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October 2023

Oct 25, 2023

Equity Partners – Valuation of Shares and Affordability

Question:

I am one of three founding partners in a 12 lawyer general litigation firm in San Francisco. All three of us are in are sixties and are looking to begin admitting others as equity partners. We have three non-equity partners and five associates in the firm. The three of believe that we should receive some value for founding the firm and our contributions over the past twenty years. We would like to sell each of them a ten percent interest and we are trying to determine a firm value for calculating their buy-ins.

Response: 

In the final analysis the value of the practice is what an outside buyer or an attorney working for the firm will pay for (or invest) the practice. A balance often has to be struck between valuation,  affordability, and willingness to pay. The valuation process is simply a tool to use to help you begin discussions and get to this point.

I believe that firm value has to be balanced with affordability and a prospective equity member’s willingness and ability to pay for the shares. It all comes down to compensation. Generally, I find that a prospective equity member or partner must be able to see a significant compensation increase with a breakeven/payback period of around three years – no more than five. I also believe that when shares are seller financed the period should be no longer than five years. Many firms do not sell shares based on formal valuation – other methods are used.

Questions that equity member candidates usually raise:

  1. Is the breakeven/payback from the investment in say three years as a result of the compensation gap?
  2. How much more will he or she earn as equity shareholder?
  3. Can he or she earn enough more as an equity member to justify the investment?
  4. Can he or she earn more as a partner somewhere else with as an large investment, a smaller investment, or even with no buy-in at all?
  5. Can he or she earn more somewhere else as an associate or non-equity partner?

In many law firms’ compensation is based upon performance and contribution and ownership shares have little or no bearing on member or partner compensation. Their primary goal is to acquire and retain talent.

Use a valuation methodology as a starting point – such as a multiple of firm past five year’s average revenue and adjust for the affordability factor. Keep in mind that many of your competitors are offering equity partnership with no buy-ins at all.

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John W. Olmstead, MBA, Ph.D, CMC

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