Due diligence on a professional services target: what the numbers hide

A law firm partner once told an acquirer that the firm's "revenue" for the year was $40 million. What she didn't mention: $6 million of that was unbilled work sitting on the books as WIP (work in progress), some of it for a client who had already fired the firm. The deal still closed, but at a price $4 million lower than the original offer. That gap was found in three weeks of due diligence, not in the glossy pitch deck.

Professional services firms (law, accounting, consulting, architecture, actuarial) look deceptively simple to value. There's no factory, no inventory, no patents to fight over. But the balance sheet hides risks that generic M&A due diligence checklists, built for manufacturers or software companies, routinely miss.

Why professional services firms are different

Three structural features drive the risk:

• The "asset" is people, not property. Revenue depends on partners staying, not on machinery.
• Revenue recognition is judgment-heavy. Much of the top line is an estimate of value not yet billed or collected.
• Liability often follows the individual, not just the firm, especially in partnerships and LLPs (limited liability partnerships).

This means the real due diligence work happens off the income statement.

WIP valuation: the first place to dig

WIP (work in progress) is unbilled time and disbursements for client work already performed. In law and accounting firms, WIP can represent 15 to 25% of annual revenue as an estimate, and it's almost always marked at "expected recoverable value," a number set by the partners doing the work.

That's a conflict of interest. Partners have every incentive to overstate WIP before a sale, because it inflates both revenue and the acquisition price if the deal uses a revenue or EBITDAEBITDAEBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) measures a company's operating profitability before financing and accounting decisions, used to compare core performance across firms.View full definition → multiple.

The check: pull WIP aging by client and matter. Anything unbilled for more than 90 days deserves scrutiny. Compare WIP write-off rates (the percentage of WIP never billed) over the last three years; a rising trend signals the firm is capitalizing optimism, not cash.

Worked example:

A consulting firm reports $10 million WIP on its balance sheet. Historical write-off rate: 12%. Adjusted recoverable WIP = $10m x (1, 0.12) = $8.8 million. If the deal values WIP dollar-for-dollar in the purchase price, that's a $1.2 million overpayment before any negotiation even starts.

Contingent liabilities: what's not on the balance sheet at all

Professional services firms carry liabilities that often don't appear on a standard balance sheet:

• Professional negligence claims in progress or threatened but not yet filed.
• Regulatory investigations, for example by the SEC (Securities and Exchange Commission) into an accounting firm's audit quality, or by the SRA (Solicitors Regulation Authority) in England and Wales into a law firm's client money handling.
• Tax exposure from partner draws treated inconsistently across jurisdictions.

Auditors' own liability is a live sector issue: major accounting networks have paid nine-figure settlements tied to audit failures (see, for example, publicly reported PCAOB, Public Company Accounting Oversight Board, enforcement actions against Big Four affiliates).

The check: request the claims register and correspondence with the firm's professional indemnity (PI) insurer for the past six years, not just the past two. In the UK, most PI policies for solicitors are written on a "claims made" basis, meaning a claim is covered by whichever policy is active when the claim is *reported*, not when the underlying error occurred. That timing detail matters enormously in a sale.

Partner guarantees: liability that walks out the door, or doesn't

In an LLP, individual partners are generally shielded from the firm's debts, that's the point of the LLP structure introduced in the UK by the Limited Liability Partnerships Act 2000, and in the US through state-level LLP statutes. But shielding is not absolute:

• Partners may have signed personal guarantees on office leases, bank facilities, or equipment financing.
• Departing partners in many firms remain liable for acts committed while they were partners, surviving the sale.
• Equity partners often have capital accounts (money they've contributed or that's been retained from profits) that must be repaid or rolled over as part of the deal.

The check: get a full schedule of personal guarantees tied to firm obligations and confirm who releases them, and when, on completion. Buyers frequently assume guarantees disappear automatically; they don't unless the lease or loan is formally amended.

Insurance run-off: the risk that outlives the deal

This is the check that generic M&A diligence teams miss most often, because it doesn't fit a standard financial model.

When a professional services firm is acquired and stops operating as an independent legal entity, its PI insurance needs a run-off policy, cover for claims arising from work done before the sale but reported afterward. Run-off cover is not automatic and not cheap.

As a rough market estimate, run-off premiums for a mid-sized professional firm can run 200 to 300% of the final year's annual PI premium, as a one-time cost, because insurers are pricing years of "tail" exposure into a single payment. For a firm paying $500,000 a year in PI premiums, that's potentially $1 million to $1.5 million in run-off cost that someone (buyer or seller) has to fund.

The check: confirm in the sale and purchase agreement (SPA) exactly who buys the run-off policy, for how many years (six years is common for UK solicitors under SRA minimum terms rules), and who pays.

Regulatory bodies to know by sector

Each regulator can block, delay, or unwind parts of a deal if change-of-control notifications aren't filed correctly. In the UK, the FCA's change in control regime (under the Financial Services and Markets Act 2000) requires pre-approval before a buyer acquires a controlling interest in an FCA-authorized advisory business, this is frequently overlooked when a professional services firm has even a small regulated subsidiary.

For a readable primer on how run-off and claims-made insurance actually work, the International Risk Management Institute (IRMI) glossary is a solid free reference.

Key Takeaways

• WIP is an opinion, not a fact. Always adjust for historical write-off rates before accepting it at face value in a valuation.
• Contingent liabilities in professional services rarely sit on the balance sheet. Get the claims register and six-plus years of correspondence with the PI insurer.
• Partner guarantees and capital accounts can survive the deal unless the SPA explicitly releases or restructures them.
• Insurance run-off cover is a real, sometimes six-figure-plus cost that must be negotiated explicitly; assume nothing transfers automatically.
• Regulatory change-of-control rules (FCA, SRA, state bars) can delay or block closing if not filed early, treat them as a critical path item, not paperwork.