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Attorneys in all practice areas experience divorce at least as often as the rest of the population, and

some statistical information indicates that female lawyers may experience a higher divorce rate than women in other professions.1 In addition, your practices and licenses may be considered marital property and subject to equitable distribution. This article discusses various issues and methods surrounding law firm valuations, whether you are a sole practitioner partnership (LLP), P.C. or P.C. “S” Corporation.

This article presents a very general approach to matrimonial valuation of law firms and does not purport to explain all unique or special situations which may affect a particular set of circumstances. However, if you have the misfortune of going through the very unpleasant experience of a contested divorce sufficient understanding is always beneficial.

LAW FIRM VALUATIONSLaw firm valuations in a divorce

provide unique and special problems. There are numerous valuation factors that define the scope of a law firm valuation pursuant to a divorce, most of which will also apply to other businesses. The issues discussed below are general, but I indicate which ones are particular to law firms. (See box on this page.)

The valuation and written or oral report performed by a qualified appraiser who is also a CPA must be conducted in accordance with standards established by the American Institute of CPAs (AICPA), in accordance with

its Statement of Standards of Valuation Services (SSVS).

The valuation expert performs a detailed analysis of both financial and non-financial factors, including those previously discussed as well as: history and nature of the practice, financial performance and historical growth in revenues, billable hours, cross-selling history and opportunities and profitability. The financial analysis considers the economy; law firm practice issues in the marketplace within which it operates; the type of law practiced;

nuances with respect to certain practices previously mentioned, such as personal injury and trust and estate practices.

The valuation of a law firm is considered an asset sale regardless of the legal form of the practice. This means that a hypothetical buyer is not acquiring all the assets and liabilities, and a separate calculation of assets retained by the hypothetical seller is added to the valued practice reduced by the liabilities similarly retained.

What is value for a law firm?

... if you have the misfortune of going through the very unpleasant experience of a contested divorce sufficient understanding is always beneficial.

Valuation of Law Firms When Couples Divorce

By DeNNIS B. KReMeR

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July 2012

WESTCHESTER COUNTY BAR ASSOCIATION

NEWSLETTERwww.wcbany.org

Westchester County Bar Association 5

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LAW FIRM VALUe IS A PROPHeSy OF ITS FUTURe INCOMe!

The past may be indicative of the future, but if the valuation expert determines — based on his or her valuation procedures and judgment — that it may not be, or is not an indicator, the expert must look to projections of future earnings discounted to present value at the appropriate risk adjusted rate.

See box on this page for some of these future indicators.

TRADITIONAL VALUATION APPROACHeS

Simplified definitions of various valuation approaches are described below. The methodology would be affected by whether the interest to be valued is controlling or non-controlling, among other issues.Income ApproachDiscounted Cash Flow (DCF): A key income-based business valuation method that establishes the business value as a stream of future economic benefits discounted to their present value. The objective of the method is to determine what the expected economic benefits stream is worth

in present day dollars, given the risks associated with owning and operat-ing the practice within the current economy. Because of the method’s solid financial theory foundation, it is favored by many seasoned investors and business valuation professionals. This method is only as good as the projected earnings and the risk ad-justed discount rate developed.Income Approach: A build-up of a capitalization rate (applied to a num-ber representing and annual stream of

future income) is developed starting with a risk free rate and adding addi-tional premiums based on informed judgment as follows:

Equity risk premium (Excess average risk over tax free trea-suries)Small stock premium Specific risk premium

Market Approach: The market ap-proach is based on a comparison of the subject law firm to similar law

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firms which have been sold in the same or similar markets. The exact similarities may be broadened to include an accept-able broader range in year of sale.Net Adjusted Asset Approach: The required approach when an entity’s orderly liquidation is worth more than the calculated value of the practice as a going concern.

INCOMe STReAM ANALySISWhen the divorcing parties have

minor children, frequently the valuation expert will be asked to produce an income stream analysis for a number of years. Domestic Relations Law 240 defines income (although not limited to the definition):■■ Total income that should be reported

or should have been reported in the most recent Federal income tax re-turn…

■■ Net investment income (gross invest-ment income reduced by related ex-penses)

■■ Other income such as worker com-pensation, disability, unemployment,

veterans benefits, pensions and retire-ment, fellowship and stipends, and annuity payments

■■ Imputed income from personal perks, employment fringes and funds, goods and services provided by friends and relatives

■■ Other items described in the lawFrom these amounts, the following

shall be deducted: unreimbursed business expenses, alimony and child expenses paid to a former spouse or a spouse that is a party to the instant action, public assistance, supplemental security income, NYC and City of Yonkers taxes actually paid and FICA taxes. The adjudicated income stream is used as a basis for applying a percentage, based on the number of children, to calculate child support.

NON-FINANCIAL FACTORSQualitative practice factors can be

extremely important and either validate or refute some of the assumptions derived from the foregoing procedures. A law firm is a business providing personal services. It is one the oldest legitimate professions in the United States, if not the world, practicing professionally

and economically in a dynamic and changing environment. The paradigm for operations, ownership, succession, billing and coping with a changing world into the second decade of the 21st century alone adds a dynamic to its success, longevity and value.

