Law Firm Capital

A strong balance sheet enables firms to take advantage of the marketplace by adding key laterals and implementing strategies, including new offices and practice areas. It also places the firm in a better position to negotiate loan terms.

Capital should be of sufficient size to accommodate investments in lawyer growth, technology, equipment, leasehold improvements, one to three months of operating expenses, debt service, client costs advanced, and other areas such as the return of capital to former partners.

The preceding paragraph lends itself to some common benchmarks for establishing a capital base that include, but are not limited to: 1) capital should equal from one to three months of operating expenses; 2) plus amounts necessary to fund capital outlays less bank financing; 3) plus amounts to fund client costs; 4) equal to or greater than long-term debt. However, each firm must review its own unique needs and situation.

Incorporating Strategic Initiatives

A firm's strategy often includes growth, which in turn means more attorneys, more infrastructure costs and possibly more offices.

While such moves are expected to pay for themselves in the long run, the startup costs of adding a group of laterals or opening a new office can be significant. Laterals joining the firm rarely bring their work-in-process and accounts receivable with them, so the acquiring firm needs to finance the group's operations for some time ' typically from three to five months.

Consequently, a firm's capital plan should consider the firm's strategic growth initiatives. In the case of a lateral expansion, many firms use bank financing to pay for any additional infrastructure, such as furniture and equipment. This is consistent with the use of debt to fund ongoing operations and is not inappropriate. Some firms will also use bank financing to fund the startup costs for the new group. This can cause problems because it represents the financing of ongoing operating costs. While incurring a small amount of short-term debt to pay the startup costs may be acceptable in certain instances, financially stronger firms use existing capital to fund these costs.

For example, what if your firm attracted six lawyers from a competing firm and started an office in a new location? Further, assuming three staff and 5,000 square feet of office space, it is not inconceivable that the firm would need to absorb costs totaling between $500,000 and $700,000 before the firm would start receiving revenue from services rendered during the preceding months. A number of similar acquisitions would place a severe strain on capital.

What-If Scenarios

From a historical perspective, too many firms established capital targets that focused solely on expected operations and failed to adequately plan for unexpected cash needs. The nature of these unanticipated events can range from the loss of a key client to the departure of a group of lawyers, even to weathering a recession (as we have seen).

In each instance, much can be said for maintaining a capital cushion to help the firm get past the difficulty. Take the loss of the key client, for example, which can have significant ramifications on the firm's operations. While collections from the client will not dry up immediately, the firm needs to be prepared for reduced revenue in the future.

In such a scenario, the firm's ongoing operating expenses are not likely to shrink as much as the reduction in revenue. To ensure that the firm continues to meet its financial obligations, it can take on bank debt or, it is hoped, fall back on a strong capital position.

Those firms that lose a major client and then take on bank debt to prop up operations are truly taking a gamble that they will be able to regenerate their business before the loan obligation is due.

The firm would be in a far-better position if it had adequate capital to weather the storm and then, if business did not pick up, consider other alternatives free of unplanned bank debt.

Leasehold Improvements

Often firms will overlook the unamortized portion of leasehold improvements and its impact on capital. Many firms may find that they have an overstatement of assets pertaining to the net book value of the firm's leasehold improvements. This situation arises when firms chose to amortize these improvements over the statutory tax life of the asset versus the life of the lease.

The problem with amortizing leaseholds over the tax life comes on two fronts: 1) partners who leave the firm enjoy a higher return of their capital at the expense of current partners; and 2) when the lease expires and the office either closes or is relocated, the firm will recognize a significant write-off on its income statement, thereby reducing net income ' also at the expense of current partners.

For purposes of illustration, let's assume office A has a leasehold improvement of $2 million from a remodel in 2001, and the firm chose the statutory tax life for amortization of 39 years or $51,282 per year. Had the firm amortized the improvements over the life of the lease (excluding other factors) of say, 10 years, annual amortization would have been $200,000 ' an increase of $148,718 per year.

At the expiration of the lease, the firm may be faced with a write-off of $1,487,180 that current partners will have to absorb through their capital accounts. The options for addressing this include increasing the annual expense over the remaining lease term, reasonably assured extensions or somewhere in between. Furthermore, this firm should make adjustments to the capital accounts of partners who leave the firm based on their pro rata share of this adjustment or “true-up.”

Firm Capital Needs and Sources

An analysis of a hypothetical firm's current and future cash needs and estimated sources of funds for the next three years might look something like Table 1, below.

