Law Firm Survival: Tough Economic Times Call for Sound Management

Even if firms are on stable financial ground, there's another reason to ensure that their books are in as good as shape as possible and that cash flow is strong: The best time to get or expand your credit with lenders is when you don't need it. Some are predicting a recession that could last 18 months or longer. Given all the vagaries of the market and the industry, law firms should be planning now to lock down access to additional funds at the best rates possible.

Spencer Barback, CPA, a member of this newsletter's Board of Editors, and Rick Hayden, CPA, are partners at accounting firm Citrin Cooperman & Company, LLP (http://www.citrincooperman.com/). Both are members of the firm's professional services practice, providing accounting and business services to law practices and other professional service firms.

Given the economy, discussions among law firm partners have gone from “How do we maximize revenues and profits?” to “How do we survive?” seemingly in just a few short months. Partners, or even groups of partners, may depart from firms with fast-declining revenues; some firms may consider selling or merging; and others may simply dissolve. Some will even file for bankruptcy. While more than one industry report points to tough times ahead, there are steps firms can take ' many in the areas of accounting and financial planning ' to best ensure that they emerge from the current economic slump just as strong as when they entered it.

As businesses and a great many individuals feel the pain of the recent turmoil in the financial markets, the fortunes of law firms have been mixed. Business is picking up at firms with active bankruptcy practices, and angry investors are hiring class-action firms to fight over whatever assets the crisis leaves. Many law firms are retooling because of steep drops in areas such as mergers and acquisitions, litigation, and commercial real estate. Corporate legal departments report reduced spending on outside law firms. Spending is up just 3% in 2008, as compared with 6-7% last year, according to a Hildebrandt International survey in the second half of 2008.

Others are even worse off. Several high-profile firms have closed, and lots of smaller ones dissolved with little fanfare. Many others are moving onto financial thin ice and may be a client or partner defection from dissolution. In “survival mode,” firms are re-evaluating their structure, compensation, and overall organization.

Many of the problems law firms are facing, though, have probably been there for years. The crisis has merely brought to the surface myriad problems that were masked by a strong economy which saw many law firms increase substantially since 9/11 and the dot.com crash in 2001. Now that clients aren't spending as freely, firms may realize they've been running on autopilot for some time, and that they lack direction.

What Causes Law Firms to Falter?

There are several reasons law firms slump. The collapse and dissolution of a firm is usually the result of several debilitating factors conspiring to cause the downward spiral. A single problem in most cases can be identified and fixed rather quickly. When several issues plague a firm, partners often have trouble identifying the most important issues, and even when they do, it's difficult to address all of them at once. While leaks in the proverbial management dam are being plugged on one part of the wall, water ' i.e., cash ' may be flowing out through other unattended leaks.

Firms, in fine financial shape one day, may face major problems the next with the loss of one of their larger clients. This is especially true if a client represents an inordinate amount of the firm's billings. Another fast-track path to instability is the defection of a group of attorneys to another firm. Even if the clients that leave with them aren't large, the sheer volume of work lost can strain a firm's financial viability.

While financial problems may seem to come on suddenly, typically no single incident causes the collapse of a healthy firm. Take the loss of one big client for example. While that is a sudden event, the firm's downfall began with its inability to bring in additional clients to offset the risk of one client dominating revenues. Take the defection of several partners at once, especially if they leave with a number of accounts. This firm's downfall here may have begun with a faulty compensation structure or general mismanagement that caused these partners to consider departing in the first place.

Firms can wither more slowly through mismanagement, which may include runaway expenses, inflated salaries, overstaffing, and a lack of performance parameters for billing attorneys. In this scenario, revenues may increase year over year, but expenses and overhead increase even more, so profitability (the real number to be tracked) suffers.

