Which is more important – deal structure or valuation?

Type of Business – Law or Accountancy

Most businesses have a value to someone somewhere, but the answer to this question depends very much on the type of business you are.

For accountancy firms the valuation is key, and is usually fairly easy to do, with most accountants valuing their own practices using the multiple of gross recurring fees (GRF), which can vary widely (and roughly) between 1 and 1.6. So, if your business has a recognised £100,000 in gross recurring fees then the value is likely to be somewhere between £100,000 and £160,000 depending on your firm’s circumstances. Market valuations for accountancy practices tend to be looking at the very particular detail in relation to the client lists and the practice itself. We do spend time with accountants advising on deal structure, partly because of the clawback clauses that invariably find their way into any agreements.

Certain Law Firms – Deal Structure is King

However, for law firms of a certain size and a certain type, deal structure is considerably more important than any valuation, although a valuation can play an important part in deciding a deal structure.

NB: we sometimes hear of accountants using the accountancy valuation technique (GRF x a multiple) to value law firms – it doesn’t ever seem to reflect reality (which is a shame because the valuations can look nice and high on paper!). Law firms of a certain size rarely get clients with recurring fees..

Two examples follow.

Retiring Owner/Managers..

Lets take a law firm with two partners who both want to retire, move on and have nothing more to do with the law because they’re in their late 60s and need to enjoy some time themselves rather than working. Their firm has no fee earners other than themselves, very few assets, fairly high professional indemnity insurance premiums which are going to result in fairly high run off cover if they close down, very little in the way of goodwill because most of the work is coming via themselves, and a commitment to a lease of premises for the next 5 years.

..compared to a Standalone Law Firm

The second example is a fully functioning practice turning over £5,000,000 with a team of 40 staff, ongoing contracts with clients, extensive assets and clear goodwill. The owners have little to do with the day to day operations.

Deal Structure v Valuation

In the first instance, we think the format of the deal structure is considerably more important than a cash sale price. A market valuation will of course be good for indicating what the practice may potentially be worth, as well as suggestions on how to improve chances of getting a particular value. Deal structure advice will be focussed on how to achieve maximum return.

In the second example, the valuation will be much more important than the deal structure. Any seller of a practice set up to be self-sufficient, with ongoing sources of work, evidence of good practice (low PII premiums), good reputation and a loyal team of staff, is going to be looking to extract value from the business at the point of sale. The deal structure will be looking at the specifics, but the overall aim has to be to achieve maximum value and ideally as much of it up front as possible.

Retiring Partners Example in Detail

In this case, the work being done in the practice is by the partners who are retiring, and quite probably the reason the work is there in the first instance is because of the partners. It is quite likely in a case like this that the partners need to be considering the structure of a deal rather than a specific valuation. After all, if they do not manage to sell or dispose of the practice they will be left with the runoff cover on their professional indemnity insurance which could be as high as 3.5 times their annual premium. By way of example, a firm with an annual professional indemnity insurance premium of £30,000 may well have to find runoff cover of £105,000, which is substantial to say the least.

The valuation may well identify certain parts of the business that do add value – for example CQS accreditation, lender panel membership, low PII, legal aid contracts, sources of work, particular specialisms etc.. It will also include suggestions for improving the value.

However in most cases for firms of this size and structure, the disposal of the practice needs to be focused more on the actual deal, because it’s unlikely that any buyer is going to make a substantive cash offer upfront to purchase the business. It is more likely in circumstances like this that a buyer will look to structure a deal to give the seller assurances that they will take over liabilities, become the successor practice, assume responsibility for the staff, continue to service the clients, but at the same time perhaps be prepared to negotiate paying the seller for work in progress, possible consultancy arrangements for a period of 12 or 18 months, recovery of bad debt and/or a commitment to lease the offices.

So, in these cases a deal structure is considerably more important than a valuation, because although a valuation will give a seller an idea as to potentially the value of the practice, it will not really give them the full reality of exactly what they are likely to get for the practice and how the money is likely to be paid to them.