For many lawyers, retirement is out of reach because the value of their homes, investments and retirement plans took heavy hits over the last few years. But for those lawyers who can retire, their firm typically represents a “pot of gold” in their minds. It is the asset on which they can depend.
However, it is necessary to be very clear about what that asset really is. Every firm represents an investment of years of hard work and financial resources in growing the practice and building goodwill. Goodwill is certainly an accounting term, but it has another, qualitative dimension as well. Understanding both helps the average lawyer better understand a practice sale.
From an accounting perspective, goodwill is the reputation, client base and client loyalty that have been created over the life of the practice. Although there is no definitive way of calculating goodwill, an “excess earnings” model is often used by courts in divorce matters. This defines goodwill to be a differential advantage resulting from the individual lawyer’s skill, reputation and special talent. Typical steps to calculate this are:
- Ascertain average annual earnings of the firm over the previous five years.
- Fix the amount by which the law practice exceeds what an employee of comparable qualifications would earn, using local, not national, statistics.
- Compute a fair return on investment in physical assets used in the practice.
The amount by which the five-year average earnings of the practice, less the fair return on physical assets, exceeds the fair compensation figure for a comparable attorney is the amount of excess earnings.
Capitalize this amount as a function of the risk of retaining the clientele, and maintaining the stability of the firm’s earnings during the time period chosen and the competitiveness of the practice.
Lawyers typically do not understand this financial calculus and cannot comprehend even the possibility that their many years of effort may actually have produced a monetary value of some significance. This value can enhance their retirement as a measure of organizational goodwill. But there is a second measurement that can make the number understandable, and that is one of personal goodwill.
At the end of the day, the value of a law practice is based on that lawyer’s success and the many people that success has touched over the years. This is a significant legacy that contributes to organizational goodwill on retiring from the practice. It involves a lawyer’s reputation, practice management system and way of doing business — all the intangible elements that made the practice successful and provide the selling lawyer with what is most valuable to sell.
The better a lawyer’s reputation, the more value the law practice will have. A firm with positive, provable goodwill shows that a lawyer has been focused and passionate about the practice of law and effective at client service. By contrast, firms that have had to contend with bad publicity, a declining client base, or malpractice and disciplinary matters have little goodwill.
The value of goodwill can be passed on to a lawyer’s family and heirs when monetized through a practice sale. After investing years of hard work and financial resources in growing the practice, a well-planned practice sale allows any lawyer to reap the benefits of that value and realize the legacy that a years-long investment of time and effort created.