Partner Capital: Why Firms Need More in 2003

Most law firm partners react skeptically to the suggestion that their capital contributions should go up in 2003. After all, with the cost of borrowing at its lowest level in over 40 years, why should partners invest more capital in the firm, thereby delaying or reducing personal cash flow?

Nevertheless, even well managed firms are now likely to need more partner-contributed capital than they did just a few years ago. Reasons firms currently need more capital relate to changes in the costs of firm growth, to technology requirements, and to additional cash flow stresses. Let's examine those changes, and then look at some capitalization challenges that are also new.

Organizational Growth Funding

Even in these difficult economic times, successful firms continue to seek growth opportunities, which invariably require capital.

• While firms are embarking on fewer mergers, they continue to seek large acquisitions or large numbers of smaller acquisitions. These expansions typically require substantial cash to fund the ramp-up operations.
• Many firms have reduced their bottom-up growth by limiting recruitment. The expected saving in the capital cost of funding new hires has been offset considerably, however, by the increased compensation of new lawyers and a renewed focus on lateral hiring.
  Not only are these new hires now paid more, but billing for their work must now be more conservative than previously. Clients are increasingly reluctant to 'pay for training young lawyers.'
• Cash requirements for compensating laterals similarly continue to increase. Moreover, most laterals have multiple options to consider, so few firms have the luxury of negotiating back-end loaded compensation arrangements. Instead, laterals are getting compensation arrangements that pay them right away, long before the additional cash flow they help generate is collected by their new firm. As in the case of new hires, the resultant cash flow lag must be covered with working capital.

Technology Funding

Clients increasingly demand the use of advanced technology by outside counsel to create and deliver legal services more efficiently. 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.
• Litigation support systems.

Technology latecomers may find it more burdensome than previously to raise capital for acquiring competitive systems. Banks and other third party lenders now often require personal guarantees or impose restrictive loan covenants that have become difficult to meet. One way or another, this tends to increase the capital commitment required of partners.

Cash Flow Stresses

Firms that keep work-in-process and accounts receivable to a minimum require less working capital from the partners (or the bank) to fund day-to-day operations. Most successful firms continue to work hard 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.

Practice changes can also aggravate cash flow problems. The firm may require additional funds for client advances, eg, if the firm takes on a major piece of litigation. Developing new practice areas can have this effect as well; eg, in a bankruptcy practice, collections will be slower and courts often withhold a reserve.

Some cash-strapped firms have reduced cash distributions to partners or slowed payment of their own trade payables, but the most common method of acquiring working capital and allaying cash flow shortfalls continues to be line-of-credit borrowing.

Given the current economic trends, partners should not get 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 owners of a business.  Instead, they need to formulate an appropriate, flexible capitalization policy for the firm, and then follow it.

Guidelines for Partner Contributions

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

It's important for capital policies to 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 in the firm unattractive for laterals or the firm's own associates.

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.
• 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 firms consider when setting their required levels of capital. For warning signs that not enough capital is being maintained, see the sidebar on page 6.

' Set capital equal to 30 days of operating costs. The theory is that the partners will contribute an amount of cash sufficient to operate the firm for 30 days. Does this mean that the firm will maintain these funds in a separate 'cash reserve'? Practically speaking, no.

' 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 Partner Contributions

Since partners are the ultimate source of a firm's capital, firm leaders need to educate them about capital requirements. They also need to help manage partner expectations regarding capital contributions and distributions, and the risks partners assume as owners of the business.

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.

Bank Funding

With or without a formal capital plan, most firms use several types of bank funding concurrently to fulfill working and long-term capital needs. Due to changed business conditions, accessing each of these capital sources is getting more challenging.

' Using Lines of Credit to Aid Cash Flow. With clients taking longer to pay their bills, 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. Also now the norm: 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.

' Bank-Financed Growth. 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.

' Capital Loans to Partners.  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.

' Long Term Debt. 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 banks' newly sophisticated benchmarks for loan monitoring. (See sidebar on page 3).

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.

Firm leaders need to 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, it is crucial to manage partner expectations regarding income distributions.

Howard L. Mudrick, CPA, is the president of HM Solutions in Dallas. He has more than 20 years experience helping law firms with strategic planning, mergers and acquisitions, partner compensation, financial management, firm reorganizations, and general counseling. He can be reached at 972-906-1951.

Gone are the days when banks didn't worry about a law firm defaulting on a loan. If your firm seeks bank funding for a long-term capital investment or establishing a line of credit, you can now expect the bank to screen the firm closely ' not to say intrusively. Moreover, the bank will likely continue to monitor the firm's ongoing ability to repay the loan.

Screening of Financials

Banks now carefully examine reams of data from their law firm clients!

• At a minimum, banks examine income statements and balance sheets, typically for a three-year period.
• Often they will prepare cash flow statements to better understand how the firm uses its cash.
• They will quite likely compare your firm's key ratios to other firms in the profession. These ratios could include revenue per lawyer, expense per lawyer, net income per partner, and debt and capital per partner.
• They especially look at whether distributions exceed net income, ie, whether the firm has a history of borrowing money to make partner distributions.

