Industry Experience is Key When Valuing Professional Practices
In litigation involving professional practices, many courts have recognized the importance of industry-specific valuation experience. A recent Nebraska Supreme Court case — Fredericks Peebles & Morgan, LLP v. Fred Assam — illustrates this point.
Battle of the Experts
The primary issue in this partner buyout case was the fair market value of a departing partner’s 23.25% interest in the law firm Fredericks Peebles & Morgan, LLP (FPM) in late 2014. Both sides hired experts to value the interest:
FPM’s valuation evidence. FPM hired a law firm management consultant who had worked with more than 500 law firms of all types and sizes over the last 25 years. As a specialist in law firm M&A, FPM’s expert had previously performed around 25 law firm valuations. He also had published articles and spoken on law firm valuation and financial management.
After considering the asset-based, market and income approaches, FPM’s expert used the discounted cash flow (DCF) method. He relied on five years of historical income statements adjusted for certain nonrecurring expenses and liabilities. His DCF analysis considered economic and government regulation risks, as well as firm-specific risks associated with sustainability, infrastructure, technology, and data security.
The expert’s discount rate was computed using a build-up method. Specifically, he started with a risk-free rate and then added incremental amounts to reflect legal-industry-specific risk and firm-specific risk. The expert believed that FPM was riskier than other law firms because its collection rate was below average and its revenues were generated primarily by aging partners. After applying a 60% discount for lack of control and marketability, the expert valued the partner’s interest at $590,000.
Departing partner’s valuation evidence. The departing partner was a financial attorney who often dealt with business valuation matters. He testified that his interest was worth approximately $4.9 million, based on his own analysis. He also submitted valuation opinions from three external business valuation experts.
Two experts were from the same CPA firm and co-authored a calculation report in 2014 and a full valuation report in 2016. Though the experts had significant valuation experience in other industries, together they had previously valued only one law firm. Neither had published any articles or spoken publicly about valuing law firms.
Using the income approach, the experts valued the interest at roughly $3.42 million, based on average normalized annual pretax revenue over a four-year period. Their valuations also included a 10% discount for lack of control (due to nonoperating assets) and a 5% discount for lack of marketability (because FPM’s partnership agreement effectively created a market for the partners’ interests).
The third expert reviewed the other valuation opinions and found numerous errors. He concluded that FPM’s expert had understated the interest’s value by $1,235,000 and that, based on the 2014 calculation report, the departing partner’s experts had overstated the interest’s value by $1,275,000. Based on those adjustments, the departing partner’s third expert believed that the value of the interest ranged from $1,825,000 to $2,145,000.
A Matter of Credibility
The trial court adopted the valuation opinion of FPM’s expert. On appeal, Nebraska’s Supreme Court upheld that determination. Both courts stressed that expert’s substantial, relevant experience and detailed analyses in finding him more credible than the valuation evidence submitted by the departing partner.
The judges criticized certain aspects of the co-authored valuation opinions. For example, the experts relied on only four years of revenue, disregarding data from 2010, a year with unusually low revenue. Also, they assumed that the buyer was FPM, rather than an objective hypothetical party — despite the use of the term “fair market value” in the partnership agreement. And they criticized the experts’ upward adjustment in value to reflect the fact that, as a pass-through entity, FPM wasn’t subject to corporate taxation.
This case demonstrates the importance of industry-specific experience in establishing credibility for a business valuation expert. Because of his “vast” experience in valuing and managing law firms, the prevailing expert was able to show the court why his methods were appropriate and how the unique risks inherent in operating a law firm require an approach different from that used for other types of professional service firms.
Close-up on Key People
Many professional practices are highly dependent on a founder, visionary leader, rainmaker, or other key person. For some firms, a key person discount may be appropriate. The discount reflects the risk that the business would suffer a major financial setback if the key person died, retired or otherwise left the business. However, the mere presence of a key person doesn’t automatically warrant a valuation discount.
To determine whether a discount is appropriate, a business valuation professional evaluates the potential impact of losing the key person. Important factors to consider include:
- The nature of the business,
- The key person’s role,
- The individual’s specialized technical knowledge and relationships with customers and suppliers,
- The quality and depth of the rest of the management team, and
- The strength of the company’s succession plan.
Even when a key person discount is appropriate, it can be challenging to quantify. Experts may, for example, account for key person risks by reducing future earnings, increasing the discount or capitalization rate, or discounting their value conclusion by a certain percentage.