HOW TO VALUE YOUR LAW FIRM

INSURANCE FOR PRINCIPALS

FWO GROWTH CLUB

EFFICIENCY - WHAT DOES IT REALLY MEAN

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The traditional way of valuing a practice that is considered to have

an ongoing future is to apply a multiple to its future maintainable

annual profit (FMP). This valuation method is commonly known as the

Capitalization of Earnings Method. There are other valuation methods

but this is the most common one used.

The Value Equation is:

Practice Value = Multiple x FMPThe multiple used in determining the value of the practice is a reflection

of the perceived risk in owning and operating the practice and

generating a profit. The multiple is the inverse of a required rate of

return of a prospective purchaser.

We have all heard the term “high risk, high return; low risk, low return”

What that means is that if an investment is considered to be a high

risk, the investor is looking for a higher return to accommodate taking a

higher risk with their money. Conversely, if an investment is considered

to be a low risk, an investor will accept a lower return in taking a lower

risk with their money.

In other words an investor or prospective purchaser will pay less money

for a riskier practice.

To illustrate how this works, say we have Practice A and Practice B that

both have an annual net profit of $1,000,000. However, Practice A is in

an industry and is managed and operated in a way that has far more

risk variables attached to generating revenue that could negatively

impact on sustaining and growing that profit in the future compared to

Practice B.

The prospective purchaser of Practice A wants a required rate of 50%

per annum to accommodate taking a higher risk on acquiring the

practice.

The prospective purchaser of Practice B will accept a lower rate

of return of 25% per annum in taking a lower risk on acquiring the

practice.

The Value of a Law FirmA law firm is like any other business, it generates income and incurs expenses and its net profit in any period is the excess of income over expenses.

Michael Ward Partner FWO Chartered Accountants

For a 50% pa return on a $1,000,000 net profit practice, the prospective

purchaser of Practice A will pay $2,000,000 which is a multiple of 2

times the net profit.

For a 25% pa return on a $1,000,000 net profit practice, the prospective

purchaser of Practice B will pay $4,000,000 which is a multiple of 4

times the net profit.

On the surface we have two practices making the same profit but

one is more valuable than the other because they have taken steps to

minimise the risk of not achieving and sustaining current profitability.

So what this means is:

• The Higher the Risk, the Higher the Required Return

The Lower the Multiple = Lower Practice Value

• The Lower the Risk, the Lower the Required Return,

The Higher the Multiple = Higher Practice Value

Going back to the Value Equation, the other component to multiply is

the future maintainable profit (FMP).

In valuing practices, the FMP is often determined by referring to recent

years results and adjusting for abnormal, non-recurring and unique

to current owners’ income and expense items as well as commercial

remuneration for working owners, as a predictor of future maintainable

profit of the practice.

A law firm that can demonstrate that it has systems and processes

in place to control and quantify its recurring and proactive revenue is

always going to be valued higher than a firm that just relies on reactive

revenue and the charging hours revenue model.

This is because they will be able to demonstrate to a prospective

purchaser that there is less risk to them being able to sustain and grow

future profitability because of the systems and processes in place to

generate recurring and proactive revenue and place less reliance on

An investor or prospective purchaser will pay less money for a riskier business

Greater Risk50% Rate of Return

Lower Risk 25% Rate of Return

Practice A Practice B

Practice Value $2,000,000

Practice Value $4,000,000

reactive revenue.

A law firm that has a focus and defined systems and processes in the

following areas is going to provide more confidence to a prospective

purchaser of their ability to sustain and grow profit:

Product: What you sell

Marketing: What you do to tell your clients and prospective clients what

you do and help them learn what they need.

Sales: What you do so that your client agrees to buy from you.

Production & Delivery: What you do to do the work, finish the work and

deliver it to your client.

Client Relationship Management: What you do to make sure your clients

keep coming back to buy from you again and again.

With more confidence, a prospective purchaser will assess less risk and

require a lower return and will apply a higher multiple and pay a higher

price for your law firm.

So if you want to maximise the value of your law firm start implementing

systems and processes that are focused on building recurring and

proactive revenue streams and you will soon attract the attention and

confidence of prospective purchasers to pay a higher price for your

firm.

