Avoiding Extinction in a Turbulent Legal Market: Financial Hygiene Perils

' Lack of financial hygiene

If management can act to strengthen these areas early on, they can often limit their problems and bring the firm back to a prosperous track.

Financial Hygiene

At the end of the day, very little makes up for a lack of profitability. Firms with poor economic performance risk losing key partners. Usually, these are firms that lack strategic direction, leadership, operational effectiveness and a service-oriented culture. A few lateral defections can transform an outwardly successful firm to a failing firm overnight. The larger the economic gap between firms, the higher the probability that partners will make lateral moves. To ensure that partners remain committed, the firm's leaders need to quickly identify financial weakness and take corrective action. As illustrated in the accompanying figure, some of the warning signs that management needs to identify include:

Excessive financial leverage and a weak 'Economic Balance Sheet.' Excessive borrowing is the most obvious aspect of a weak economic balance sheet (which may be defined as the entirety of the firm's assets and liabilities regardless of whether included in the standard, cash-basis balance sheet). Many firms still rely on bank debt to fund operating cash flow, plus substantial additional debt to fund infrastructure and growth. There also remain a large number of firms that philosophically do not believe in significant partner capital, which drives an increased need for debt financing. While some firms can sustain unusual debt loads during good times, they act as an accelerant in bad times. If the firm hits a rocky patch, high debt firms are more likely than others to experience a raft of partner defections, particularly when the partners are individually responsible for the debt.

Significant deferred compensation payments (typically for retired partners) and excessive lease commitments. Too many firms overextend themselves in good times, either assuming growth rates will continue, or that somehow they can continue to pay for unnecessarily lavish office designs.

Inventory Buildup. Law firms need to pay close attention to their billing and collections patterns, beginning with assuring that the firm is accepting the right clients in the first place, and culling those that do not fit the firm's target profiles and have difficulty paying the firm's bills. Any excessive or unexplained buildups in inventory levels should also draw management attention, and remedial action with the responsible partners.

Realization. All too often, billing partners strike deals with clients to provide the firm's services at some discount from the firm's standard rates. There are a host of reason why this happens ' including inadequate client intake procedures, a compensation system that awards any kind of origination, and actual or perceived rate pressures.

Unfortunately, many partners fail to realize that a small discount from standard rates translates to a major reduction in the firm's profit margin. With overall realization rates for well-run firms ranging between 92-94% of standard rates, there is little room for a partner to offer discounts. In their role, management needs to ensure that partners comply with appropriate policies regarding write-offs and discounts, including the levels of pre-recording discounts happening in their practices.

Productivity. Law firms have recently experienced softness in workloads in some practice areas, particularly in corporate transactional matters. Firms that fail to deal with under-productive lawyers (at all levels) will find it increasingly difficult to compete. It is easy to say that the firm's leaders should eliminate under-producers; actually doing so is much harder. Firms that are unable to make hard decisions with respect to these lawyers are less competitive than their well-run brethren.

It is also important to make sure the firm carefully analyzes its productivity. One issue that arises regularly in slow practices is a shift of hours from the associates to partners. If the firm sees a shift in the levels of effective leverage in a practice, it is generally a signal that the partners are hoarding the work to prevent appearing under-productive.

Conclusions

The legal profession is in a turbulent state, and while most firms are doing well economically, others are feeling significant stress. As importantly, many apparently healthy firms have conditions that, left unattended, will result in long-term decline and eventual collapse. However, for most, time remains on their side, and early intervention and commitment to change can place a firm back on a solid long-term footing.

To avoid finding your firm on the side of the road with other broken-down entities, evaluate and test your strategy, empower your leadership and management, and take a renewed interest in your clients and their needs. Ultimately, that will keep you on the road to long-term success.

Joseph B. Altonji, a Director in Hildebrandt International's Strategy Group and Strategic Implementation Group, works with law firms nationwide to improve their strategic focus, planning, business management
and competitiveness.

William G. Johnston, a CPA, is a member of Hildebrandt's Strategy Implementation practice and leads Hildebrandt's financial/crisis management sub-group.

