Show Me the Money ~ Why Firms Need More Partner Capital

by Joel A. Rose
 

The complexities and uncertainties resulting from the recession that have intensified the competition among law firms to attract and retain clients, coupled with more productive and profitable partners, have created special financial problems for law firms, especially for those firms that are undercapitalized.

In simplest terms, the cash flow and undercapitalization problems experienced by many law firms, of all sizes, are most frequently due to inadequate revenue and capital to support the firm's operations.

In the current economic and practice environment, even well-managed firms are now likely to need more partner-contributed capital than they did just a few years ago. Some reasons behind why firms need more capital relate to additional cash flow stresses due to the slowing of client payment of bills, the fall-off in the volume of profitable transactional work, the cost of technology and greater opportunities for well-managed firms to attract partners (and associates) as lateral hires who are presently in firms, but who may be seeking career opportunities with other law firms.

This article reviews these changes, considers some new capitalization challenges and approaches for capitalizing law firms.

Organizational Growth:

In these difficult economic times, firms of all sizes continue to seek profitable growth opportunities, which invariably require capital.

Even though law firms are pursuing fewer mergers, many firms are continuing to seek acquisitions of lateral hires — partners who control profitable client business and associates who assist them produce the work. These opportunities for growth typically require substantial cash to fund the ramp-up operations.

Many firms have reduced growth by limiting their recruitment of associates.

However, the expected savings in the capital cost of funding recent law school hires has been offset considerably by the additional cash flow requirements for the hiring of lateral attorneys and their support staffs.

Since potential lateral hires who control a substantial amount of client business may have multiple options to consider, few firms have the luxury of negotiating back-end loaded compensation arrangements. Instead, laterals are being offered compensation arrangements that pay them immediately, before the additional cash flow they help generate is collected by their new firm. As in the case of new hires, this cash flow lag must be covered with working capital.

Technology Funding:

In today's practice environment, partners and associates who are accustomed to working with sophisticated hardware and software demand the use of advanced technology to produce their work. Further, clients increasingly expect their outside counsel law firms to have advanced technology to create and deliver legal services more efficiently and cost-effectively.

That being said, many firms have already invested long-term capital in technology infrastructure and applications, including: Internet-connected office, home and mobile computers for all lawyers, local and wide area networks, knowledge systems for retrieval of information and prior work product and litigation support systems.

Those law firms that are "technology latecomers" may find it more financially burdensome than it previously was to raise capital for acquiring competitive systems. Banks and other third-party lenders now often require personal guarantees of partners or impose restrictive loan covenants that may be difficult to meet. This tends to increase the capital commitment required of partners.

Cash Flow Stresses:

Well-managed firms that keep work-in-process and accounts receivable to a minimum may require less working capital from the partners (or the bank) to fund day-to-day operations.

Most financially successful firms have established systems and procedures in an effort to shorten their billing and collections cycles. Nevertheless, the tightening economy has resulted in many clients stretching out payments, thereby generating cash flow shortfalls at law firms.

Adding new practice areas and expanding existing ones can also increase cash flow problems. The firm may require additional funds for client advances if it accepts a major piece of litigation; by adding a new bankruptcy practice, collections will be slower and courts often withhold a reserve. Adding or increasing a family law practice during the current recession will require more working capital, especially when the real estate market is down and it may take much longer for clients to sell real property.

Some cash-strapped firms have been forced to reduce cash distributions to partners or to extend the time of paying their own payables to vendors. In any event, the most common method of acquiring working capital and covering cash flow shortfalls continues to be line-of-credit borrowing or partner funding through cashcalls.

Given the current economic trends, partners should not become too comfortable with readily available "low cost" debt to satisfy cash flow needs, to maintain current levels of partner draws and to remain competitive.

Such behavior can breed partner complacency and often can result in behavior inconsistent with sound financial business practices for managing a law firm. Instead, lawyer management should formulate an appropriate, flexible capitalization policy for the firm, and then implement it.

Guidelines For Contributions:

Setting capital requirements is an art, not an exact science.

It's important that firm capitalization policies be reasonable. For example, many well-run firms add capital each year simply by deferring a small portion of undistributed earned income. This is a relatively painless method for accumulating capital. By contrast, a firm should not adopt a capital policy that requires partners to contribute more than they can reasonably afford. Such a policy could make partnership opportunities in the firm unattractive for its own associates and/or potential lateral hires.

In defining a firm's capitalization policy, the partners should carefully consider what they are trying to accomplish by setting capital requirements. Capital is most often used for the following purposes:

  • To accommodate growth and expansion;
  • To purchase technology; and
  • To provide a cushion when collections lag behind expenses, and similarly to cover client costs advanced.

