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The value of goodwill

18 June 07

The accountant's approach to the valuation of goodwill in a legal practice, and the factors that influence value

by Bob Dallas

I was recently consulted by a solicitor client whose practice had been approached by the partners in another firm. There was no natural succession in that firm and the partners were looking to retire and sell on the goodwill. My client presented me with the accounts for the last three years, and after giving me five minutes to read them asked what the value of the goodwill was. Not wishing to lose a valued client, I refrained from asking the obvious question: how long is a piece of string? Instead, I asked how much he would be prepared to pay. The immediate response was “You’re the accountant, you tell me.” Talk your way out of that, Mr Beancounter!

The whole issue of goodwill valuation does present problems to accountants. Admittedly they have an interest, in that at some stage they may need to value the goodwill of their own practice, though with a higher proportion of recurring fee income it is generally more straightforward to value the goodwill in an accountancy firm.

I should establish at the outset what goodwill actually is. It is defined as a non-financial fixed asset that does not have a physical substance but does have a value to the business. Whilst it is straightforward to define goodwill, its valuation is much more complicated.

The components which give rise to goodwill in a legal practice comprise such factors as:

    name and reputation of the practice;

    potential to generate future income;

    client loyalty;

    partner and staff continuity;

    practice location.

Valuation of goodwill is a very subjective matter and in the majority of cases there is no right or wrong answer. In certain instances a low valuation may be more beneficial than a higher one, and vice versa. The specific facts of each case will dictate this.

Generally the circumstances which require the valuation of goodwill are:

    incorporation of a legal practice;

    acquisition/disposal of a practice;

    partners joining/leaving a practice.

The adage that something is only worth what someone else is prepared to pay for it applies to the latter two scenarios; the first is slightly different.

Valuation on incorporation

The increase in claims against solicitors over recent years has prompted the profession to seek ways to limit liability. The options are converting from partnership to limited liability partnership (LLP) or limited liability company (LLC)

Larger firms tend to go down the LLP route, but for smaller practices there is a distinct tax incentive to convert to LLC. The LLC buys the goodwill of the existing partnership and incorporates it into the company balance sheet.

The liability for the purchase price is included in the directors’ (formerly partners’) loan accounts.

Creating goodwill on incorporation gives rise to a one-off tax charge on the individual partners in the year of sale, but at a much reduced rate. The tax benefit is that the directors reduce their own tax liabilities by taking reduced salaries and dividends and top up their cash requirement by drawing down on their loan accounts.

The valuation of the goodwill, although giving rise to a tax charge, does crystallise an asset sooner rather than later, or indeed at all if there is no subsequent account taken of goodwill.

It follows that in this situation it is beneficial to value the goodwill at as high a figure as possible, as this increases the benefit to the partners. Given the situation of willing seller and willing buyer, it should be possible to agree a valuation without too many problems. In this situation the normal method is based on fee income, averaged over a number of years, normally three. A rate per £1 of fee income is applied to the average to produce a goodwill balance.

I have seen cases where the valuation has been set on the basis of £1 of fee income equating to £1 of goodwill, although this is at the higher end of the spectrum. A more conservative multiple would be around £0.80 per £1 of fee income, but it does depend on the individual circumstances.

You will not be surprised to know that HM Revenue & Customs are aware of this situation, and any attempt to overvalue the goodwill could give rise to a challenge by them and potential tax problems. The accountant and client must consider the valuation basis and ensure they can justify their choice should the Revenue seek to query it.

Acquiring or disposing of a practice

This is definitely a situation where the approach to valuation could be influenced by whether we are acting for the seller or purchaser. However the first step should be to arrive at a valuation based on sound principles, which can then be adjusted to take account of any other matters which impact on value.

My approach is to start with the practice accounts for the last three years. I then make various adjustments for items of a non-recurring nature, both income and expenditure. It is also important to take account of income/expenditure not included in the accounts, but which the practice would expect to incur in the normal course of business. The principal example of this is to charge a commercial salary for the partners to take account of the cost of their time. I then take the average to give the profit before taxation (see example opposite).

The average adjusted profit in this illustration is £70k. This is based on simple averaging, but in practice I would tend to weight the adjustments to try and spread the effect more evenly over the period. I then apply a multiple to arrive at an initial value for the goodwill. Based on experience, I initially use a multiple of one, here giving a valuation of £70k.

There are other factors which influence the valuation. Whether acting for the seller or the purchaser I consider the reputation of the firm: does the name itself attract new business? I then consider the client profile to establish whether any clients generate significant recurring fee income. I also consider the various disciplines of the practice and whether these will integrate with the purchaser; a large private client base which potentially generates future fee income can add significantly to the value. Also if the seller provides services not offered by the purchaser, this will add value.

In certain circumstances there may be an element of opportunity costing in that the purchaser will be able to reduce or eliminate certain expenses of the selling practice, adding value to the deal, for example by relocating in one premises.

I then consider the potential effect on my initial goodwill valuation and adjust the figure to take account of this.

Ultimately, whether acting for the seller or the buyer, the objective must be to provide the client with a realistic valuation on which to base future negotiations. Once this is established, the client can either inflate or discount the value for the opening negotiations, and as discussions continue can evaluate any concessions back to the starting value.

Incoming/outgoing partners

In my experience very few legal practices account for goodwill either on the adoption of new partners or the retiral of outgoing partners. In the case of an outgoing partner moving to another firm, not surprisingly, I have never seen goodwill recognised.

With regard to partner movements

I find practices are generally happy to maintain the status quo and not value the goodwill, as at some stage the incoming partners will become outgoing partners. It is less problematic to ignore goodwill than go to the time and expense of valuing it on every partner change, which could give rise to a potential tax charge.
This issue should be covered in the partnership agreement by specifically stating that goodwill is excluded, or if it is to be included, stating the circumstances and basis for valuing it.
Problems can arise where the partnership agreement does not address the issue of goodwill and the retiring partner considers that he/she is due a share. This can be a very awkward situation for the accountant, who could well be acting for both parties.
At this point the outgoing partner should seek independent advice.
Where there is no partnership agreement the governing legislation is the Partnership Act 1890. This makes no mention of goodwill valuation, and in the event of a dispute it could be argued the outgoing partner is not entitled to any goodwill. However, invoking the Act could result in a dissolution, which the remaining partners may well wish to avoid.
Unless there were specific guidelines on the basis for valuing the goodwill, I would adopt the first stage of the method outlined above. I would then consider factors relating to the individual partner, such as the size of their client portfolio, the type of work they generate, their experience of client loyalty, whether they introduce significant business to the practice etc.
A favourable outcome to these questions would result in a case for enhancing the goodwill value, whilst if there was a negative outcome I would consider reducing the value.

The last word

From an accountant’s point of view this is a very interesting area of work. The factors that there is seldom a right or wrong answer and that in many cases the valuation itself is not the final outcome, but the starting point for a negotiating process, make this type of case very challenging.

Also the value of the transaction itself can be very significant, and the fact that the client is placing such a significant reliance on the accountant’s judgment does help to keep the PI insurance file dust free.

Whilst the accountant can use his or her experience to produce a valuation, ultimately it is the solicitor who makes the final decision and it is up to the accountant to make sure this is based on as robust information as possible.

I suppose that in the scenario in the first paragraph my response to my client should be, “Here’s my valuation. Can you afford it?” I suspect however, that on the basis the solicitor always has the last word, he would have an answer to this!

    Bob Dallas is Managing Partner of Campbell Dallas, Chartered Accountants and Business Advisers t: 0141 887 4141