Firms can also get into trouble when making investments that aren't as successful as planned. Investments may be made, for example, when a firm wants to expand a specific practice, and hires several attorneys, only to find that business has dried up, or that this new practice isn't marketed properly in order to succeed. Sometimes this investment is made in office space and equipment. Upgrading the entire office's computers and the network in one fell swoop can be costly, as can the sudden purchase of mahogany desks and ergonomic chairs for all associates and partners. Some of the investments provided here as examples were probably ill-advised; others were well-intentioned business decisions that just didn't work out.

Firms, even in good times, can buy into the notion that profits will only grow, and while it's great to have a positive attitude about the future, it needs to be tempered with realism, and some financial risk management. We recommend that the decision to take on debt only be made after serious consideration. Firms not only need a plan to make loan payments, but also a rock-solid idea of the return on investment, or how much profit the loan will net the firm in the next 12, 24, or 36 months.

If one could say that there's a silver lining to the current economic slump, it's that a slow economy has caused firms to re-examine their operations. That includes staffing, expenses, compensation and performance monitoring, as well as billing and collections.

Compensation/Monitoring Individuals' Performance

At one small law firm in the New York City area, an accounting professional recently related how the founding partner has only recently made an effort to understand other attorneys' contributions to the bottom line, and has finally begun looking at each partner as a “profit center.” Odds are that this founding partner will find out that at least some of his billing attorneys are not pulling their weight. It's only natural in a good economy to be somewhat overstaffed and to operate at least a little inefficiently. Cardinal rule of law firm survival: Know the profitability of each partner and associate. Although it sounds obvious, during good times, many firms may have tracked partners' performance in a loose and inaccurate way by merely tracking hours and/or the size of accounts they serviced. In both strong and weak markets, the monitoring of performance must include tracking hours, realization figures, and collection figures for each attorney.

Risk Management and Business Continuity Planning

It goes by many names: Risk management, disaster planning, and business continuity are a few of them. Managing partners or the executive committee at every law firm need to analyze the firms' risks and take proper steps to either eliminate, if possible, or mitigate their effects. And we're not talking about acts of nature here such as hurricanes and floods, but rather self-inflicted disasters. Too much reliance on one practice area for revenues creates a risk that key members of that practice, feeling undercompensated and underappreciated, might up and leave. If a firm's real estate practice is driving a lion's share of the revenue, take steps to compensate the group properly while also diversifying and growing other areas of the law firm.

Likewise, an over-reliance on one client's billing creates a risk to the firm's overall revenues. We believe firms should try to ensure that no client represents more the 5-7% of their revenue. They should continually strengthen the relationship with this client, while also striving to bring in additional business to lower its percentage of overall revenue. If all else fails, the firm needs to have considered staffing options, layoffs, and reorganizations if the large client were to depart.

Multi-partner defections create a risk when clients associate a firm only with one partner who controls all aspects of an account. It's in firms' best interest to show their clients a “team” of attorneys which has the ability to provide quality service. Additionally, firms should be cross-selling additional services into each client, especially the larger ones, as a way of spreading revenues throughout practice groups. If not, those clients may leave with the lead attorney.

Partners and associates depart in some cases for more autonomy or flexibility, but never underestimate the importance of compensation. It goes back to knowing which partners and associates are most profitable to the firm and compensating them accordingly to retain them.

Creating a 'Rainy Day' Fund

Many years ago, a book landed on The New York Times Best Seller list with the title, “Everything I Needed to Know, I Learned in Kindergarten.” The book contained one lesson often learned with the receipt of a first allowance: “Save your money for a rainy day.” Many law firms today wouldn't be fretting about the next 12-18 months if they had heeded this relatively simple advice.

Profits placed into this “rainy day” fund will be taxed, but the additional costs are well worth it, knowing that the firm has capital available in case of an emergency or downturn.

Like individuals trying to grow a savings account, it's never too late to start. Treat contributions to this account like any other monthly expense that needs to be paid. If times are truly tough, a firm's leadership may ask partners to roll back some of their compensation to ensure the firm's future success.

