At the end of last year, the Legal Services Act gained Royal Assent, with provisions for alternative business structures (ABS) heralding opportunities for major changes in our legal services market – currently estimated to be worth £19bn. Although the law – which allows law firms to go into business with other professionals and list on the stock market – does not come into force until 2011, both investors and existing law firms are starting to rethink the delivery of legal services and explore market potential. This is an unprecedented opportunity for financial institutions and retailers to provide a range of legal products and for investors to take equity in existing legal practices.

Talk of redistribution of clients, work, profit, capital and ownership is forcing partners to ask a fundamental question: "How much is our business worth?" But, in any market undergoing deregulation, the question should in fact be: "How much could our business be worth?"

In a sector that has evolved with equity partnership structures as the norm, the application of commercial business principles in relation to valuation, succession planning and exit strategies can seem alien. However, those firms that invest now in developing strategies to maximise the potential value of their businesses will be the ones benefiting fully from the commercial opportunities the market will present in a few years' time.

Partners now have to assess exactly what their position is moving forward. Are they going to position themselves as excellent lawyers, whose primary raison d'etre is to dispense best advice to clients? Or is their role that of a business owner, who runs a law firm with the primary objective of maximising profits? The difference will have significant implications for the value of the business.

Historically, a solicitor's career path has been governed by the coveted goal of equity partnership status within a firm, with senior partners appointed on length of service. Being a good solicitor determines suitability for partnership and a share of the equity and profits. On retirement, equity is sold within the firm and, unlike other commercial sectors, goodwill is not a recognised asset.

By comparison, the value of a commercial organisation is usually determined by a traditional benchmark in each industry sector, based on an organisation's profit times a multiple (usually somewhere between two and four), and taking into account industry standards, goodwill and issues such as prevailing market conditions. But times are changing and those companies that are able to demonstrate they not only have the processes in place to run a profitable business, but also strategies to continue to develop profitable growth, are increasing the valuation of their organisations considerably.

So, while initial reaction to 2011 from the legal profession may be to focus on increasing profitability to add value to the business, it should also be focusing on developing organisations where capital assets, such as goodwill, are recognised, valued and consequently multiples are enhanced and potential valuations increased.

For the first time, if partners can demonstrate that recognised business valuation layers – from clients, staff and systems, down to product extensions, distribution channels, brand/position and scale – have been built into their practice, then they will be able to demonstrate underlying business assets and sell their own shareholdings for potentially much greater sums.

Seven layers of valuation

We have developed a valuation model, or framework, for use with clients, the so-called 'seven layers of valuation'. From experience, we know that each layer from the list that is put in place increases the worth of a business by a particular multiple – details of which you can see in the table below.

Business-worth multiples

The first three layers relate to operational aspects of the business and roughly correspond to traditional benchmarking practices as viewed by a potential investor. If someone is simply buying access to a firm's existing clients, then they are buying current revenue only, with no guarantee of future income, and hence this type of sale attracts the lowest multiple.

If a firm has invested in developing its staff so that they are functionally efficient, then they have a value to the business and the potential benchmark doubles. Add to this a number of effective processes in place that are better than the competitors, for example in IT, marketing, sales and training, and the business attracts a benchmark multiple of three. However, if the firm has also developed the business strategically, the benchmark multiple increases significantly. You will see from the table below that the remaining four layers of valuation really enhance desirability and value to a purchaser.

Do partnerships hold back business?

At this stage, it is appropriate to look at the partnership structure and consider how appropriate this traditional arrangement is in today's commercial environment. When profitable growth is the goal, does a partnership actually allow a business to react quickly to market changes – whether that is taking advantage of new opportunities or fighting off increased competition?

Partnerships rarely fulfil the potential of their employees or maximise the commercial potential of the business. In functional terms, the more people who become partners the less efficient the collaborative process.

The tale of 35 partners deciding on the type of coffee machine to purchase may be apocryphal, but partnership meetings invariably have agendas packed with day-to-day administrative issues. With partners billing out time at around £350-plus an hour, how does this make sense?

Streamlining for control

Levels two and three on the seven layers of valuation table refer to a firm where the functional side of the business is streamlined to achieve maximum efficiencies. Starting at partner level, this means defining the roles that are needed to run the business and then putting the people with the right skills in the right jobs.

As an example, in a mid-tier firm, a team of three is sufficient to take on the responsibility of driving the business effectively. This team would consist of a general or practice manager who runs back office and business support; an operations manager to oversee revenue generation functions and a CEO to coordinate the two, while also concentrating on developing business strategies looking at future development.

While many firms already have some kind of management team in place, much of what they do in the traditional structure is focused on back-office work at the expense of strategic projects that look at achieving profitable growth.

This leaner team of three shifts the balance of power back to the interests of the company and out of individuals' hands. Via a CEO, the trio is still answerable to a board that represents shareholders' interests, but the decision-making process and day-to-day running of the business becomes faster and more transparent. This leaves the board free to be more strategic in its thinking and allows high fee-earning lawyers to concentrate on their core skills.

After going through this process, one mid-tier firm we worked with conducted research among its team leaders and found that, as a group, this more efficient structure released 63 billable hours per month for the team leaders. In fee terms, this meant they now had the potential to add £150,000 direct to the bottom line without increasing resources.

For the majority of law firms, successfully implementing the first three layers of the valuation model are the most challenging and crucial steps. They demand an understanding of the opportunities inherent in the post-Clementi world and a clear vision of their place in it. But once this base work has been achieved, the final valuation layers are the platform for continued growth and significant value.

Layer four is related to the range of offerings and how these have expanded. If a business has built sufficient customer loyalty so that new products or offerings are readily accepted by them, then the multiple doubles from three to six.

Following on from product range, a business that can demonstrate a strategy to open up new markets through establishing networks with creditable third parties, and has the (distribution) channels in place to develop and expand further, increases its value again.

Next on the list is an organisation's market positioning and the strength of its brand. If it is a strong brand then it has equity that is reflected in the balance sheet. A strong brand attracts client loyalty, it makes new offerings attractive and desirable, it attracts the best talent to work for it, and it makes other organisations want to be associated with it. In short, a firm that has developed a distinct and strong positioning has increased the desirability of its business to investors.

Finally, if you can add to the above list the ability to replicate the business in multiple markets, then you can achieve the highest multiple of all.

Mark Riminton is a director at Shirlaws.