The Key to Maximising Value

Maximise Profit

Minimise the Risk of not being able to sustain and grow the future profits of the firm

The Value of a Law Firm

FWO Growth ClubIn Australia 95.6% of private firms operating are 1-4 partner practices.

How is your firm positioned in this highly competitive market? What are you doing to stand out?

Most practitioners are too busy doing the work and running the day-to-day activities in their practices to think about strategy. Moreover, they rarely take regular time out to reflect on their practice and develop and implement actions that will drive improvement in PROFITABILITY and CASH FLOW.

The FWO Growth Club is an exclusive club for like-minded practitioners in the 1-4 partner practice space.

The FWO Growth Club is exclusive because:

1. Only 5 of these clubs will be run over the next 12 months with each group being limited to 10 non-competing (by location) legal firms in Brisbane, Sydney and Melbourne.

2. You and your firm will need to have a desire for growth in profitability and cash flow.

3. You will receive an insight into other firms, how they work, their ideas, strategies and actions.

4. Try something different and contact Matt Schlyder today...

To register your interest in the FWO Growth Club please email us and we will be in contact with you to discuss in more detail. REGISTER HERE

We all hope for an accumulation of wealth after a lifetime of hard work

and diligent saving.

For many principals of legal practices, their wealth is tied up in the

practice and we need to protect this valuable asset.

Few principals plan for the outcomes their practice would endure in

the event of death or disability, or the death or disability to their fellow

principals or business partners.

Two of the most important questions that need to be answered for

principals are:

1. In the event of death or disability, who will pay for the principals

share of the business?

2. Who do the principals want to follow in their footsteps?

A succession plan will help answer these questions and more

importantly provide actions to deliver the desired outcomes. A

succession plan increases the likelihood of survival of a practice when

the principal chooses to leave on a voluntary basis, or involvement is

sadly terminated by death or disability.

A succession plan aims to ensure that when involvement in the practice

ceases for any reason, the departing principals or family receive

adequate value for the practice. This protects the wealth that principals

accumulate in their working life.

All practices have points of vulnerability which can materialise at a

point of stress such as death or disability. Successful practices are not

exempt from risk of destructions by a principal’s death or disability.

In fact, the destruction of wealth following the death or disability of a

principal of a successful practice may be greater than the destruction

which would arise in the less successful practice. There is more at

stake in the successful practice.

The main items that will contribute to the vulnerability of a practice

include the following:

Insurance for Principals

Tim Ward Finanical Adviser FWO Chartered Accountants

As a principal of a law firm, you mitigate risks for your clients on a daily basis but do you do this with your future in mind? Understanding how to ensure you’re protected as part of a partnership is essential when involved in a legal practice.

• Loss of revenue in the period following a principal’s death or

disability.

• Additional cash flow pressures caused by creditors such as

suppliers who perceive a credit risk following a principal’s death or

disability.

• Foreclosure on a bank loan by a bank nervous to protect the

amounts advanced by pursuant to an overdraft facility.

• Stress between deceased principal’s family and the surviving

principals over the future direction of the practice.

There are a number of simple strategies and solutions which can be put

in place to reduce or eradicate these risks. For example, an insurance

policy on the life of a key principal can be arranged so that in the event

of the principal’s death, this policy will provide an amount equal to the

bank loan. This provides a source of funds to repay bank debt and also

to discharge personal guarantees given to the bank.

The risk of death and disability confronts everyone, and principals

of a legal practice have special needs in this area. It is important to

address these risks before it is too late. We can never have adequate

compensation for human life. However, we are able through appropriate

risk mitigation strategies to prevent the loss of wealth and destruction

of lifestyle which often accompanies the death and disability. This gives

bereaved families the opportunity to grieve without financial pressures

and surviving principals of the firm the opportunity to plan for the future.

The risk of death and disability confronts everyone, and principals of a legal practice have special needs in this area. It is important to address these risks before it is too late.

Most firms that I visit are inefficient. Yes, they do their client work in

a way that gets it done as quickly as they can, with the best outcome

they can for their client. In my world, efficiency isn’t measured by the

speed and accuracy of work. That’s one definition, but when I refer to

EFFICIENCY, I mean the utilisation of the hours a firm actually pays for

in fee-earner labour by generating revenue. In other words, how much

revenue does a firm generate compared to it’s fee-earner labour cost?

