Edward Poll, The Daily Record Newswire
Thin Mints. Samoas. Do-si-dos. Those Girl Scout cookies are too good to resist.
But it’s more than the flavor of the cookie that makes them so tempting. It’s the history of the organization behind them, the girls who sell them, and the good cause they fund. In short, it’s the whole package of goodwill developed by the scouting organization over many years.
Similarly, goodwill makes a law firm irresistible when it’s time to sell the practice.
For many lawyers, retirement is out of reach because the value of their homes, investments, and retirement plans took heavy hits over the past few years. But for those lawyers who can retire, their firm typically represents a “pot of gold.” 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 can be said to equal the difference between the price paid for the business and its “book value.” This is a number that is quite low in a professional service firm. Since most lawyers haven’t yet sold their practice, goodwill is usually discussed in terms of 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 before a sale, an “excess earnings” model was developed and is often used by courts in divorce matters. This defines goodwill as a differential advantage resulting from the individual lawyer’s skill, reputation, and special talent. Typical steps to calculate this include the following:
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, exceed 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, as well as the competitiveness of the practice.
This financial calculus is “mumbo jumbo” and generally not well understood. There is a second measurement that can make the concept of goodwill better understood.
Personal goodwill 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.
At the end of the day, the value of a law practice is based on the lawyer’s success and the many people who have been touched by that success over the years. This is a significant legacy that contributes to organizational goodwill, the value of which can be passed on to a lawyer’s family and heirs when monetized through a practice sale.
After a lawyer has invested years of hard work and financial resources in growing the practice, a well-planned practice sale allows him to reap the benefits of that value and realize the legacy that a yearslong investment of time and effort created.
Like those Thin Mints, Samoas, and Do-si-dos, a law firm that has developed a surplus of goodwill will find itself irresistible when it’s sale time.
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Edward Poll, J.D., M.B.A., CMC, is a law practice management thought leader and contributor to this publication. His website is at www.lawbiz.com.
