doing your standard work you generally do. That doesn’t just mean you’re going to up your interest charge rates.
It might be that you’re going to say ‘well we are actually going to define the work that we do and we’re going to set minimum pricing standards, so we’re going to take away discretion around how people are going to price. We’re also going to get an uplift in our average matter value just from the work that we’re currently doing. But we’re also going to focus with our proactive marketing strategy and a proactive revenue strategy. We’re going to target higher average matter values for doing a specific type of work’. So, let’s just say we got an increase of 15 percent in our average sale. So, in that case, our average net of value is going up by about one hundred seventy dollars per matter. It produces an average matter value therefore of 1.828.
Just with an increase in the matter numbers and getting a higher average amount of value per matter in a very structured and organised way and not just leaving it up to chance, it produces about an extra two hundred and fifty thousand dollars’ worth of profitability.
What we’re also going to do is implement some strategies that are going to drop out direct labour costs by about thirty-five thousand dollars because we’re going to restructure how we do things. We have been carrying these extra legal support labour costs for way too long. We’re going to use some technology, or we’re going to just bite the bullet and slice some costs so that we can produce more revenue from a lower cost structure.
So, we’re going to drop 35,000 dollars out of there. That combination of activities has the impact of improving our gross profit, which is our revenue minus our direct labour costs from six hundred fifty-nine thousand to nine hundred and forty-three thousand.
So, we’ve just got a number of additional matters, but not a huge number. We’ve got a 15 percent increase in our average value per matter, which is less than one hundred seventy dollars per matter, and we’ve saved ourselves thirty-five thousand dollars in labour cost. But we’re also going to then focus on some of these new strategies.
It could cost us maybe twenty thousand dollars to implement some of these strategies, but as an outcome, our net profit before principal salaries has increased to a five hundred eighty-eight thousand dollars.
Having some marginal increases in each of these areas means our profitability is then grown from three twenty-four to five eighty-eight. And even if we didn’t change our earnings multiple, that then has the impact of increasing our business’s value to six hundred seventy-seven thousand.
But we’ve implemented these strategies and they have reduced the risk in the business because we’ve tightened up our cash flows and strategies by better billing, better cash collection and better engagement. We’ve also got proactive revenue systems that increases our earnings multiple by three times, then the net value of our businesses has gone from one hundred forty-eight thousand dollars up to over a million dollars.
If the systems were so strong that it reduced the business risk even further and its 3.5 times multiplied, it brings it up to 1,185. But let’s just leave it at three.
So hopefully that just gives you a little bit of a demonstration there about how small changes in the significant drivers of profitability and business risk can have a big impact on the business, even if we go lower than that.
Let’s say that we only had a 5 percent increase in matter values and a 5 percent increase in our average sale. We still got off thirty-five thousand dollars and we still added twenty thousand dollars of extra cost at a three times multiple. We still get a good increase in value to 556 at a two times multiple. We more than doubled the value of our business with minimal changes in our core drivers.
So, that just gives you a little bit of an indication around if you sit back and plan about how your revenue is going to be determined based on structures and a number of matters in your pricing policy, then you can go and build from these strategies to reduce the business risk in your business.
This can have a significant impact on the value of what your business is worth. So hopefully that has given you a little bit of an insight into what drives value in your business and what things that you can implement in your business to produce a greater value.
Well, I want to leave you with this thought. If you’ve got a business that produces really good profits and can produce those profits with a lower amount of reliance on a principal for generating those profits, then you will always find somebody to purchase that business. It just comes down to what price they’re willing to pay.
So, as always with my growing law firm webinars I run, if you’d like to have a discussion with me on the value of your practice or on the strategic direction of your business with a focus on looking at the strategies and activities and actions in your business to drive an improvement in that value, just send an email to email@example.com.
For the first five people to e-mail me today, we’ll schedule a free 45-minute conversation. I’ll get a bit of data from you and then we’ll have a bit of a chat about your business and talk about some of those strategies you can implement in your business to improve your position and to get you financially well-organised.
So, thank you for your attendance. My name’s Matt Schlyder of the Lawyers’ Accountants from FWO Chartered Accountants, please watch out for future webinars. We’ll be running another one in November before Christmas and then probably have a break until February. We’ll say maybe one in December.
But thank you for your attendance today. Send me an email if you’d like to chat about your firm and we’ll see you next time. Thank you.