As Yogi Berra claimed, “the future isn’t what it used to be.” And no profession needs to adapt more quickly to the future in its present state than the legal profession.

A law firm is a bundle of finite labor-intensive hours that work primarily by leveraging the efforts of younger and less experienced professionals who want to become owners. To thrive and survive, the firm must grow faster than its present owners retire. This is the model with which the valuation expert works.

What are some of the critical non-financial factors influencing the valuation of the law firm that a valuation expert may wish to explore?1. Conduct, integrity, competence and

reputation of the law firm, its reputa-tion along with that of its partners, professional and non-professional employees

2. Avoiding confusion when providing

Law Firm Valuations(continued from page 5)

Westchester County Bar Association 15

(continued on page 18)

non-legal services (New York Law-yers Code of Professional Responsi-bilities EC 1-9)

3. Contractual relationships with bothlawyers and non-lawyers

4. Grievances which result in citationagainst lawyers and their firms

THe LeGAL PROFeSSION IN TRANSITION

The April 18, 2012 issue of Bloomberg Businessweek published a very interesting article on turmoil in the legal profession, including the number of lawyers v. the intuitive capability of law firms to maintain the spectacular growth to which they became accustomed.2

Some of the issues discussed are:1. The economy and ability to continue

to realize sufficient and profitable billing realization

2. Growth rates3. Leadership and management — after

all it is a business4. Partner departures

Also an Altman Weill 2011 Flash Survey identified the following issues:• Economic recession—a game changer• Succession of baby boomers• Change in practice efficiency• Traditional law firm model under siege• Growth is no longer a given• Ownership propositions-non-lawyer

owners

SALe OF LAW FIRMSNew York Lawyers Code of

Professional Responsibilities EC2-34 through EC2-36 allow that law practices and, particularly sole practitioners, should have the ability to sell their practices including goodwill as long as clients are appropriately protected. Although not relevant to valuation for divorce purposes, lawyers should consult with ethical specialists when contemplating practice sales.

OTHeR VALUATION FACTORSIf possible consult my article in

the October 2011 of this newsletter on Social Media Risk Issues. This new

millennium game changer was expertly presented at a recent White Plains Bar luncheon by Deborah Scalise, Esq. I was surprised to learn that many attorneys are unaware of:• All the factors encompassing social

media• Ethical laws about transmission of

client information to both clients and non-clients

• Associated risks and protection toreputation

• The vast amount of informationabout attorneys and law firms on the InternetThe foregoing should definitely be a

part of the valuation process.

VALUe TO THe OWNeRIf valuation of the law firm (e.g., its

large size) is impractical or difficult, or there is a remote possibility of the practice ever being sold or merged (a sole proprietorship where personal goodwill is just too integral to the practice),

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July 201218

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or one of the partners refuses to produce the required financial information required, another concept may consist of an argument that the partnership has a unique value to the partner and worth something to the marital estate. This will involve some measurement of the unique value of partner earnings relative to a market valuation of attorneys providing similar services.

DOCUMeNT PRODUCTIONStandard documents requested normally consist

of five years of practice and personal returns, financial statements, and management reports:

• client profitability• realization• partner billings• billable hours• unbilled hours• accounts receivable• client disbursements due• business development expenses• Minutes of Executive Committee Meetings• fringe benefits• partner perks• memberships• buy-sell agreements• partner agreements• major clients• bartered transactions

Additional information that may be required consistsof comparable compensation v. productivity of partners, empirical evidence and empirical reference studies, e.g., Altman Weill. Goodwill is the excess of value above the stated financial statement capital which values the brand, client loyalty, reputation for skill and performance (paraphrased from Justice Joseph Story, Holbrook v. Holbrook 103 Wis.2d 327, 309 N.W.2d 343 (Wis. App. 1981)).

CONCLUSION OF VALUeS DeFINeDFair Market Value – IRS Ruling 59-60 defines as “the

amount at which property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”Fair Value – New York State represents fair market value with only a discount for lack of marketability. Discounts for lack of control not considered as this value is used primarily for Shareholder dissenting based on case law resulting there from.

Investment Value –Represents a value to a particular buyer as compared with a population of willing buyers.

While no real value standard or formula has been generally accepted for law firms, the value for law firms should be higher when the attributes in this article are favorable.

A sanity check for cash flow and returns should be used to justify the results.

eNDNOTeS1. http://divorce.foryouworld.com/divorce-1/divorce-statis-tics-westport-women-cater-to-divorce-industry/2. http://www.businessweek.com/articles/2012-04-18/law-firms-white-shoe-blues

Dennis B. Kremer, CPA, ABV/CFF, CVA, CFE, FCPA, a partner at Fairfield Forensic and Valuation Services, LLC (FFVS).

Mr. Kremer has recently been appointed by the Westchester Coun-ty Executive to serve on the Westchester County Board of Ethics. In addition, he serves on the Westchester Medical Center Foundation Board and its Audit Committee. The opinions expressed in this article are his own and do not represent those of FFVS.

Law Firm Valuations(continued from page 15)

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