MCLE Article and Self-Assessment Test For What It's Worth
Recent California rules that allow the buying and selling of law practices have opened up opportunities for small firms and solo practitioners. By Edward Poll
Time-honored traditions in the legal profession die hard -- even when their demise is relatively quiet. Practitioners may not be aware that the decades-long prohibition against selling a law practice is changing, state by state. California took the lead in 1989 by permitting this type of sale,1 and other states have followed suit.2 The American Bar Association altered its opposition in 1991.3 With these actions, the legal profession continues to move toward recognizing the economic realities of modern professional life.
Some large-firm attorneys4 have bemoaned this latest example of the continuing commercialization of the legal profession. These very same attorneys, however, have always had mechanisms available that provide them (and their heirs) with funding for the value of their interests in their firms. The recent changes in attorney rules of conduct allow sole and small-firm practitioners the same opportunity to reap the rewards of years of effort building a reputation for delivering quality legal services. The ability of sole and small-firm practitioners to transfer, for value, their interest in their law practices levels the economic playing field for all segments of the legal profession. Now that all attorneys potentially can sell their practices, the true value of a practice, measured by the marketplace, can be determined.
Larger firms buffeted by mergers, retirements, or breakups know the drill for selling a law practice. By contrast, an increasing number of sole and small-firm practitioners have not only left the practice of law to do something else but simply closed their office doors one day and never returned. By doing so, these lawyers are forsaking the chance to cash in on a valuable asset that has taken time and hard work to build. The death of the old prohibitions should galvanize attorneys to salvage more from their decision to change their own lives.
It is not uncommon for an attorney to die without prior arrangements regarding his or her practice, with the expectation that the surviving spouse will mop up. Is there anything of value to be sold? Yes, there are the books in the library, the used computer equipment, the office furniture, and the like. There are also accounts receivable. But the decedent also left client files, and goodwill -- and both have value. Further, that value can now be recognized as a result of the changes in the California Rules of Professional Conduct.
So the right and ability to sell a practice is a sure thing. Lawyers may still be uncertain how to reach a determination of the value of the practice as well as the price to be paid or received for its sale. First and foremost, the long-standing paradigm of the value of a law firm must be changed. Attorneys must realize that their practices are valuable and that the value (not the practice) can be passed on to their heirs at the time of death.
There are two conceptual values that can be assigned to a law practice. "Book value" is calculated by subtracting liabilities from the sum total of the "historical" (or "book") value of hard or tangible assets (such as furniture and equipment), plus other assets such as accounts receivable, cash, and other liquid instruments. "Fair market value" requires the addition of goodwill and other intangible assets such as leasehold rights. Valuation, however, does not equal price. Price is determined by the amount a "willing and knowlegeable buyer" actually pays to acquire the law practice.
Most published opinions concerning the valuation of a law practice appear in the context of a marriage dissolution and can only be described as convoluted. One commentator has noted that in dissolution proceedings, "[a]ppraisal of a law firm is an intricate maze riddled with valuation rules and exceptions."5 A trial court judge said privately that he chooses the valuation most closely aligned with his perception of an equitable division of the family's wealth and the needs of the parties. In fact, according to another commentator, the valuation approach used in marital breakups "is not necessarily the approach that would be used for other valuation purposes ...[because in divorce] a distinction is drawn between past and future (post-divorce) earnings...[and thus the valuations] tend to be more narrowly focused."6
There are several approaches to law firm valuation in the context of a buy-sell transaction, but at least two commentators recommend the "capitalized excess earnings method"7 as the "most compatible with law firms" and the "most appropriate for valuing law firms."8 How does a practitioner apply the capitalized excess earnings method?
- First, calculate the law firm's average net income, before partner draws are deducted, for the past four or five years. Use an accrual-basis method of accounting, eliminating any unusual or nonrecurring expenditures. Review revenues for any nonrecurring items, such as proceeds from the sale of assets.
- Second, subtract a reasonable rate of return (say, 8 percent to 10 percent) based on the law firm's net tangible assets from the average net income. This amount reflects what the firm could have earned on the value of its tangible assets if that value had been invested for other purposes.