[IMGCAP(1)]

Sources to fund the deficiency set forth in Table 1 include increasing partner capital, increasing long-term debt financing and/or relying on the firm's operating line of credit. Careful management over the firm's inventory of accounts receivable and work-in-process can help alleviate monthly working capital pressure.

However, the scenario does not address or include any ramifications from strategic planning initiatives. See the earlier assumptions regarding the cost of adding a lateral group.

Firm Capital Structure and Policy

Most firms require capital contributions from equity partners in varying amounts with little consideration for capital needs. Furthermore, the capital contributions are accumulated over time with little regard to current needs. Policy should also include a relationship between capital and individual partner income. Good capital policy should recognize the risk and reward characteristics of compensation and capital contributions.

A number of firms that do not require capital from non-equity partners are re-evaluating their policies and in some instances, revising their policies to require capital from non-equity partners.

The timing of partner capital varies in the industry; some firms require an upfront payment, while some allow partners to accumulate their capital account over time ' usually as a percentage of a partner's compensation ranging from 5% to 8%. Asking partners for the funds upfront obviously builds capital more quickly and helps to alleviate the pressure or burden on partners who have been in the firm for many years.

When it's time to return capital when a partner departs, many firms are looking at extending the payment period to better correlate with the time it took the partner to accumulate his or her capital account. This helps to preserve capital and as the baby boomer generation retires, significant obligations will come due. This generation of partners likely own 30% to 40% of a firm's capital.

Funding Mechanisms and Alternatives

• Firms should consider lifting maximum caps and require a higher contribution percentage from higher income partners (recognizing the risk/reward equation). The variable contribution, based upon the percentage of earnings is perceived by partners in most firms to be fair. It is generally assumed that the higher earners utilize more overhead to produce their higher fees and therefore should be obligated to pay more toward their overhead and overall operations.
• Have newly admitted partners contribute the maximum amount within the first year; the firm could arrange a credit facility at the bank that permits partners to take out personal loans to fund their capital requirement.
• Require capital from other partner classifications (income, non-equity, and the like); they should have some “skin” in the game, and we find that 10% to 15% of larger firms require capital contributions from such partners.
• Depending on the firm's debt tolerance, establish a separate line of credit to fund client advances. This strategy would also reduce phantom income since net income formerly used to pay non-deductible client advances could be used to increase partner income.
• Retain a percentage of year-end net income to a new partner equity account labeled Retained Earnings or similar. Ideally, this would be considered permanent “firm” capital and would not be allocated to individual partner capital accounts.
• Implement a special withholding via a capital call at the end of the year. Naturally, this comes at a high tax cost, but most if not all capital plans have a tax cost.
• Continue to rely on bank financing for the firm's short- and long-term needs. This comes with increased scrutiny and monitoring of the firm's financials, market position, and firm management and leadership.
• Retain more capital by extending the period of time for returning capital to departing partners.

Closing Thoughts

Law firms, like their clients, have found that it's challenging to manage long-term capital during these times of economic turbulence. Capital requirements at many firms are increasing despite the financial gains most firms enjoyed up until the recession. The credit crisis fueled more challenges, further exacerbating the problem.

Banks are conducting greater due diligence. Even so-called sophisticated lenders such as Citibank and Bank of America have suffered sizable losses from their law firm lending portfolios (consider the recent failures of Howrey, Yoss, McDonough Holland, Thelen, Heller, Thacher, Wolf Block, and more.)

Developing a capital plan includes an ongoing assessment of the firm's strategic plan and related financial needs. It is not a one-time exercise. Furthermore, firm leaders need to continually educate partners on capital needs. Law firms need strong leadership, management, and financial resources to create a sustainable capital plan.

Stephen M. (Pete) Peterson is the CEO of the accounting and business advisory firm, Maxfield Peterson, and a member of this newsletter's Board of Editors. For more than 20 years, Peterson has advised law firms on strategic planning, M&A, compensation and financial management. He can be reached at pete@maxfieldpe terson.com.

The business world is facing significant economic challenges, and it is not entirely clear when these challenges will subside. Law firms have been reacting to this situation by layoffs, de-equitizing partners, discretionary cost reductions, postponement of associate start dates, and more. Just as important, firms are reassessing their capital needs and structures.

Another challenge facing most firms is the pending retirement of partners from the baby boomer generation. It is estimated that partners in this category represent 40% to 50% of all law firm partners. Furthermore, firms have also increased the barrier for entry to equity partnership, thereby increasing the capital burden that the other equity partners must shoulder.