The fundamental focus for the production and delivery strategy for your

firm is to drive growth in Gross Profit (GP).

The gross profit for a legal firm is:

Revenue minus Fee Earner Labour Cost

Your Revenue is your professional fees and your Fee Earner Labour

Cost is the cost of your labour including superannuation for all fee

earners. Fee earners for the purpose of GP for traditional legal firms is

exclusive of equity principal salaries and inclusive of support staff and

paralegals where their time is predominantly spent doing client work.

The greatest cost to a legal firm is labour. There’s a rule of thumb that

has been around in professional service firms forever, one-third of

revenue is for labour, one-third of revenue is for overhead, and one-third

of revenue is for profit.

Revenue

What does EFFICIENCY really mean?For a legal firm, efficiency can be described as the ratio between revenue and the direct labour cost to produce that revenue. The ultimate financial measure for an efficient practice is Gross Profit.

Matt Schlyder Partner FWO Chartered Accountants

Labour

Overhead

Profit

Firstly, I see a lot of firms that struggle to achieve a 33% net profit,

and that’s before principals’ salaries. The main driver is that their

labour cost is too high for the revenue that they generate. The key to

profitability is leverage: the number of fee earners (not just lawyers) per

equity principal and the ratio of the revenue earned per fee earner to

their labour cost.

The type of firm you have will drive your fee earner:equity principal

ratio. The top performing firms that I see generally target at least 3:1

fee earner:labour cost ratio (or in other words a 75% Gross Profit or

revenue equals 4 times labour cost). Given that labour is the biggest

cost for a firm, you need to leverage this cost to drive profitability. After

fee earner labour cost, you should keep your administration costs as

low as possible. Your overheads are relatively fixed, so the strategy

of driving leverage from your fee earners is the only real variable you

have in your business (provided other costs are maintained) from a

production perspective. With this said, remember that production can

only drive margin, so you need to maintain and manage your costs, but

drive activity to grow your revenue via sales.

Key Performance Indicators (KPI’s) are a measure of an activity or a

series of activities. Changes in KPI’s are a direct result of changes

to activities. Not enough firms understand, measure and take action

to improve the fundamental KPI’s around production management

to improve margin, which is driven by efficiency. For a legal firm,

efficiency can be described as the ratio between revenue and the

direct labour cost to produce that revenue. Improvement in margin

is achieved by a combination of efficiency and price. Price is a direct

result of your sales strategy. The ultimate financial measure for an

efficient practice is Gross Profit.

The core production KPI’s are:

File Velocity Days Average rate

Productivity Write-on (off)

To improve Gross Profit from an efficiency perspective, you must

ensure you carry the right amount of labour, as this is the only

production cost you have. To determine the right amount of labour

you must have a “Capacity Management Plan”. Most firms confuse

their Capacity Management Plan with a budget. They work out how

many people they have and that tells them the amount of revenue

they can make. This approach is a function of how much revenue you

could make, or in other words, your capacity. This is your Capacity

Management Plan.

The capacity in your business is calculated on a fee earner/principal by

fee earner/principal basis using the formula:

Business Capacity:

FTE standard available hours x productivity % target x charge rate

The total of each individual’s capacity is added together to provide you

with your capacity. In driving improvement in your Gross Profit, how

does your capacity compare to your revenue. This is what I call your

efficiency factor.

Efficiency Factor

Revenue ÷ Capacity

Whilst there are many other factors that can go into an equation to

determine your real efficiency, my efficiency factor provides firms with a

contextual benchmark to assess how efficient they are.

Efficiency Factor Comment

100%

High level of efficiency, but may need to consider acquiring additional capacity to fund growth.

90% - 100%

Some spare capacity for revenue growth, but the business is relatively efficient. Additional capacity may be unlocked by improving production KPI’s, but it is likely to only be marginal.

75% - 90%

Reasonable level of spare capacity. Likelihood of unlocking additional capacity by improvement in production KPI’s, however, depending on your revenue plan there may be some labour costs that need to be cut.

