Proctor : April 2019
51 PROCTOR | April 2019 What’s your practice worth? by Graeme McFadyen The 2017 Macquarie Bank Legal Benchmarking Report included an interesting commentary about succession planning, noting that only 44% of the survey’s 275 respondents nationwide had a succession plan. My expectation is that the majority of medium and small-firm principals whose turnover is less than $5M will struggle to justify any goodwill payment on the sale of their practice. Goodwill arises when the value of a business exceeds the value of its net assets. However, the concept of goodwill attaching to law firms is a vexed and much misunderstood issue. Usually goodwill is only payable if a practice enjoys a significant and, importantly, sustainable profit. It is little comfort to practitioners, but the reality is that, as the market becomes more competitive, profitability becomes less predictable. Unless a practice enjoys a brand which has a demonstrated history of profitability and, importantly, a reasonable expectation of continued profitability, then there is unlikely to be a queue of ready buyers. Demonstrated profitability This is the single most important variable in the value chain. So what is the profitability required for a legal practice to notionally qualify for goodwill? Let’s look at both the ALPMA/Crowe Horwath and the Macquarie Bank legal benchmarking surveys for 2017 in respect of mid-sized firms (turnover $5-20M) and small firms (turnover less than $5M). Both surveys provided extraordinarily similar outcomes. Traditionally, 25% was the median profitability benchmark used for legal practices – that is, 25% was regarded as the targeted norm. And just to be clear, this is 25% before tax. This proposition proved to be true, as both surveys found that the average net profit of law firms in the $5-20M and <$5M cohorts was indeed 25%. However, as they drilled deeper a different story emerges. Both surveys split their revenue groups into better-than-average and worse-than-average performers. This further analysis showed that the better-than- average performers in both groups achieved an impressive average net profit of around 40%. However, the under-performers in both groups, the majority, scored a dismal 13%. At 13%, you are making a bare wage at best. Coincidentally, IBISWorld founder Phil Ruthven recently reviewed the profitability of international service industries. 1 His research shows that the international best practice benchmark for service industry profitability was 22% after tax. The 25% profit benchmark referred to above is pre- tax, so if we assume a tax rate of say 35%, then to meet the international benchmark of 22% after tax, law firms need to achieve 33% before tax. This performance measure sits comfortably with the two surveys noted above. So for the purposes of this article, it is argued that to qualify for any goodwill consideration, a legal practice’s profitability needs to be 33% or better. And it needs to be sustainable. Predictability of profits Predictability is a function of brand strength, areas of practice, quality and transferability of clients and degree of competition. Brand strength With more intense competition, the sustainability of profits has become more difficult, especially with new disruptive legal models and new technologies. Consequently, those practices which do not have a strong brand are having to compete on price in a number of areas of practice. Areas of practice George Beaton recently identified conveyancing, wills and family law as three areas of practice which are now largely commoditised and therefore largely compete on price2. Beaton concludes that “commoditization means competing on price...and competing your profits away”. Quality and transferability of client base The quality and transferability of the client base in this context has enormous value. If the client is a large corporate which uses a particular legal brand as a matter of corporate choice, then that brand has significant value. Regrettably though, this is not the experience of the smaller law firms whose mainly consumer clients, believing that all lawyers have similar skill sets, tend to choose based largely on convenience and price. Degree of competition If the majority of client relationships are grounded in convenience and price, it is inevitable that the addition of more competition and disruption must erode the relationship over time as your clients encounter other lawyers in their social and commercial lives, both physically and via the now inevitable Google search. Conclusion What the above analysis demonstrates is that no principal can assume that there is a capital windfall at the end of the road. This realisation should alert practitioners to the need to optimise profits today rather than wait for some future windfall that is likely to become less achievable over time. Practice management Graeme McFadyen has been a law firm GM/COO/CEO for more than 20 years. He currently provides consulting services to law firms – email@example.com. Notes 1 “It takes more than serendipity or good fortune to achieve strong profitability”, Phil Ruthven in The Australian, p27, 12 September 2018. 2 “All would agree that conveyancing, wills and family law, to name some, are familiar, largely commoditized forms of legal services provided to consumers” in Remaking News of the Week posted by George Beaton on 13 September 2018, remakinglawfirms.com/remaking-news-of-the- week-law-firm-partnerships-are-losing-their-lustre.