Screening of Market Position and Management

In addition to purely financial analysis, lenders often attempt to evaluate the risk of lending money to a firm by assessing the firm's market position and internal management. For example, lenders may:

• Examine what kinds of clients the firm services.
• Assess the firm's reputation.
• Determine whether there is an unusual concentration of clients in a particular industry.
• Evaluate whether there is a concentration of lawyers in a single practice area.
• Measure whether the firm is overly dependent on a few clients (or even a few rainmakers) for business.

Lenders may also review:

• Quality of firm management.
• Cohesion of the partners.
• Demographics of the partnership.
• Trends and projections in partner growth.
• Billing and write-off policies and history.
• Controls on client acceptance or intake.
• Contingency work.
• Quality assurance, including malpractice history.
• Firm financial commitments, including office leases, equipment leases, and amounts due former or retired partners.

Obviously this is a very subjective analysis. But these are all genuinely important questions regarding a firm's financial health ' questions that some firms never ask themselves. Firms are well advised to consider these questions before the bank does.

Ongoing Monitoring

More sophisticated lenders will (and should) prepare projections to get some sense of the firm's ability to repay debt. Lenders are more closely monitoring firm finances to ensure firm compliance with covenants. They are better attuned to firm performance and departures that may raise red flags. Increasingly, lenders are performing monthly and quarterly checkups and comparisons of:

• The value of hours worked.
• Trends in firm inventory, including amounts billed, fees collected and write-offs.
• Cash flow and net income versus budget.
• Cash distributions to partners versus budget.

In the current business climate, a firm can be undercapitalized even if it has already cut back on growth plans, has already made necessary investments in technology, and already actively manages its billing-collection cycle. Here are the most common signs that partner capital contributions may be inadequate:

• The firm overly relies on the bank to fund cash flow. A likely example is a firm that consistently borrows from its line of credit, month after month, to get by. Even more telling is a firm's inability to fully pay off its short-term line of credit at the end of the year, especially if that pattern persists.
• The firm has increasing inventories of work-in-process and accounts receivable without a corresponding increase in collections over the long term.
• The firm has increasing levels of accounts payable that are going unpaid beyond the normal period. (Partners should pay closer attention to whether their firm is deferring accounts payable in order to pay the partners.)
• The firm is unable to pay partner draws or salaries on a regular or timely basis.
• The firm's total expenses are increasing at a rate greater than revenue is increasing. This is common in firms that are adding partners who are unable to generate sufficient dollars to justify their own compensation.

Most law firm partners react skeptically to the suggestion that their capital contributions should go up in 2003. After all, with the cost of borrowing at its lowest level in over 40 years, why should partners invest more capital in the firm, thereby delaying or reducing personal cash flow?

Nevertheless, even well managed firms are now likely to need more partner-contributed capital than they did just a few years ago. Reasons firms currently need more capital relate to changes in the costs of firm growth, to technology requirements, and to additional cash flow stresses. Let's examine those changes, and then look at some capitalization challenges that are also new.

Organizational Growth Funding

Even in these difficult economic times, successful firms continue to seek growth opportunities, which invariably require capital.

• While firms are embarking on fewer mergers, they continue to seek large acquisitions or large numbers of smaller acquisitions. These expansions typically require substantial cash to fund the ramp-up operations.
• Many firms have reduced their bottom-up growth by limiting recruitment. The expected saving in the capital cost of funding new hires has been offset considerably, however, by the increased compensation of new lawyers and a renewed focus on lateral hiring.
  Not only are these new hires now paid more, but billing for their work must now be more conservative than previously. Clients are increasingly reluctant to 'pay for training young lawyers.'
• Cash requirements for compensating laterals similarly continue to increase. Moreover, most laterals have multiple options to consider, so few firms have the luxury of negotiating back-end loaded compensation arrangements. Instead, laterals are getting compensation arrangements that pay them right away, long before the additional cash flow they help generate is collected by their new firm. As in the case of new hires, the resultant cash flow lag must be covered with working capital.

Technology Funding

Clients increasingly demand the use of advanced technology by outside counsel to create and deliver legal services more efficiently. 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.
• Litigation support systems.

Technology latecomers may find it more burdensome than previously to raise capital for acquiring competitive systems. Banks and other third party lenders now often require personal guarantees or impose restrictive loan covenants that have become difficult to meet. One way or another, this tends to increase the capital commitment required of partners.

Cash Flow Stresses

Firms that keep work-in-process and accounts receivable to a minimum require less working capital from the partners (or the bank) to fund day-to-day operations. Most successful firms continue to work hard 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.

Practice changes can also aggravate cash flow problems. The firm may require additional funds for client advances, eg, if the firm takes on a major piece of litigation. Developing new practice areas can have this effect as well; eg, in a bankruptcy practice, collections will be slower and courts often withhold a reserve.

Some cash-strapped firms have reduced cash distributions to partners or slowed payment of their own trade payables, but the most common method of acquiring working capital and allaying cash flow shortfalls continues to be line-of-credit borrowing.