<75%

Significant levels of spare capacity. Decisions need to be made regarding labour cost and most likely there are significant gains to be made from improvement in production KPI’s. Often occurs when there is high partner productivity and low fee-earner productivity.

To explain, Let’s put some numbers to it. Let’s compare three 2 partner firms that have different leverage

ratios:

FIRM A FIRM B FIRM C

Fee earner:equity principals 2:1 4:1 4:1

Gross profit % 75% or 4 x cost 66% or 3 x cost 75% or 4 x cost

Average labour cost per fee earner $75,000 $75,000 $75,000

Revenue $1,200,000 $1,800,000 $2,400,000

Gross Profit $900,000 $1,200,000 $1,800,000

Standard Available Hours (including principals)

10,032 16,720 16,720

Target Productivity

• fee earners

• principals

73%

85%

50%

78%

85%

50%

76%

85%

40%

Charge Rates

• fee earners

• principals

$150

$400

$150

$400

$150

$400

Charged Hours

• fee earners

• principals

5,858

3,918

1,940

9,665

7,491

2,174

12,406

11,102

1,304

Average Rate $119.62 $107.66 $143.52

Productivity

• fee earners

• principals

58%

59%

58%

58%

56%

65%

62%

83%

39%

Write-on(off)% -12% -10% +7%

Capacity $1,805,760 $2,372,240 $2,240,480

Efficiency Factor 0.66 0.76 1.07

Gross Profit per FTE equity principal $450,000 $600,000 $900,000

Before I draw some observations from these numbers, let me clarify some definitions for you:

Fee-earner:equity principals Full Time Equivalent (FTE) number of fee earners, excluding equity principals

(solicitors, paralegals and support staff whose predominant role is to charge

time to WIP for the work they do) per to one FTE equity principal. The higher

the number of fee earners, the greater the leverage.

Gross Profit % (revenue – fee earner cost) ÷ revenue

Standard Available Hours Number of hours available to be charged to clients by Fee Earners and

Principals. This number is calculated by the total paid hours for the year

minus leave (sick, annual, long service, parental, bereavement, unpaid, public

holidays, etc). I use 1,672 hours per FTE = {52 weeks – 4 weeks annual leave

– 2 weeks sick leave – 2 weeks public holidays} x 5 days per week x 7.6 hours

per day.

Charged hours The total number of hours actually charged to WIP by principals and fee

earners

Average rate Revenue ÷ available hours. This rate represents the average rate of revenue

for every hour of wages paid, excluding leave.

Productivity Charged hours ÷ available hours. This is a measure of the amount of

time on average each fee earner is charged. It is recommended to separate

productivity between fee earners and principals to obtain a real

understanding of where capacity shortfalls are being incurred

Write-ons(off) +write-on or –write-off ÷ total value of WIP charged. This measures the

efficiency of time charged to WIP compared to billings.

Capacity The sum of the capacity result for each FTE fee earner and equity principal,

where capacity for an FTE = FTE standard available hours x target

productivity % x charge rate

Efficiency factor Revenue ÷ Capacity

When labour costs are too high, you will

struggle to achieve a 33% net profit

Some of my observations from working with many and varied

professional service firms over the years are:

1. There is a direct correlation between lower productivity of equity

principals and higher profits, provided that the non-chargeable

time spent by equity principals is on product, marketing and sales

activities. These firms are forced to leverage, whereas the high

equity principal productivity firms are more focused on production

activities and have very few structured product, sales and

marketing activities, which means they must Squeeze the Orange

for every dollar of revenue per available hours. Often these firms

are quite inefficient;

2. Firms with high partner productivity often have low fee earner

productivity because partners don’t lift their heads up from their

work to manage and drive the business. This results in significant

spare capacity within the firm which is under-utilised and therefore

means the fee earner labour cost is too high, which equals lower

Gross Profit; and

3. Firms that actively measure and manage production KPI’s reduce

their write-offs because they take action to improve efficiency and

resist carrying spare capacity in excess of their growth targets.

A word of warning:

KPI’s should not be assessed in isolation, they MUST be assessed

within the context of all KPI’s that impact on the result.