Strong Management; Future Communicated

Like in just about any business in any industry, leadership quality varies from firm to firm. Inconsistent leadership leads to partner defections and to a lack of consistent service across a firm. While an increasing number of law firms, large and small, have flat growth, that's not the problem. The real issue is the lack of a plan for growth or direction forward. If none exists, partners and associates will leave for firms where futures are better defined.

If they haven't done so already, firms may want to consider the value of a non-lawyer executive. This may mean granting partner status to a non-attorney or merely elevating the influence and responsibilities of the chief financial officer to ensure that he or she has a voice at the executive management table. A strong business and financial professional can bring management and financial controls, and expertise, that may be lacking among senior partners.

Your firm has a CFO? Here's a little test: Is your CFO empowered to demand prompt billing, substantial realization, or timely collections? If any of the answers were no, your firm doesn't have a strong financial leader.

Adopt an Accounting Mindset

A strong financial presence within a law firm will help with the adoption of an accounting mindset that's needed to navigate tough economic times. It's not that managing partners and executive committee members are incapable; we've worked with many law firms where the founding partner could go toe-to-toe with most CPAs. A strong CFO or financial professional isn't worried about keeping up with case law. The CFO's number one mission is to monitor the firm's economic performance and to provide financial input into any long-range planning and direction the firm should take.

This professional will also make sure that budgets are set and reviewed vs. expenses and revenues on a monthly basis; that systems for tracking billable hours are in place and implemented; that invoices are handled in a timely manner and, perhaps most importantly, that fees are collected. Senior partners have their ideas of where they want the firm to be in five to 10 years, and may have thoughts on how to do it, but it's the financial professional who provides the guidance on what it will take from a cost perspective.

A strong CFO should also be providing input into compensation issues, especially at a time when instabilities in the market may call for changes in compensation levels, and billing levels.

Different Sizes, Different Problems, Different Solutions

Problems such as mismanagement, faulty forecasting, partner defections, and a lack of direction can befall law firms of any size. In general, though, we see larger firms being hit harder by the economic slump because of higher expenses, such as associates' salaries and office space. Smaller firms have somewhat unique challenges as well. The one issue many of them face is cash flow, as they tend to have a more difficult time collecting fees from clients in a timely manner.

Smaller firms have different options as well. Because of their size and relatively simple structure, they are easier to “sell off” or wind down. A founding partner can announce intentions to dissolve a firm and seek out safe landings for his billing attorneys at other local or competing firms while moving onto an “of counsel” position with a larger law firm.

Raise Rates to Get in Line with Industry Standards

A combination of marketing and accounting advice here: It's never a great idea to position and market yourself based on price. A successful campaign that positions a firm as a cost-effective alternative will only handcuff it from raising rates accordingly in the future. And as energy, rents, and the price of just about everything else have increased, law firms will find their profits squeezed if they are unable to raise their fees.

If your firm has not raised rates in some time, the current economic climate may not be the best time. If you must raise them, we recommend that key partners communicate the fee increases to their clients several months in advance.

Good Financial Positioning Creates Merger Opportunities, Lifelines

For a struggling law firm, a merger may be the most attractive lifeline. Well-capitalized firms will likely be on the lookout for firms as a way to grow market share through acquisition. So for lagging firms, this means taking the right steps so that they look as attractive as possible to potential suitors. Firms that are “reclamation projects” don't stand a chance in this economy. Not even the healthiest of firms wants to risk being dragged down to rescue a sinking ship.

Even if firms are on stable financial ground, there's another reason to ensure that their books are in as good as shape as possible and that cash flow is strong: The best time to get or expand your credit with lenders is when you don't need it. Some are predicting a recession that could last 18 months or longer. Given all the vagaries of the market and the industry, law firms should be planning now to lock down access to additional funds at the best rates possible.

Spencer Barback, CPA, a member of this newsletter's Board of Editors, and Rick Hayden, CPA, are partners at accounting firm Citrin Cooperman & Company, LLP (http://www.citrincooperman.com/). Both are members of the firm's professional services practice, providing accounting and business services to law practices and other professional service firms.