Canada: When Opportunity Knocks, Can Your Firm Afford It?

Consider one of the following scenarios: Your firm's leadership wants to become the employer of choice for young professionals — and this includes a workplace that appeals to them — calling for significant leasehold improvements.

Your firm would like to bring on new partners while ensuring that their capital investment in the firm does not impose a burden to their financial stability.

There's been a gap in your firm's service lineup, compromising its "one-stop-shop" image.

You've learned of a boutique firm that's for sale, that fits into that gap perfectly — and you want to be sure your bid is competitive.

What do all these scenarios have in common? A need for access to capital. However, many firms would not be in position to deal effectively with developments such as these. This means that they may be outgunned by competing firms that do have an effective capital strategy.

Being effective regarding capital starts with the metrics the firm probably already tracks, such as billable hours, average hourly rate and utilization. However, many firms do not take the next step, which is getting an accurate idea of their financial performance. This includes return on capital employed (ROCE), which measures net profit that is generated against the level of partner funding or capital held in the practice.

A recent legal benchmarking report by Collins Barrow's U.K. colleagues found that ROCE differs dramatically, with the larger firms having significantly better ratios than the smaller firms. The report concludes this is generally because the larger firms can attract partners who are already established and can bring investment capital into the firm, so that the firm does not have to rely just on its own capital.

Greater need for capital

Research by Collins Barrow Toronto has found that today's mid-market law firms need a higher level of capitalization than in the past due to higher operating expenses, or a higher need for capital investments to generate future earnings. As a result, all of the firm's partners need a clear understanding about the need to watch the firm's ROCE as much as they do their own billable hours and understand the nature of capital and need for a solid capitalization strategy.

This is not a smoothly functioning world. Clients default, they pay late, they dispute invoices. Unexpected expenses — like the need for a new IT network — ensue. Opportunities occur as well, such as the chance to move into better offices or make a strategic acquisition to round out the firm's service offering, resulting in moving expenses and leasehold improvement costs. Good capital planning ensures that the financial strength is available to deal with problems and to jump on opportunities, without reducing the firm's ROCE.

Law firms' capital mix includes undistributed earnings, capital contributions, bank borrowings and partner loans and depends on factors such as the collective risk profile of the partners.

Consider your borrowing options

In some cases, the firm can borrow at a more favourable interest rate than the individual partners can, so firm debt may be better than partner capital/loans. Some firms pay interest on partner capital, and others do not.

Adapt

Adapt your strategy depending on economic climate. Firms are advised to reduce their financial risk in tough economic climates with a more conservative capitalization policy, so that permanent capital — money invested in furniture, computer networks and other hard assets — is funded by long-term sources (long-term bank debt and partner loans). In contrast, working capital — money used to fund operations until fees and disbursements are collected — is funded by a mix of short-term bank borrowings and undistributed earnings.

Skin in the game

Give your partners some. Experience working with law firms has found that one advantage to partner loans is that partners feel more committed to the firm. It is "their" firm, and this means they tend to consider the firm's interests rather than just their own. It keeps in check any risky behaviour that might expose the firm to the threat of financial loss or loss of reputation. It also increases their feeling of investment into the firm's overall objectives — such as doing all they can to support the firm's strategic goals.

Money worries

Don't let money worries stop new partners from joining your firm. One of the financing issues facing law firms involves making sure that the firm has the right leadership in place, in part through making sure that the right people are able to become partners. For many lawyers, becoming a partner is a huge career milestone — it announces that they've "arrived" with regards to professional recognition and acclaim. Unlike some career milestones, "making partner" arrives relatively early in a lawyer's career. It comes at a time when they are just becoming established in their personal life, maybe with hefty mortgage payments, possibly with a young family, too. So, potential partners may be concerned about how to come up with a partner loan.

It's becoming clear that Canadian law firms can succeed better if they continue to adapt to changes in the legal marketplace and have a tight focus for their strategy. Part of success comes from having access to the capital resources to seize opportunities when they come along, and to weather difficult times as well.

Just as individuals and organizations look to law firms for their expertise on resolving legal issues, law firms can benefit from looking to professional expertise to ensure they have a capital strategy that meets their needs and culture. It helps to find external advisers whose advice is based on working with a wide range of law firms, to see what works under which circumstances.

This article originally appeared on The Lawyer's Daily website published by LexisNexis Canada Inc.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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