Capital usage should be realistic. For example, capital for growth can legitimately be used to cover the initial draws of new hires. By contrast, capital for covering advances and expenses should not be used to cover the draws of established partners. Those draws should simply be deferred until there is sufficient cash available.

How do you determine how much capital is ideal? The following are some guidelines that firms should consider when setting their required levels of capital.

• Set capital equal to one to three months' expenses for the firm, exclusive of partners' draws.

This time average will vary depending upon cash flow. Some firms with a very liquid cash flow ~ clients pay bills promptly ~ may calculate one or two months' expenses, exclusive of partners' draws. Those firms that have experienced slower client payments are encouraged to consider extending their "time cushion" of firm capital. Does this mean that the firm will maintain these funds in a separate "cash reserve?" Practically speaking ~ no.

• Bank credit lines.

Many firms utilize their bank credit lines in lieu of or to supplement 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 often flirt with financial difficulties, especially if the usual collection cycles from important clients are extended by 60 to 90 days or longer.

• 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 firms should re-examine 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 or firm debt or whenever the firm increases its number of lawyers.

• Set capital equal to net fixed assets.

Firms commonly borrow to fund the purchase of furniture and equipment, thereby spreading the cost of each acquisition over the productive life of the asset. An equal amount of financing is then provided by the partners to fund the working capital needs of the firm. This "funding" can assume many forms, including actual cash capital contributions by partners (the most fiscally responsible and conservative approach) or deferred distribution of earned income.

• Set capital equal to one-half of the firm's long-term debt.

This ties in with the item above. Lenders are increasingly looking for a comfortable level of shared risk. They are still willing to lend money for acquiring assets, but they want some assurance that the partners and firm can repay the obligation.

Acquiring Contributions:

Since partners are the ultimate source of a firm's capital, lawyer management must educate them about the basic elements of law firm economics, including firm capitalization. They also need to help manage partner expectations regarding capital contributions and distributions, and the risks partners assume as owners of the firm. Whenever a firm admits a new partner, the firm should require the new partner to contribute capital. Increasingly, a partner's capital requirement mirrors the partner's share of profits.

Most firms either withhold some portion of a partner's earnings, allowing the partner to fund his or her capital contribution over some definite time period. Partners in some smaller firms expect the value of their 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 midsized 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. Although this approach for capitalizing a firm may appear to be fiscally sound, 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. Also, the unfunded debt to retiring or withdrawing partners may become so high that either the firm cannot aff ord to pay it or the younger partners refuse to buy capital interests of other partners.

Regardless of whether a firm has a formal capital plan, most will use several types of bank funding concurrently to fulfill working and long-term capital needs. But due to changed business conditions, accessing each of these capital sources is getting more challenging.

Clients are taking longer to pay their bills and more firms are becoming overly reliant on banks to cover operational cash shortfalls. Loans to law firms are no longer viewed as "low risk," so banks are evaluating firms on a more business-like basis. Now, the norm is restrictive bank covenants and/or some level of loan guarantee.

Law firms should make a practice of being totally paid up on all their lines of credit for 30 consecutive days each year. This will assure partners, as well as the banks, that the firm is not totally dependent on the banks. Increasingly, banks are insisting on this annual demonstration.

In firms lacking the profit levels and partner willingness needed to finance growth internally, firm leaders have increasingly turned to bank credit to finance the addition of lateral hires, including individuals and groups. Even with today's attractive interest rates, however, many firms have not exercised the fiscal responsibility needed for this type of financing. Part of a lateral hiring plan should include a repayment plan for the debt incurred. Typically, firms should plan on a three- to four-year principal repayment plan. This helps spread the ramp-up cost over a number of years, during which the firm should achieve initial benefits.

Some firms require partners to meet their capital obligations immediately. These firms create a facility at the bank that permits partners to take out personal bank loans to fund their capital requirements, with the firm guaranteeing those loans.

Banks now scrutinize law firm financial data in much greater depth than previously. After lending money, banks increasingly perform in-depth monthly and quarterly checkups to assure themselves of the firm's ability to repay. Firms may need to reevaluate their billing and accounting reports to anticipate and comply with the bank's newly sophisticated benchmarks for loan monitoring.

Conclusion:

Developing a capital plan is not a one-time exercise. Instead, it should include an ongoing assessment of the strategic and financial needs of the law firm. At a minimum, firms should focus on their annual capital and cash flow requirements.

A firm's lawyer management must educate partners about the needs for capital in law firms, including alternate sources of working capital to address firm cash flow shortfalls. As part of managing cash flow, it is crucial to manage partner expectations regarding income distributions.

©1999-2017 Joel A. Rose & Associates