The early days of 2003 have brought a stark reminder to the leaders of law firms: While strong law firms have experienced an exceptional level of prosperity and growth in a consolidating market, continued expansion and ever increasing profitability are not the only potential destinies for law firms today. As the high profile closures of long established firms such as Brobeck; Peterson & Ross; Hill & Barlow and others demonstrate anew, firms can fail. And with failure come career interruption, client uncertainty and financial distress for many. Recent dissolutions reinforce the fact that law firms are fragile enterprises. If not carefully and constantly renewed and developed, they are in danger of falling apart, often rather quickly. In reality, in spite of appearances of rapid failure, the seeds of collapse are generally sown long in advance ' in most cases, even long before the firm begins to noticeably decline (eg, as seen in the form of firm shrinkage or lowered profitability). The lessons learned from dissolving firms offer leaders an opportunity to avoid seeing their firms consigned to the dustbins of history ' if properly focused and motivated, there is almost always time to intervene and change a firm's direction, before it is faced with a final crisis. Of course, leaders must know where to focus their efforts. There is no simple list of things that drive a firm to failure, and in most situations the underlying problems are many and complexly interwoven. In general, the sources of failure come from three overriding areas, and usually from more than one simultaneously:

' Weak or non-existent strategic focus

' Poor operational effectivenes

' Lack of financial hygiene

If management can act to strengthen these areas early on, they can often limit their problems and bring the firm back to a prosperous track.

Financial Hygiene

At the end of the day, very little makes up for a lack of profitability. Firms with poor economic performance risk losing key partners. Usually, these are firms that lack strategic direction, leadership, operational effectiveness and a service-oriented culture. A few lateral defections can transform an outwardly successful firm to a failing firm overnight. The larger the economic gap between firms, the higher the probability that partners will make lateral moves. To ensure that partners remain committed, the firm's leaders need to quickly identify financial weakness and take corrective action. As illustrated in the accompanying figure, some of the warning signs that management needs to identify include:

Excessive financial leverage and a weak 'Economic Balance Sheet.' Excessive borrowing is the most obvious aspect of a weak economic balance sheet (which may be defined as the entirety of the firm's assets and liabilities regardless of whether included in the standard, cash-basis balance sheet). Many firms still rely on bank debt to fund operating cash flow, plus substantial additional debt to fund infrastructure and growth. There also remain a large number of firms that philosophically do not believe in significant partner capital, which drives an increased need for debt financing. While some firms can sustain unusual debt loads during good times, they act as an accelerant in bad times. If the firm hits a rocky patch, high debt firms are more likely than others to experience a raft of partner defections, particularly when the partners are individually responsible for the debt.

Significant deferred compensation payments (typically for retired partners) and excessive lease commitments. Too many firms overextend themselves in good times, either assuming growth rates will continue, or that somehow they can continue to pay for unnecessarily lavish office designs.

Inventory Buildup. Law firms need to pay close attention to their billing and collections patterns, beginning with assuring that the firm is accepting the right clients in the first place, and culling those that do not fit the firm's target profiles and have difficulty paying the firm's bills. Any excessive or unexplained buildups in inventory levels should also draw management attention, and remedial action with the responsible partners.

Realization. All too often, billing partners strike deals with clients to provide the firm's services at some discount from the firm's standard rates. There are a host of reason why this happens ' including inadequate client intake procedures, a compensation system that awards any kind of origination, and actual or perceived rate pressures.

Unfortunately, many partners fail to realize that a small discount from standard rates translates to a major reduction in the firm's profit margin. With overall realization rates for well-run firms ranging between 92-94% of standard rates, there is little room for a partner to offer discounts. In their role, management needs to ensure that partners comply with appropriate policies regarding write-offs and discounts, including the levels of pre-recording discounts happening in their practices.

Productivity. Law firms have recently experienced softness in workloads in some practice areas, particularly in corporate transactional matters. Firms that fail to deal with under-productive lawyers (at all levels) will find it increasingly difficult to compete. It is easy to say that the firm's leaders should eliminate under-producers; actually doing so is much harder. Firms that are unable to make hard decisions with respect to these lawyers are less competitive than their well-run brethren.

It is also important to make sure the firm carefully analyzes its productivity. One issue that arises regularly in slow practices is a shift of hours from the associates to partners. If the firm sees a shift in the levels of effective leverage in a practice, it is generally a signal that the partners are hoarding the work to prevent appearing under-productive.

Conclusions

The legal profession is in a turbulent state, and while most firms are doing well economically, others are feeling significant stress. As importantly, many apparently healthy firms have conditions that, left unattended, will result in long-term decline and eventual collapse. However, for most, time remains on their side, and early intervention and commitment to change can place a firm back on a solid long-term footing.

To avoid finding your firm on the side of the road with other broken-down entities, evaluate and test your strategy, empower your leadership and management, and take a renewed interest in your clients and their needs. Ultimately, that will keep you on the road to long-term success.

Joseph B. Altonji, a Director in Hildebrandt International's Strategy Group and Strategic Implementation Group, works with law firms nationwide to improve their strategic focus, planning, business management
and competitiveness.

William G. Johnston, a CPA, is a member of Hildebrandt's Strategy Implementation practice and leads Hildebrandt's financial/crisis management sub-group.