Working Capital Issues for the Law Firm

Part One of a Two-Part Series

Working capital is about cash flow and the cash needs of your law firm. Simply put, it is the cash gap between when your firm pays for something and when the firm receives payment from the client. Ideally, a firm would receive client payment before incurring the costs, creating a negative cash gap situation. At one time Amazon.com worked on a negative cash gap process ' Amazon.com was paid by the consumer, by way of a credit card charge, before it had to pay its vendors for the purchased product and shipping. The law firm equivalent of a negative cash gap is retainers. 'Retail' law firms could also exploit the credit card mechanism exploited by Amazon.com.

Typically, the cash gap for law firm payables and receivables runs about 105 days. Unbilled time turns over in 60-70 days. Accounts receivable turn over in 60-80 days. Accounts payable generally run on a 30-day cycle. With labor costs being the single largest overhead item for law firms (usually paid bi-weekly or semi-monthly), the financial burden is aggravated because labor's cash gap is closer to 120 days on average.

Client Costs Advanced

Client costs advanced are essentially interest-free loans to clients that require working firm capital to fund. While some firms expense these advances and reflect the reimbursement as income, this is not the method the IRS generally sanctions. In most instances, law firms record the advances as assets, and record reimbursements as payments on those receivables. The only tax deduction occurs when an advance is deemed uncollectible and written off.

In most general-practice firms, this investment is between $18,000 to $22,000 per partner. A plaintiff-contingent litigation practice averages nearly five times that, at $94,000 per partner. Even higher are the intellectual property practices where client costs advanced are averaging $166,000 per partner, or over eight times the average firm. This is a significant capital investment that is permanent and growing. And these figures do not include the investment portion floated by the vendors in the payment terms they grant the law firm.

Retainers and direct billing to clients by vendors are two common alternatives to the firms needing to raise the necessary capital to fund their cash gap. Some firms finance their client costs, then back-charge the clients for interest costs on that debt. Software programs track client advances, allocate interest based on actual client responsibility for the debt, and reconcile client back-charges to actual interest paid by the firm.

Yet, none of these three alternatives are widely utilized by most firms in the profession, as evidenced by the ongoing significant investments law firms continue to make. A competitive legal market and client reluctance are likely reasons for the slow acceptance for these measures.

Growth

The capital drain of a growing business is a critical issue to understand. It is possible to grow a business so rapidly that you literally grow a profitable business into bankruptcy. Growth requires access to capital to fund investment. Remember that for most law firms, revenues trail the costs to produce them. Growth of a law firm's business also grows its working capital needs. Too rapid growth could over-commit a firm's capital resources (i.e., the firm lacks the cash on hand to pay bills).

Consider what happens when a firm adds a new associate:

• Day one: Associate begins work ' it is hoped, billable work.
• End of second week: Associate receives first paycheck.
• End of first month: Associate's second paycheck is issued; firm pays the computer vendor for the new laptop, smart phone, and other start-up accessories ordered for associate.
• Beginning of second month: Associate's benefits begin.
• Second week of second month: Third paycheck is issued; pre-bills are submitted to accounting.
• End of second month: Fourth paycheck is issued; initial bill is mailed to the client.
• Two or more months later: Client pays first bill; four more paychecks and two months of benefits have been paid.

Add in the partial cost of general overhead increases for that timeframe, and the firm experiences a sizable financial outflow before it sees any receipts.

Now let's consider the increased use of lateral hires and its affect on working capital. No longer are the least expensive lawyers being funded at startup. Now, much more expensive labor must be covered. However, the more experienced lateral is up and billing faster than the law school graduate, at a higher billing rate, and with fewer write-offs. So, while the average law school graduate may require an initial investment of approximately $92,000, the more seasoned four-year lateral associate only requires an $82,000 initial investment. Payback (breakeven cumulative cash flow) is also faster for lateral hires, at about halfway through their third year with the firm. New law school graduates may not reach payback until early in their fifth year with the firm.

Next month's installment will address retirement and risk tolerance.