Don’t generalise from a specific.

Let’s take a look at the production KPI’s for the 3 firms in isolation:

Firm A Firm B Firm C

Average rate $119.62 $107.66 $143.52

Productivity: 58% 58% 62%

Write-ons(offs)% -12% -10% +7%

1. The average productivity for each firm appears to be low. Only

58%-62% of all available hours are being charged on client work.

In a standard work-week, that represents 2 days of non-chargeable

time. A general observation would be that there are significant

gains to be made in each firm in terms of improving productivity,

and the assumption being that there is spare capacity. This is

not the case for each firm. In fact, there is minimal if any spare

capacity in Firm C to drive growth as it has a strong efficiency

factor of 1.07. For Firms A and B, there is spare capacity within

the fee-earner ranks, however, if the philosophy of the firm is for

principals to charge 50%+ of their time, then for the short term,

without significant growth plans, there might be an argument that

costs need to be cut. Alternatively, there might be a need for the

principals to delegate more work down to free up their capacity;

2. The average rate results vary significantly. Firm C is a stand-out

with an average rate of $143.52. Its systems might be working

exceptionally well, but it will struggle to maintain a consistent

increase in this KPI without considering the need to build spare

capacity. Fee earners are working at capacity (evidenced by their

productivity), so if the firm drives growth, their team might be burnt

out which will then have a negative impact on productivity, and

ultimately on the average rate. When comparing Firms A & B, whilst

B has a lower average rate the efficiency factor and Gross Profit

per FTE Equity Principal is higher. Dollar for dollar, it is a more

profitable business;

3. When considering Write-on(off) you need to delve deeper into

the make up of the write-off. In firms that have high partner

productivity, often they have higher write-offs, which means that

partners who charge more time to WIP don’t necessarily recover it.

The recovery rates for fee earners might be OK, but making general

assumptions about the overall write-on(off) rate might be fraught

with danger. Firm C may have had a single matter that produced

15% of the revenue with a 15% write-on. If this was excluded from

the calculation, what would this tell us?

How does this impact on the client experience. Poor production

KPI’s generally mean inefficiencies. Some of these inefficiencies are

visible to the client, some are not. A firm might have great file velocity,

Poor production KPI’s generally mean inefficiencies.

however to achieve it, it means that their fee-earners must achieve

a 100% productivity rate by working longer hours. In my view, this

activity is not sustainable, which will eventually mean that the client

experience is impacted via employee turnover, employee burnout or

error. A firm might have poor file velocity, but good productivity so

that it maintains an excellent Gross Profit. Eventually clients will get

frustrated because their work is taking too long. If average rates are

driven upward via price increases that exceed client value, clients will

eventually leave. If write-offs are driven down at any cost by taking

short cuts, then ultimately the quality of the work will be impacted. So

be wary of the impact that your current production systems have on

clients as well as the changes that you make.

Below are some key activities for driving changes in production KPI’s

from a production perspective only:

Average rate:

Charge rate increases across the board

Bill everything in WIP, no write-offs

Have the right people doing the right work, delegate

Manage file velocity daily and weekly. The shorter the period of time a

file is in the office, the better the recoverability of hours charged.

Productivity:

Track all time charged. Timesheets completion is mandatory for all

principals and fee-earners.

Timesheets prepared and posted on a daily basis. It’s amazing the

amount of time that isn’t trapped in WIP. If it’s not in WIP it won’t be

billed. Most bad debts are written off after the work is done because

the time just doesn’t make it to WIP, so it can’t get billed.

Set weekly hours and dollar based budgets for fee-earners. Measure

and manage their results.

Focus on file velocity.

Write-on(off):

Systemise, systemise, systemise. The opposite to Einstein’s definition

of insanity: once you get the process right systemise so you keep doing

the same thing over and over again and keep getting the same result.

Bill it. If it’s in WIP, bill it. The majority of clients will pay it.

Ground Floor, Green Square North Tower515 St Paul’s Terrace, Fortitude Valley QLD 4006

GPO Box 81, Brisbane QLD 4001

www.financiallywellorganised.com

Ph: 07 3833 3999 Fax: 07 3833 3900

info@fwo.net.au