The legal industry tends to hold itself apart from the rest of the corporate world. But with talk of allowing outside investment in law firms gaining steam both inside and outside the U.S., Hunton Andrews Kurth CFO Madhav Srinivasan decided to subject firms to an exercise that’s routine in other enterprises: pinning a dollar value on their business.
Srinivasan, who also lectures at Columbia Law School, spent nearly two years building and testing a methodology for valuing law firms before applying it to the firms in the Am Law 100 in a report for ALM Intelligence.
Just as in a number of recent industry rankings, Kirkland & Ellis came out on top. But here, the results are eye-popping. According to Srinivasan’s calculations, the firm is worth almost $23 billion, more than twice as much as Morgan, Lewis & Bockius, the second-highest-valued firm.
The approach differs from more traditional efforts to rank and evaluate law firm financial performance, which focus on past results.
“Nobody’s done forward-looking stuff before. I’m going out on a limb,” Srinivasan said. “I’ve shown how the sausage is made. People can either agree with it or not.”
The veteran financial analyst, who has worked at two other major international law firms as well as in industry, acknowledged that former American Lawyer reporter Chris Johnson put together a model for valuing law firms in 2012. But he said that the time was ripe for an even more rigorous attempt, putting to use Wall Street evaluation techniques.
Srinivasan ultimately arrived at a six-step approach, starting with separating partner compensation into two categories: salary and “at risk” income. Taking the aggregate of the latter as the firm’s profit, he then subtracted a sum for taxes to arrive at net income. For the Am Law 100 in the aggregate, these calculations yielded a net income margin of 11.8%.
He then paused to see if this figure made sense. While far below the combined profit margin for the 2018 Am Law 100 of 40%, it was in line with two peer groups with publicly available valuation figures: publicly traded U.S. consulting firms and publicly traded U.K. and Australian law firms. With a data set of the former yielding a net income of 8% and a data set of the latter yielding 13%, Srinivasan saw his figures were comparable and knew he was on the right track.
The final steps involved using standard accounting techniques to project cash flow over the next five years and then a terminal value at the end of year five, using a firm-specific growth rate, and finally arriving at an individual valuation of each law firm.
One limitation of the model, as Srinivasan acknowledges, is that it relies on the assumption that growth will continue at a fixed rate based on recent history for a given firm.
“If there’s a recession, I cannot predict if profits will fall,” he said.
But he didn’t do his work in a vacuum. Srinivasan sent off his work to experts in valuations, including professionals at Deloitte and PwC and an academic at the Wharton School.
“This went through many iterations,” he said.
For now, Srinivasan’s exercise is purely academic. While there’s growing talk about regulatory change, nonlawyers are currently barred from owning or investing in U.S. law firms.
The results should still spark a conversation, as Srinivasan says they shed light on firms with comparable historical financials. Those with a higher value are likely doing more things right.
That opens the door to a challenge that’s messier than assembling a valuation model: determining what those things are, and finding ways to implement them.