- Third, deduct partner compensation. This sum should reflect what the partners could earn as employees of a comparable law firm, or what the firm would have to pay to hire additional attorneys to replace the partners as employees. Salary surveys may be useful at this point.
- Fourth, capitalize the remaining amount to determine the value of the law firm's goodwill. The specific rate used may vary depending on individual circumstances, but a rate of 20 percent is reasonable.
- Fifth, add the value of the law firm's tangible assets to the goodwill. The total is the value of the law firm. (See "Calculating Value," page 42.)
Of course, not every practice has goodwill, or is even saleable. Some practices are so small and so personal in nature that, without a continuing involvement of the founding attorney, a successor attorney could not succeed in keeping the original clients. Also, if the valuation calculation does not show excess earnings -- perhaps the earnings are equal to or less than the compensation that the partners could earn elsewhere -- "then realistically the law practice does not have any goodwill."9
However, even rules of thumb have exceptions. Indeed, the smallest and most personal practices may be saleable for the right price and under the right terms. If the buying attorney were assured that he or she would receive a law practice with a certain volume of revenue or a certain client base that remained with the buying attorney for a designated period of time, a sale would be highly likely.
The question of value precedes only slightly the bottom-line question that every attorney wants answered: "How much can I get for my practice?" The price to be paid may be estimated by reference to financial data and certain marketplace guidelines. But no amount of analysis will determine the precise price a willing buyer and a willing seller will accept. That figure is subject to myriad factors such as terms of payment, geography, the nature of the practice, history of client retention, and size of the practice.
A key issue for the buyer is whether the buyer will retain the seller's practice. The seller can provide assurance for the buyer by creating an earnout or payout based on collections. The buyer will know that the payments for the sale will be made only after designated revenues are received. The selling attorney then has an incentive to help the buying attorney keep the ongoing clients. Of course, the selling attorney wants assurance that payments will be made in accord with the buying attorney's promises.
In other types of businesses, parties frequently find that it is easier to buy an ongoing operation rather than start a new one. The advantages of an existing business may parallel those of a law practice, but inevitable differences will emerge, primarily in the areas of ethics (the rights of clients and the transition process); negotiations (attorneys tend to negotiate their own deals rather than involve third-party experts such as brokers); and pricing protection (lawyer/buyers usually want more security than they would ever receive in a bargain for another enterprise).
California attorneys will find some ethical guidance in the Rules of Professional Conduct,10 which set forth requirements for transferring an interest in a law firm.11 In all cases:
- Fees charged to clients may not be increased solely as a result of the sale.
- Buyers must be licensed members of the State Bar, and confidential information cannot be disclosed to nonmembers.
- Purchasers or potential purchasers must insure that all of their activities comply with the conflicts-of-interest rules.12
California disclosure requirements are very specific. For example, the selling attorney must give written notice to clients no less than 90 days before the transfer that 1) the practice is being transferred to the purchaser; 2) the client has the right to retain other counsel; 3) the client may take possession of any client papers and property as required by Rule 3-700(D); and 4) the purchaser may act on behalf of the client until otherwise notified. While the selling attorney is required to "obtain the written consent of the client prior to the transfer," this consent is presumed until otherwise notified by the client if no response is received within the 90-day period.13
The rules are designed to protect clients with the knowledge that they can take their matters to new counsel. Despite this, however, most clients remain with the new attorney, especially when the selling attorney participates in the transition and assures clients that the new attorney is well qualified.
In California, selling attorneys have a limited right to split their practices upon sale. Rule 2-300 states that "all or substantially all..." of the practice may be sold. The discussion that accompanies Rule 2-300 states that "a member may retain one or two clients who have such a longstanding personal and professional relationship with the member that transfer of those clients' files is not feasible...,[but the rule] is not intended to authorize the sale of a law practice in a piecemeal fashion...."14
Does client confidentiality prevent discussion about specific clients or their matters? Rule 2-300(E) provides that "confidential information shall not be disclosed to a nonmember in connection with a sale under this rule." As a member of the bar, the buyer/attorney will be deemed to be acting in the stead of the retained attorney in the same manner as the retained attorney's staff.