Firms also rely on additional outside financing, but lenders have been increasing their scrutiny over law firm finances and are reacting by establishing stricter lending standards and loan covenants ' including partner guarantees. These loan covenants place a tighter collar on firms. For example, firms are subject to ongoing screening and monitoring regarding firm finances, partner departures, top clients, practice areas, firm governance, and the like. Not so surprisingly, a number of financial institutions have instructed firms to increase their capital in relation to outstanding debt and working capital needs.

A strong balance sheet enables firms to take advantage of the marketplace by adding key laterals and implementing strategies, including new offices and practice areas. It also places the firm in a better position to negotiate loan terms.

Capital should be of sufficient size to accommodate investments in lawyer growth, technology, equipment, leasehold improvements, one to three months of operating expenses, debt service, client costs advanced, and other areas such as the return of capital to former partners.

The preceding paragraph lends itself to some common benchmarks for establishing a capital base that include, but are not limited to: 1) capital should equal from one to three months of operating expenses; 2) plus amounts necessary to fund capital outlays less bank financing; 3) plus amounts to fund client costs; 4) equal to or greater than long-term debt. However, each firm must review its own unique needs and situation.

Incorporating Strategic Initiatives

A firm's strategy often includes growth, which in turn means more attorneys, more infrastructure costs and possibly more offices.

While such moves are expected to pay for themselves in the long run, the startup costs of adding a group of laterals or opening a new office can be significant. Laterals joining the firm rarely bring their work-in-process and accounts receivable with them, so the acquiring firm needs to finance the group's operations for some time ' typically from three to five months.

Consequently, a firm's capital plan should consider the firm's strategic growth initiatives. In the case of a lateral expansion, many firms use bank financing to pay for any additional infrastructure, such as furniture and equipment. This is consistent with the use of debt to fund ongoing operations and is not inappropriate. Some firms will also use bank financing to fund the startup costs for the new group. This can cause problems because it represents the financing of ongoing operating costs. While incurring a small amount of short-term debt to pay the startup costs may be acceptable in certain instances, financially stronger firms use existing capital to fund these costs.

For example, what if your firm attracted six lawyers from a competing firm and started an office in a new location? Further, assuming three staff and 5,000 square feet of office space, it is not inconceivable that the firm would need to absorb costs totaling between $500,000 and $700,000 before the firm would start receiving revenue from services rendered during the preceding months. A number of similar acquisitions would place a severe strain on capital.

What-If Scenarios

From a historical perspective, too many firms established capital targets that focused solely on expected operations and failed to adequately plan for unexpected cash needs. The nature of these unanticipated events can range from the loss of a key client to the departure of a group of lawyers, even to weathering a recession (as we have seen).

In each instance, much can be said for maintaining a capital cushion to help the firm get past the difficulty. Take the loss of the key client, for example, which can have significant ramifications on the firm's operations. While collections from the client will not dry up immediately, the firm needs to be prepared for reduced revenue in the future.

In such a scenario, the firm's ongoing operating expenses are not likely to shrink as much as the reduction in revenue. To ensure that the firm continues to meet its financial obligations, it can take on bank debt or, it is hoped, fall back on a strong capital position.

Those firms that lose a major client and then take on bank debt to prop up operations are truly taking a gamble that they will be able to regenerate their business before the loan obligation is due.

The firm would be in a far-better position if it had adequate capital to weather the storm and then, if business did not pick up, consider other alternatives free of unplanned bank debt.

Leasehold Improvements

Often firms will overlook the unamortized portion of leasehold improvements and its impact on capital. Many firms may find that they have an overstatement of assets pertaining to the net book value of the firm's leasehold improvements. This situation arises when firms chose to amortize these improvements over the statutory tax life of the asset versus the life of the lease.

The problem with amortizing leaseholds over the tax life comes on two fronts: 1) partners who leave the firm enjoy a higher return of their capital at the expense of current partners; and 2) when the lease expires and the office either closes or is relocated, the firm will recognize a significant write-off on its income statement, thereby reducing net income ' also at the expense of current partners.

For purposes of illustration, let's assume office A has a leasehold improvement of $2 million from a remodel in 2001, and the firm chose the statutory tax life for amortization of 39 years or $51,282 per year. Had the firm amortized the improvements over the life of the lease (excluding other factors) of say, 10 years, annual amortization would have been $200,000 ' an increase of $148,718 per year.

