Does your law firm have any value? These lawyers argue it doesn't.

Dixon v. Crawford, McGilliard, Peterson & Yelish, 2011 WL 4348058 (Wash. App. Div. 1)(Sept. 19, 2011)

One of the five founding partners of a well-established, thirty-year old public defense firm left in 2006, taking all of his civil defense clients with him. Two years later, a junior (non-equity) partner left the firm, and sued for an accounting and purchase of his interest. At this point, the senior founding partner—concerned about potential liability, intervened in the suit, but only after the court dismissed the junior partner’s claims did he assert his own for a judicial buy-out.

Notably, the firm had no written partnership agreement and the partners had always distributed 100% of the practice’s profits equally among themselves. Since the late 1990s, public defense contracts had generated over half the firm’s income, sufficient to pay its overhead as well as the salaries of employees who handled this work.

Law firm retains three experts. To establish the value of his one-fifth share in the firm, the dissociated partner presented an accounting expert, who used a capitalization of excess earnings approach, defining goodwill value as the “difference between the firm’s earnings and the remaining partners’ collective ‘replacement values.’” The expert ultimately determined the partner’s 20% interest ranged between $350,000 and $360,000, which included both the tangible and intangible (goodwill) values.

The law firm presented three accounting experts to value the entire practice. One testified that in his experience, law practices carried no goodwill value, but the other two experts conceded that they do. All three agreed that to the extent there is any goodwill value, the capitalization of excess earnings is an appropriate approach. Two of the three experts (the ones who conceded goodwill value) used substantially higher “replacement values” for the remaining partners than the expert for the dissociated partner did, and ultimately concluded that there was no goodwill value in this particular firm, leaving only the tangible assets, which all four experts agreed were worth between $36,000 and $48,000 for a one-fifth share.

The trial court considered the experts’ evidence against the age, demonstrated earning power, and professional reputation of the. Because the firm was “highly respected” and had “enjoyed success as a preeminent public defense firm,” the court found the excess earnings method was appropriate and adopted the earnings figure used by the partner’s expert but used replacement values that were in the mid-range of all the parties’ experts. Ultimately the court valued the entire firm at $1.16 million and awarded the dissociated partner $232,142 for his share, plus nearly $100,000 in statutory interest, and the law firm appealed.

The firm agreed that the state’s partnership dissolution statute applied a going concern standard of value to the dissociated partner’s share. In this case, however, the firm argued that the local Rules of Professional Conduct (RPC) for attorneys precluded goodwill in the buyout price for a law partnership. It cited a case in which the seller of a law firm agreed to encourage clients to use the buyer’s services, but the court ruled that such a provision violated the RPC’s prohibition against the solicitation or referral of clients for compensation.

In this case, however, the precedent did not apply, because there was no sale of the law firm and no promise to encourage clients, the appellate court held. Instead, the only issue was the practice’s value as a going concern, and the law firm had failed to cite any “law, policy, or disciplinary rule” that barred a dissociated partner from receiving his share of that value that constituted goodwill. Moreover, numerous matrimonial cases recognize goodwill as an asset when valuing a law firm or any professional practice.

As to the method for valuing goodwill, the court rejected the law firm’s argument that the capitalization of excess earnings approach was proper only in matrimonial cases, particularly since four out of the parties’ five experts agreed that it applied in this case. “There is no suggestion in the cases that certain valuation methods apply only for purposes of marital dissolution whereas other methods apply for partnership dissociation.” Similarly, there was no support for the law firm’s argument that the dissolution context was “unique” due to the need to protect the non-professional spouse. “Essentially [the law firm] contends an asset with value in a dissolution has no value otherwise, and has value in a dissolution only where there is a non-professional spouse in need of protection,” the court said. This argument defied “logic” as well as the law.

Finally, the firm tried to argue that by including the earnings from its public defense practice, the trial court had essentially “forced” the sale of the firm’s contracts and treated its clients as “commodities.” But this contention was equally unfounded, the appellate court held. Public defense contracts are no different for purposes of valuing firm goodwill than agreements to handle large litigation for employees, union members, or any other large class of clients.

In sum, “there is no definitive formula for ascertaining the value of goodwill,” the court held, essentially defining goodwill as “the monetary value of a reputation.”  In this case, there was no partnership agreement that excluded a departing partner’s claims to goodwill, and the trial court’s method was logical and provided an “accurate reflection of the goodwill value of the firm as a whole. It was also substantially supported by the expert evidence, the appellate court found, and affirmed the award.