Other issues must be considered that are not so clearcut. Does the buying attorney's existing errors-and-omissions insurance policy cover the new cases acquired from the selling attorney? Does the same policy cover the selling attorney for allegations of negligence made after the transfer of the files? What about the client who doesn't realize until after the transfer that the alleged negligence occurred? Is the selling attorney protected when the claim for the alleged negligence is filed after the expiration of the policy in effect at the time of the transfer?
The alleged malpractice might be the result of the selling attorney's own negligence that occurred before the sale of the law practice but was not known to the client until after the sale. What if the alleged negligence was committed by the buying attorney and the client is trying to use a large net to ensnare anyone with deep pockets? What choices for protection are available to the selling attorney?
Is the sale of a law practice equivalent to a referral for a fee -- a practice that is not allowed in many jurisdictions? Like the other questions, the answer remains unresolved.
State and local bar associations are becoming more sensitive to the needs and realities facing sole and small-firm practitioners. Ethics opinions that balance these conditions against legitimate concerns for client protection will benefit all parties.
The conflicts check is the last element before the actual transfer of ownership. In smaller communities, the possibility of conflicts of interest increases substantially. The parties may want to negotiate a modification in the price or terms of the sale in the event a conflict of interest does arise in one or more matters that would prevent the buying attorney from assuming representation. A potential conflict of interest could arise between the lawyer/seller's professional interest in seeing that the practice is purchased by the most competent buyer and the lawyer/seller's financial interest in securing the highest bidder, regardless of competence. In most instances, full disclosure can alleviate the potential for conflict.
Who are these sellers and buyers? The profile of a selling attorney is not that difficult to imagine. Among the likely possibilities include the attorney who has been in practice for a number of years and wants to retire, the attorney whose dreams about his or her practice have not been fulfilled, the attorney who has been elected or appointed to a judgeship, and the attorney whose family has decided to relocate to another geographic area.
Buyer candidates include lawyers practicing in larger firms who want to go out on their own. A law firm can grow and change so rapidly that an individual lawyer feels out of step with the new prevailing firm culture. Practice ownership is a way of retrieving the personal touch and the sense of total involvement that can reinvigorate the practice of law. Another group of potential buyers is the faithful servants who fail to make partner. Prospective buyers may include attorneys who failed to develop a personal client base and were terminated. As more attorneys find the partnership track in larger firms unattractive or unattainable, the option of law firm acquisition takes on luster.
The number of law school graduates buying practices is still small but growing. These graduates, especially those in the bottom 90 percent of their class who are finding that jobs are not as easy to find as in the 1980s, are not willing to shift careers without a gallant effort to succeed on their own. They are going to hang out their shingle one way or another and succeed by sheer determination. Successful newcomers abound in other professions such as medicine and accounting. Why should the legal profession be different?
Solo and small-firm practitioners make excellent buyer candidates. Many lawyers ready to start their own practices will buy an existing practice rather than start their own from scratch.
Buyers and sellers can spread the word about their intentions via a grapevine of business brokers, law firm management consultants, accountants, valuation firms, and appraisers. The Internet is potential writ large in this area.
The determination of whether to use a broker in the buying or selling of a law practice can be crucial. Most buyers and sellers of real estate act through agents. Most buyers and sellers of cars negotiate on their own. One difference is the size of the transaction. Another difference is the personal stake in the outcome. Potential car buyers may find it easier to walk away from obstinate sellers, but a house bears more of the parties' vision of their future and their status in the community. Independent third parties reduce the tension and the opportunity for last-minute changes of heart. Legal representation requires a personal engagement. Until there is agreement on the financial aspects of the transaction, it is advisable to keep the principals' contact with one another to a minimum.
The practice of law is the marriage of an honorable profession and a modern business enterprise. Attorneys can derive value from their years of toil -- and this value can be transferred, for the benefit of all concerned.
SIDEBAR: CALCULATING VALUE
The following is an example of how to calculate the capitalized excess earnings method
1) Take a law practice with annual average earnings of $500,000 before partner distribution or draws, net tangible assets of $100,000, and three partners who could each earn $90,000 as employees of another law firm.
Assuming a 20 percent capitalization rate, and an 8 percent investment rate of return, the goodwill value of such a firm would be calculated as follows:
- Subtract from the average net earnings of $500,000 an investment return on the net tangible assets ($100,000 x 8 percent, or $8,000), resulting in adjusted earnings of $492,000.