At the expiration of the lease, the firm may be faced with a write-off of $1,487,180 that current partners will have to absorb through their capital accounts. The options for addressing this include increasing the annual expense over the remaining lease term, reasonably assured extensions or somewhere in between. Furthermore, this firm should make adjustments to the capital accounts of partners who leave the firm based on their pro rata share of this adjustment or “true-up.”

Firm Capital Needs and Sources

An analysis of a hypothetical firm's current and future cash needs and estimated sources of funds for the next three years might look something like Table 1, below.

[IMGCAP(1)]

Sources to fund the deficiency set forth in Table 1 include increasing partner capital, increasing long-term debt financing and/or relying on the firm's operating line of credit. Careful management over the firm's inventory of accounts receivable and work-in-process can help alleviate monthly working capital pressure.

However, the scenario does not address or include any ramifications from strategic planning initiatives. See the earlier assumptions regarding the cost of adding a lateral group.

Firm Capital Structure and Policy

Most firms require capital contributions from equity partners in varying amounts with little consideration for capital needs. Furthermore, the capital contributions are accumulated over time with little regard to current needs. Policy should also include a relationship between capital and individual partner income. Good capital policy should recognize the risk and reward characteristics of compensation and capital contributions.

A number of firms that do not require capital from non-equity partners are re-evaluating their policies and in some instances, revising their policies to require capital from non-equity partners.

The timing of partner capital varies in the industry; some firms require an upfront payment, while some allow partners to accumulate their capital account over time ' usually as a percentage of a partner's compensation ranging from 5% to 8%. Asking partners for the funds upfront obviously builds capital more quickly and helps to alleviate the pressure or burden on partners who have been in the firm for many years.

When it's time to return capital when a partner departs, many firms are looking at extending the payment period to better correlate with the time it took the partner to accumulate his or her capital account. This helps to preserve capital and as the baby boomer generation retires, significant obligations will come due. This generation of partners likely own 30% to 40% of a firm's capital.

Funding Mechanisms and Alternatives

• Firms should consider lifting maximum caps and require a higher contribution percentage from higher income partners (recognizing the risk/reward equation). The variable contribution, based upon the percentage of earnings is perceived by partners in most firms to be fair. It is generally assumed that the higher earners utilize more overhead to produce their higher fees and therefore should be obligated to pay more toward their overhead and overall operations.
• Have newly admitted partners contribute the maximum amount within the first year; the firm could arrange a credit facility at the bank that permits partners to take out personal loans to fund their capital requirement.
• Require capital from other partner classifications (income, non-equity, and the like); they should have some “skin” in the game, and we find that 10% to 15% of larger firms require capital contributions from such partners.
• Depending on the firm's debt tolerance, establish a separate line of credit to fund client advances. This strategy would also reduce phantom income since net income formerly used to pay non-deductible client advances could be used to increase partner income.
• Retain a percentage of year-end net income to a new partner equity account labeled Retained Earnings or similar. Ideally, this would be considered permanent “firm” capital and would not be allocated to individual partner capital accounts.
• Implement a special withholding via a capital call at the end of the year. Naturally, this comes at a high tax cost, but most if not all capital plans have a tax cost.
• Continue to rely on bank financing for the firm's short- and long-term needs. This comes with increased scrutiny and monitoring of the firm's financials, market position, and firm management and leadership.
• Retain more capital by extending the period of time for returning capital to departing partners.

Closing Thoughts

Law firms, like their clients, have found that it's challenging to manage long-term capital during these times of economic turbulence. Capital requirements at many firms are increasing despite the financial gains most firms enjoyed up until the recession. The credit crisis fueled more challenges, further exacerbating the problem.

Banks are conducting greater due diligence. Even so-called sophisticated lenders such as Citibank and Bank of America have suffered sizable losses from their law firm lending portfolios (consider the recent failures of Howrey, Yoss, McDonough Holland, Thelen, Heller, Thacher, Wolf Block, and more.)

Developing a capital plan includes an ongoing assessment of the firm's strategic plan and related financial needs. It is not a one-time exercise. Furthermore, firm leaders need to continually educate partners on capital needs. Law firms need strong leadership, management, and financial resources to create a sustainable capital plan.

Stephen M. (Pete) Peterson is the CEO of the accounting and business advisory firm, Maxfield Peterson, and a member of this newsletter's Board of Editors. For more than 20 years, Peterson has advised law firms on strategic planning, M&A, compensation and financial management. He can be reached at pete@maxfieldpe terson.com.