Firm Capitalization

by Joel A. Rose

For partners in many law firms, the world has never appeared to be as hostile, bewildering or financially unstable as it does today. The complexities and uncertainties of the changing economic and professional environment have created special financial problems, especially for undercapitalized law firms. The cash flow problems experienced by many law firms, of all sizes, is frequently due to the inadequate capital to support the firm's operations.

Although there may be many definitions of firm capital, it is usually viewed as being two separate, yet related, elements: (1) working capital and (2) long-term capital.

In its most basic form, working capital is the money necessary for the daily operation of the firm. In most financially successful firms, working capital is the capital that the firm requires to be contributed by the partners.

Long-term capital is the money that is necessary to pay for the "hard assets," i.e., furniture, automated equipment, etc. Long-term capital is usually funded through bank borrowings or leases. This allows a firm to spread the cost of these assets over their working life and thereby spread the burden for payment of that debt among the current and future partners who will benefit from that asset.

Determining a Firm's Capital Requirements

Most firms attempt to establish an amount of working capital that covers their immediate and long-term requirements. First, the amount of working capital should be sufficient to allow the firm to cover its cash flow requirements of the firm's billing and collection cycle, including costs advanced and "average" amount of write-offs and write-downs.

Second, the amount of capital should be sufficient to provide a cushion for usual expenses and partner draws during billing and collection cycles. For example, if one month is typically a slow collection month, the amount of the working capital fund should be sufficient to make-up for the short fall and then it will be repaid during the following month. The third element of working capital is that the amount should be sufficient to pay for some of the firm's growth and expansion plans, i.e., if the firm employs one or more associates, the working capital fund should be sufficient to pay the associates' salaries and related overhead until they can generate sufficient cash flow to cover their own expenses.

A few techniques have been developed for determining the amount of working capital that a firm may require. One is to periodically calculate three months' expenses for the firm, excluding partners' draws. This three month time average will vary depending upon cash flow. Some firms having a very liquid cash flow - clients pay bills promptly - may calculate two months' expenses. Those firms that have experienced slower client payments are encouraged to consider extending their cushion of firm capital to three and a half or four months. Many firms utilize their bank credit lines in lieu of partners' capital contributions as their cushion to pay firm operations and partner draws during "cash flow droughts." It has been the author's experience that firms that follow this practice too often flirt with financial difficulties, especially if the usual collection cycles from important clients are extended by 60 and 90 days or longer. A second technique is to set working capital equal to a fixed percentage of gross fee collections. Oftentimes this may range between five and eight percent. However, the timeliness of collections and plans for hiring additional associates or taking on more space or more expensive space may be a reason for increasing this percentage. We recommend that firm's should reexamine their working capital needs annually, as well as when there are significant changes in items such as payments of accounts receivable, increases in client costs advanced, firm debt or whenever the firm increases its number of lawyers.

Determining Partner Contributions

Most firms determine capital contributions based proportionately on partner earnings. The partner who earns seven percent of the firm's income usually contributes seven percent of the firm's working capital, and so on. As individual incomes go up or down, the firm periodically requests additional or less capital contributions from some partners and refunds some portion of capital to others. Some firms expect all partners to contribute the same amount. However, based upon the author's experience, this is rare. The variable contribution, based upon the percentage of earnings is perceived by partners in most firms to be fair. It is generally assumed that those attorneys who earn more require the use of more overhead than those partners who do not earn as much.

Furthermore, in firms in which fees are heavily dependent upon hourly rates of attorneys, it is logical to assume that the higher earners utilize more overhead to produce their higher fees and therefore should be obligated to pay more towards their overhead and overall operations.

Making Capital Contributions

Most firms now either withhold some portion of a partner's earnings, allowing the partner to fund his or her capital contribution over some definite time period, or the partner is obligated to borrow money from a bank or other source for the full amount, with repayment of the loan guaranteed by the partner or the firm.

Partners in some smaller firms expect the value of their a capital accounts to increase as the firm grows in order to fund their retirement. Typically, these firms determine the value of the firm, including partners' interests as hard assets plus the value of work-in-process and accounts receivable less outstanding debts. When a lawyer is admitted as a partner utilizing this system, the firm determines its value and the incoming partner buys his or her capital interest or fractional interest from an existing partner. This system does not usually work well for a larger or mid-size firm as the cost to new partners to buy into the firm becomes exorbitant, since they are expected to purchase a portion of the growth in work-in-process and accounts receivable that they were responsible for creating. A second reason for not utilizing this method of capitalization is that, should a partner leave the firm to join with another existing or new firm, the remaining partners wind up paying money to a withdrawing partner who may join with a competitor law firm, especially if that partner takes with him or her, their clients. The third reason for not utilizing this method is that the unfunded debt to retiring or withdrawing partners becomes so high that either the firm cannot afford to pay it or the younger partners refuse to buy capital interests of other partners.

Many senior partners prefer this system because they have filled the pipeline of work-in-process and accounts receivable with future income that everyone will receive, and believe they should be entitled to a portion of that income. They also claim that if work-in-process and accounts receivable are converted into cash when they retire, it will not cost the remaining partners anything to pay these accounts. The reality is that the growth in work-in-process and accounts receivable is not just the result of the efforts of one person, but an increase in the size of the firm, and that money is needed to pay the direct and indirect costs of the associates and staff who remain with the firm after the partner retires.

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