- Subtract from this adjusted earnings figure the sum of $270,000 -- the compensation that the partners could earn as employees ($90,000 x 3, or $270,000). The resulting excess earnings to be capitalized is $222,000 ($492,000 minus $270,000).
- Divide $222,000 by an appropriate capitalization rate (say, 20 percent) to find the value of the firm's goodwill -- $1,110,000.
2) Add the value of the firm's tangible assets ($100,000) to the goodwill value ($1,110,000).
The total value of the firm is $1,210,000, or $403,333 per partner.
Source: M. Kline, Firm Valuation: Picking the Appropriate Formula, National Law Journal, Jan. 15, 1990, at 15.
1. Cal. Rules of Professional Conduct, Rule 2-300 (adopted Nov. 28, 1988; effective May 27, 1989; amended effective Aug. 13, 1992). Prior to the adoption of Rule 2-300, California deemed that a contract for the sale of a law practice was against public policy. Geffen v. Moss, 53 Cal. App. 3d 215, 125 Cal. Rptr. 687 (1975). See generally Annot., Validity of Contract for Sale of "Good Will" of Law Practice, 79 A.L.R. 3d 1243 (1977).
2. Those states that allow the sale of a law practice include Alaska, Florida, Hawaii, Iowa, Michigan, Minnesota, Missouri, New Jersey, New York, Oklahoma, Oregon, and Wisconsin, as well as the U.S. Virgin Islands. Many other states have similar proposals on the table for consideration. The most recent state to join the fold is New York. The State of Washington recently approved an ethics opinion holding that a new rule is unnecessary because the sale of a law practice is not prohibited by the current rules.
3. The American Bar Association adopted Model Rule 1-17, permitting the sale of a law practice, at its Feb. 1991 midyear meeting in Los Angeles.
4. See Sol Linowitz & Martin Mayer, Betrayed Profession, Lawyering at the End of the 20th Century (Scribner, 1994).
5. J. Hempstead, Putting a Value on a Law Practice, 7 Family Advocate 14, 19 (Summer 1984).
6. M. Kline, Firm Valuation: Picking The Appropriate Formula, National Law Journal, Jan. 15, 1990, at 15 [hereinafter Kline].
7. G. Coy, Permitting the Sale of a Law Practice: Furthering the Interests of Both Attorneys and Their Clients, 22 Hofstra L. Rev. 969, 984 (1994) [hereinafter Coy]. Other valuation methods include the capitalized earnings approach, the discounted cash flow or discounted future earnings approach, the fair market value of assets approach, the price/earnings method, and the capitalized dividends approach. In law firm valuations, each approach has particular strengths and weaknesses -- and it may be possible to use several methods in combination in specific circumstances. See Kline, supra note 6.
8. See Kline, supra note 6; Coy, supra note 7.
9. See Kline, supra note 6. For a complete discussion of calculating the value of a law practice, see Poll, The Tool Kit for Buying and Selling a Law Practice (ABA, 1996).
10. See, e.g., Rule 2-300 of the Cal. Rules of Professional Conduct. See also similar rules governing the sale of a law practice in each of the 15 jurisdictions currently with such rules.
11. See also Cal. Rules of Professional Conduct, Rules 3-310 and 3-600 (conflicts of interest) and Rule 3-110 (competency to handle matters for clients); Bus. & Prof.. Code §6068(e) (maintaining client confidentiality); Bus. & Prof. Code ¤¤6157-6159 (advertising).
12. See Cal. Rules of Professional Conduct, Rule 2-300(A), (D), (E).
13. See Cal. Rules of Professional Conduct, Rule 2-300(B)(2)(a-b). If the selling attorney is deceased or has a conservator or other person acting in a representative capacity, then the notice provisions must be followed by the purchasing attorney. Rule 2-300(B)(1)(a-b).
14. Compare Wisconsin Rule SCR 20:1-17: "(b) [t]he practice is sold as an entirety to another lawyer or law firm...." In addition, Model Rule 1.17(b) of the ABA Model Rules requires that the entire practice be sold to a single buyer.
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