Opinion: Is Your Law Firm Properly Capitalized?
The business of practicing law is changing. Leaner economic times and cost-conscious clients are challenging traditional fee structures, which in turn affects how law firms manage their finances.
It's the new norm. Firms aren't as profitable as they once were, the market is more competitive, and clients are more critical of traditional billing practices. It's no longer a matter of adding up billable hours. Clients want to know up front what their costs are going to be ahead of time.
These trends are prompting law firms to re-think their financial structures. In particular, our firm has recently fielded many questions about the proper capitalization of law firms. Specifically, how do law firms determine how much capital they need and how do they obtain that capital?
All law firms need a certain amount of working capital—a reserve used to fund ongoing operations and the possible future expansion of the firm. This money is usually contributed by the partners. (This is different from long-term capital which is the money needed to acquire hard assets like computer systems. Long-term capital is usually sourced from bank loans or property/equipment leases.) The exact amount of working capital varies for each firm and can even change from year to year.
In the big picture, a firm's business strategy determines its need for working capital. So it's critical to start with a strategic plan, clearly outlining the partners' goals and objectives, including a timeline. Only then can a firm accurately forecast its capital needs and decide how to fund them.
A firm may plan to open two new offices, bring on five laterals, and upgrade its software in the coming two years. In such a case, the firm needs a relatively high level of working capital. On the other hand, if a firm expects to maintain its current operating status and expense needs for the next few years, its working capital requirements may not be as high.
When determining how much working capital your law firm needs, consider any gaps it may have in its cash flow. Most, if not all, businesses have gaps in time between client billings, payment of operating expenses, and collection of fees from clients. Examine the turnover of your accounts receivable, unbilled time, and accounts payable. This will help you determine capital needs specific to your firm's particular billing/expense/collections cycle. Working capital should also be enough to provide a cushion for common, ongoing expenses (overhead) as well as partner draws. In today's business climate, it is a good idea to have enough working capital to pay for your firm's growth and expansion plans.
Some firms may need to put capital aside to fund retirements as well. Although pre-funding retirements is waning, some firms make payments to partners even after they retire.
Once you've determined your firm's general need for capital, hone in on the exact amount and how to raise it. There are several options in calculating the specific amount of working capital your firm should have on hand. One is to base the amount on monthly expenses. The number of months you should be prepared to cover depends on your firm's cash flow. Alternatively, working capital needs can be calculated as a fixed percentage of gross fee collections. The percentage you withhold depends on several variables—including the timeliness of billings collection, whether you plan to hire additional associates, and whether you plan to physically expand your office (which increases leasing expenses).
In general, law firms depend on partners for working capital. Most firms don't like to borrow money and would prefer to buildup working capital through internally generated profits. That translates into tapping partners' earnings. Law firms can ask partners to contribute a certain amount of capital initially, withhold some portion of each partner's earnings, allow partners to make their own capital contributions over time, or do some combination of all three.
Asking partners for capital can have ramifications. Lawyers do not have restrictive covenants, so if attorneys are not in total agreement with expansion plans or the amount that each is asked to contribute, they may go elsewhere. In addition, there are tax consequences to making capital contributions: Although partners forego the income they contribute to the working capital fund, they are generally still taxed on the income.
• Add together accounts receivable and work in progress. Then, divide by the amount of debt. The resulting number should be greater than five.
• Total debt should be less than 100 percent of the net book value of your firm's fixed assets.
• Your firm's balance on any line of credit should be zero at year end.
• Owner's equity of cash basis balance sheet should be positive and sufficiently liquid to cover at least two weeks of expenses.
• Your firm should not be in breach of any debt covenants.
There are other questions to consider when relying on partners for working capital:
• What should be the initial capital contribution of an equity partner? Our firm sees amounts ranging from zero to $75,000.
• Should your firm require additional capital contributions from partners, and if so, at what percentage? What will be the maximum amount? This often ranges from zero to ten percent, with a maximum of $300,000 in total.
• Should your firm ask an equal amount of capital from every partner? Should a junior partner contribute as much as a senior partner? This contribution amount is often based on compensation level.
• Will partners receive interest on the money they contribute? If so, what will be the interest rate? This is generally in the zero to 10 percent range.
• Will the firm pay back capital contributions? If so, how and when? It's been our experience that law firms usually pay partners back over a period of several years upon retirement.
Law firms should set aside enough working capital for the future, with the amount and method depending on the firm's strategic plan. Moreover, firms should be cognizant of how capital contributions impact their partners.
There is no set formula or "packaged" solution to determining how much capital a firm needs or how to raise it. Every firm is different; each has its own unique and specific cash flow cycle and has different expansion goals. But all firms should start at the same place: by clearly defining a strategic plan. "Only then can the firm make smart choices about how to finance its future." •