Working Capital Issues for the Law Firm

Part Two of a Two-Part Series

Last month's installment addressed working capital issues including client costs advanced and the capital drain of a growing business. The conclusion of this series discusses retirement and risk tolerance.

Retirement

Changing demographics will begin to present a challenge over the next 10 to 20 years for established law firms. Until now, law firm ownership ranks have experienced relatively steady growth. Capital has been accumulated faster than it has been returned to departing owners. And, like Social Security in its early days, the leverage of those adding capital to those taking capital out (in Social Security terms the ratio of employees to retirees) was large, resulting in a modest 'tax.' But once the boomer generation begins to retire, that could significantly change. Law firms may find themselves returning capital to retiring owners faster than new and remaining owners are contributing. And the ratio of contributing owners to retirees is likely to decrease, raising the associated 'tax.' Leaving 3% to 7% of annual earnings in the firm is a prudent way to build a healthy investment mentality. If the liquidity of those investments can be secured, it could provide the reserves required to weather the baby-boomer generation retiree exodus.

Certainly, the move to abandon mandatory retirement age works to mitigate this issue. The likely result is a more spread out departure scenario, easing the burden on new and remaining owners. Opposing are the stricter admission standards that have evolved in recent years. Such standards would normally reduce the opportunity for admission into the ownership ranks. Certainly, this will be something for law firms to begin thinking about; both are important issues for all concerned.

There remains a sizable, unfunded retirement obligation of firms to their soon-to-be retired senior partners. Although vastly reduced and more modest than just two decades ago, it remains a wild card yet untested in large numbers. The benefits paid in an unfunded retirement program are a tax on current income. That tax must be accepted as fair and affordable; otherwise, the current partners could declare the tax null and void. Unsecured promises to pay benefits will not survive the demise of a firm. Such demise can happen by design (partners vote to dissolve) or by default (key partners depart with their clients, leaving a weakened, unsustainable firm behind). Generally, a tax less than 5% of owner compensation is acceptable, under 3% even better. More than 7% is dangerous, and more than 10% probably unsustainable.

Risk Tolerance

Tolerance for risk varies among law partners and, accordingly, among law firms. There are the ultra conservatives who shun debt, live on a fraction of their income, maintain a year of cash flow in liquid assets, and manage a diverse investment portfolio. Then there are the highly leveraged who borrow heavily and live from paycheck to paycheck with little or no emergency cash or savings. Law partners, even those with high incomes, have varied financial personalities anywhere between the extremes.

The collective financial personalities of the partners of a firm are reflected in the partnership's overall financial management style. On one side are the firms that carry no debt (including minimal accounts payable balances) ' financing all fixed assets out of current cash flow and maintaining three months of operating expenses in cash reserves at year-end. In these firms, the partners take out 90% of their earnings each year (which are paid out before year-end). They have lines of credit so little used that their banks implore them to draw down, even if they pay it all back two weeks later, just to show activity on the account. On the other end of the range is the law firm with little cash, accounts payable at least 90 days old, a line of credit usually at its limit, even at year-end, and debt so high that the banks are constantly pressuring about covenants. In these firms, last year's profits are barely paid out by Labor Day of the following year, and to top it off, they are so pressured to meet certain targets that last year's books are left open, possibly as late as February.

Most firms lie somewhere in between the two extremes, as do most individuals. The important point is that some individuals and some law firms have higher tolerance for debt than others. The ideal capital structure needs to accommodate the collective philosophy of its owners, and use a prudent financial-management style, within the comfort level of the partners, that will ensure long-term firm survival.

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 [email protected]. Copyright ' 2007, Altman Weil, Inc., Newtown Square, PA, USA

Part Two of a Two-Part Series

Last month's installment addressed working capital issues including client costs advanced and the capital drain of a growing business. The conclusion of this series discusses retirement and risk tolerance.

Retirement

Changing demographics will begin to present a challenge over the next 10 to 20 years for established law firms. Until now, law firm ownership ranks have experienced relatively steady growth. Capital has been accumulated faster than it has been returned to departing owners. And, like Social Security in its early days, the leverage of those adding capital to those taking capital out (in Social Security terms the ratio of employees to retirees) was large, resulting in a modest 'tax.' But once the boomer generation begins to retire, that could significantly change. Law firms may find themselves returning capital to retiring owners faster than new and remaining owners are contributing. And the ratio of contributing owners to retirees is likely to decrease, raising the associated 'tax.' Leaving 3% to 7% of annual earnings in the firm is a prudent way to build a healthy investment mentality. If the liquidity of those investments can be secured, it could provide the reserves required to weather the baby-boomer generation retiree exodus.

Certainly, the move to abandon mandatory retirement age works to mitigate this issue. The likely result is a more spread out departure scenario, easing the burden on new and remaining owners. Opposing are the stricter admission standards that have evolved in recent years. Such standards would normally reduce the opportunity for admission into the ownership ranks. Certainly, this will be something for law firms to begin thinking about; both are important issues for all concerned.

There remains a sizable, unfunded retirement obligation of firms to their soon-to-be retired senior partners. Although vastly reduced and more modest than just two decades ago, it remains a wild card yet untested in large numbers. The benefits paid in an unfunded retirement program are a tax on current income. That tax must be accepted as fair and affordable; otherwise, the current partners could declare the tax null and void. Unsecured promises to pay benefits will not survive the demise of a firm. Such demise can happen by design (partners vote to dissolve) or by default (key partners depart with their clients, leaving a weakened, unsustainable firm behind). Generally, a tax less than 5% of owner compensation is acceptable, under 3% even better. More than 7% is dangerous, and more than 10% probably unsustainable.

Risk Tolerance

Tolerance for risk varies among law partners and, accordingly, among law firms. There are the ultra conservatives who shun debt, live on a fraction of their income, maintain a year of cash flow in liquid assets, and manage a diverse investment portfolio. Then there are the highly leveraged who borrow heavily and live from paycheck to paycheck with little or no emergency cash or savings. Law partners, even those with high incomes, have varied financial personalities anywhere between the extremes.

The collective financial personalities of the partners of a firm are reflected in the partnership's overall financial management style. On one side are the firms that carry no debt (including minimal accounts payable balances) ' financing all fixed assets out of current cash flow and maintaining three months of operating expenses in cash reserves at year-end. In these firms, the partners take out 90% of their earnings each year (which are paid out before year-end). They have lines of credit so little used that their banks implore them to draw down, even if they pay it all back two weeks later, just to show activity on the account. On the other end of the range is the law firm with little cash, accounts payable at least 90 days old, a line of credit usually at its limit, even at year-end, and debt so high that the banks are constantly pressuring about covenants. In these firms, last year's profits are barely paid out by Labor Day of the following year, and to top it off, they are so pressured to meet certain targets that last year's books are left open, possibly as late as February.

Most firms lie somewhere in between the two extremes, as do most individuals. The important point is that some individuals and some law firms have higher tolerance for debt than others. The ideal capital structure needs to accommodate the collective philosophy of its owners, and use a prudent financial-management style, within the comfort level of the partners, that will ensure long-term firm survival.

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 [email protected]. Copyright ' 2007, Altman Weil, Inc., Newtown Square, PA, USA