James D. Cotterman is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia, the editor of Compensation Plans for Law Firms, and a longtime Board of Editors member of A&FP. He may be contacted in his Florida office at 407-381-2426 or by e-mail at [email protected]. Copyright ' 2007, Altman Weil, Inc., Newtown Square, PA, USA

Part One of a Two-Part Series

Working capital is about cash flow and the cash needs of your law firm. Simply put, it is the cash gap between when your firm pays for something and when the firm receives payment from the client. Ideally, a firm would receive client payment before incurring the costs, creating a negative cash gap situation. At one time Amazon.com worked on a negative cash gap process ' Amazon.com was paid by the consumer, by way of a credit card charge, before it had to pay its vendors for the purchased product and shipping. The law firm equivalent of a negative cash gap is retainers. 'Retail' law firms could also exploit the credit card mechanism exploited by Amazon.com.

Typically, the cash gap for law firm payables and receivables runs about 105 days. Unbilled time turns over in 60-70 days. Accounts receivable turn over in 60-80 days. Accounts payable generally run on a 30-day cycle. With labor costs being the single largest overhead item for law firms (usually paid bi-weekly or semi-monthly), the financial burden is aggravated because labor's cash gap is closer to 120 days on average.

Client Costs Advanced

Client costs advanced are essentially interest-free loans to clients that require working firm capital to fund. While some firms expense these advances and reflect the reimbursement as income, this is not the method the IRS generally sanctions. In most instances, law firms record the advances as assets, and record reimbursements as payments on those receivables. The only tax deduction occurs when an advance is deemed uncollectible and written off.

In most general-practice firms, this investment is between $18,000 to $22,000 per partner. A plaintiff-contingent litigation practice averages nearly five times that, at $94,000 per partner. Even higher are the intellectual property practices where client costs advanced are averaging $166,000 per partner, or over eight times the average firm. This is a significant capital investment that is permanent and growing. And these figures do not include the investment portion floated by the vendors in the payment terms they grant the law firm.

Retainers and direct billing to clients by vendors are two common alternatives to the firms needing to raise the necessary capital to fund their cash gap. Some firms finance their client costs, then back-charge the clients for interest costs on that debt. Software programs track client advances, allocate interest based on actual client responsibility for the debt, and reconcile client back-charges to actual interest paid by the firm.

Yet, none of these three alternatives are widely utilized by most firms in the profession, as evidenced by the ongoing significant investments law firms continue to make. A competitive legal market and client reluctance are likely reasons for the slow acceptance for these measures.

Growth

The capital drain of a growing business is a critical issue to understand. It is possible to grow a business so rapidly that you literally grow a profitable business into bankruptcy. Growth requires access to capital to fund investment. Remember that for most law firms, revenues trail the costs to produce them. Growth of a law firm's business also grows its working capital needs. Too rapid growth could over-commit a firm's capital resources (i.e., the firm lacks the cash on hand to pay bills).

Consider what happens when a firm adds a new associate:

• Day one: Associate begins work ' it is hoped, billable work.
• End of second week: Associate receives first paycheck.
• End of first month: Associate's second paycheck is issued; firm pays the computer vendor for the new laptop, smart phone, and other start-up accessories ordered for associate.
• Beginning of second month: Associate's benefits begin.
• Second week of second month: Third paycheck is issued; pre-bills are submitted to accounting.
• End of second month: Fourth paycheck is issued; initial bill is mailed to the client.
• Two or more months later: Client pays first bill; four more paychecks and two months of benefits have been paid.

Add in the partial cost of general overhead increases for that timeframe, and the firm experiences a sizable financial outflow before it sees any receipts.

Now let's consider the increased use of lateral hires and its affect on working capital. No longer are the least expensive lawyers being funded at startup. Now, much more expensive labor must be covered. However, the more experienced lateral is up and billing faster than the law school graduate, at a higher billing rate, and with fewer write-offs. So, while the average law school graduate may require an initial investment of approximately $92,000, the more seasoned four-year lateral associate only requires an $82,000 initial investment. Payback (breakeven cumulative cash flow) is also faster for lateral hires, at about halfway through their third year with the firm. New law school graduates may not reach payback until early in their fifth year with the firm.

Next month's installment will address retirement and risk tolerance.

James D. Cotterman is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia, the editor of Compensation Plans for Law Firms, and a longtime Board of Editors member of A&FP. He may be contacted in his Florida office at 407-381-2426 or by e-mail at [email protected]. Copyright ' 2007, Altman Weil, Inc., Newtown Square, PA, USA