Given the current economic trends, partners should not get 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 owners of a business.  Instead, they need to formulate an appropriate, flexible capitalization policy for the firm, and then follow it.

Guidelines for Partner Contributions

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

It's important for capital policies to 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 in the firm unattractive for laterals or the firm's own associates.

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.
• 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 firms consider when setting their required levels of capital. For warning signs that not enough capital is being maintained, see the sidebar on page 6.

' Set capital equal to 30 days of operating costs. The theory is that the partners will contribute an amount of cash sufficient to operate the firm for 30 days. Does this mean that the firm will maintain these funds in a separate 'cash reserve'? Practically speaking, no.

' 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 Partner Contributions

Since partners are the ultimate source of a firm's capital, firm leaders need to educate them about capital requirements. They also need to help manage partner expectations regarding capital contributions and distributions, and the risks partners assume as owners of the business.

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.

Bank Funding

With or without a formal capital plan, most firms use several types of bank funding concurrently to fulfill working and long-term capital needs. Due to changed business conditions, accessing each of these capital sources is getting more challenging.

' Using Lines of Credit to Aid Cash Flow. With clients taking longer to pay their bills, 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. Also now the norm: 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.

' Bank-Financed Growth. 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.

' Capital Loans to Partners.  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.

' Long Term Debt. 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 banks' newly sophisticated benchmarks for loan monitoring. (See sidebar on page 3).

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.

Firm leaders need to 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, it is crucial to manage partner expectations regarding income distributions.

Howard L. Mudrick, CPA, is the president of HM Solutions in Dallas. He has more than 20 years experience helping law firms with strategic planning, mergers and acquisitions, partner compensation, financial management, firm reorganizations, and general counseling. He can be reached at 972-906-1951.

Gone are the days when banks didn't worry about a law firm defaulting on a loan. If your firm seeks bank funding for a long-term capital investment or establishing a line of credit, you can now expect the bank to screen the firm closely ' not to say intrusively. Moreover, the bank will likely continue to monitor the firm's ongoing ability to repay the loan.

Screening of Financials

Banks now carefully examine reams of data from their law firm clients!

• At a minimum, banks examine income statements and balance sheets, typically for a three-year period.
• Often they will prepare cash flow statements to better understand how the firm uses its cash.
• They will quite likely compare your firm's key ratios to other firms in the profession. These ratios could include revenue per lawyer, expense per lawyer, net income per partner, and debt and capital per partner.
• They especially look at whether distributions exceed net income, ie, whether the firm has a history of borrowing money to make partner distributions.

Screening of Market Position and Management

In addition to purely financial analysis, lenders often attempt to evaluate the risk of lending money to a firm by assessing the firm's market position and internal management. For example, lenders may:

• Examine what kinds of clients the firm services.
• Assess the firm's reputation.
• Determine whether there is an unusual concentration of clients in a particular industry.
• Evaluate whether there is a concentration of lawyers in a single practice area.
• Measure whether the firm is overly dependent on a few clients (or even a few rainmakers) for business.

Lenders may also review:

• Quality of firm management.
• Cohesion of the partners.
• Demographics of the partnership.
• Trends and projections in partner growth.
• Billing and write-off policies and history.
• Controls on client acceptance or intake.
• Contingency work.
• Quality assurance, including malpractice history.
• Firm financial commitments, including office leases, equipment leases, and amounts due former or retired partners.

Obviously this is a very subjective analysis. But these are all genuinely important questions regarding a firm's financial health ' questions that some firms never ask themselves. Firms are well advised to consider these questions before the bank does.

Ongoing Monitoring

More sophisticated lenders will (and should) prepare projections to get some sense of the firm's ability to repay debt. Lenders are more closely monitoring firm finances to ensure firm compliance with covenants. They are better attuned to firm performance and departures that may raise red flags. Increasingly, lenders are performing monthly and quarterly checkups and comparisons of:

• The value of hours worked.
• Trends in firm inventory, including amounts billed, fees collected and write-offs.
• Cash flow and net income versus budget.
• Cash distributions to partners versus budget.

In the current business climate, a firm can be undercapitalized even if it has already cut back on growth plans, has already made necessary investments in technology, and already actively manages its billing-collection cycle. Here are the most common signs that partner capital contributions may be inadequate:

• The firm overly relies on the bank to fund cash flow. A likely example is a firm that consistently borrows from its line of credit, month after month, to get by. Even more telling is a firm's inability to fully pay off its short-term line of credit at the end of the year, especially if that pattern persists.
• The firm has increasing inventories of work-in-process and accounts receivable without a corresponding increase in collections over the long term.
• The firm has increasing levels of accounts payable that are going unpaid beyond the normal period. (Partners should pay closer attention to whether their firm is deferring accounts payable in order to pay the partners.)
• The firm is unable to pay partner draws or salaries on a regular or timely basis.
• The firm's total expenses are increasing at a rate greater than revenue is increasing. This is common in firms that are adding partners who are unable to generate sufficient dollars to justify their own compensation.