Many law firms struggle with determining and maintaining an adequate level of capital, or available financial resources, to support their daily operations. The nature of law firm billing, collections and expenses can create gaps in cash flow that capital must fill, so it is not surprising that firms increasingly are requiring larger capital contributions from partners. Your firm will find it easier to justify these demands if it has a formal capital plan in place.
Most firms are facing unprecedented financial pressure from, for example:
- Payable/Receipt Imbalances. Client payments slowed during the recent recession, and, even though the economy is on the upswing, it is still not unusual for clients to drag their feet when settling bills. Outside vendors, on the other hand, always expect prompt payment. Your firm might not even have a chance to invoice a client before vendors demand payment.
- Need to Expand. Another financial demand on growing firms involves hiring associates and lateral hires. Even lateral hires who bring clients with them usually receive several paychecks and incur overhead costs before those clients start generating (and paying) additional revenues.
- Fronting Expenses. Your firm may have to provide client cost advances during lengthy litigation.
- Technology Demands. Today's attorneys expect to work with sophisticated hardware and software, and clients expect their attorneys to leverage technology to provide efficient, cost-effective services. Keeping up with rapidly changing technology — and technologically up-to-date competitors — can be expensive.
- Retiring Partners. As Baby Boomers approach retirement age, some firms have more partners leaving to retire than young partners buying in.
All of these pressures can be alleviated with adequate capital reserves. When revenues fall short, your firm can tap its capital to bridge the gaps. That is where a capital plan comes in.
Your plan should address its capital needs for the next three to five years. To quantify those needs, consider your average revenue cycle, any anticipated capital investments (for example, technology or physical space), operating expenses, estimated client disbursements and perhaps partner draws (although it is usually best to defer draws rather than paying them out of capital). If applicable, your firm should take into account any payment obligations to retired partners.
Once you have calculated your capital needs, you have four basic options for determining the specific amount of capital your firm needs to keep on hand. You might base capital needs on one or more of the following:
- Monthly Expenses (Not Including Partner Draws). If your firm has a strong cash flow (meaning prompt collections), you might set capital at one to two months. If you have a slower turnaround, you may need to use three to six months as the measure.
- Fixed Percentage of Gross Fee Collections. When setting the percentage, assess the timeliness of your collections and plans regarding hiring and space. Most firms set the percentage close to 10%.
- Long-Term Debt. Putting aside capital equal to half of your firm's long-term debt provides lenders with some comfort. And reassuring lenders is especially important these days because they have become much less accommodating about extending credit to law firms than they have been in the past.
- Net Fixed Assets. Using this method assumes that your firm has secured outside loans to finance fixed assets, and that your partners will fund working capital in an equal amount.
When you have settled on the appropriate capital level, you must then decide on the proper breakdown between partner contributions and lines of credit. This decision should take into account your firm's and individual partners' tolerance for debt. The higher the debt tolerance, the greater you can rely on credit lines over contributions, and vice versa.
Capital plan development is not a one-time exercise. You should consider your firm's plan to be a "living document" that requires regular review in light of your firm's current strategic and financial needs. Adjustments should be made as needed and clearly communicated to your firm's partners and other stakeholders.
Sidebar: Can't We Use Our Line of Credit?
When faced with requests for greater capital contributions, some reluctant partners might suggest instead turning to your firm's bank lines of credit. Many firms do indeed use their credit lines in lieu of, or at least to supplement, partner contributions.
In general, though, partner contributions are preferred because such investments tie partners to your firm and make them more committed to its long-term success. Lines of credit are better used for filling short-term gaps related to late receivables and work-in-process. They are a particularly poor choice for financing long-term assets like computer systems. Indeed, term loans are more suitable for such investments.
Your partners should also consider potential personal liability associated with wielding a line of credit. Credit lines typically are subject to joint and several liability, putting all of your firm's partners at risk of liability for the entire amount owed in the event of default.
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.